6
Month Market Review
Dell
& Microsoft
Sometimes Things
Change
by Randy Befumo
(TMF [email protected])
"This time, things are different," may be the five most dangerous words for
an investor to use, but "Things will never change" ain't much better.
When DELL COMPUTER <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: DELL)") else Response.Write("(Nasdaq: DELL)") end if %> began the year, its shares were
priced at $51 1/4, the stock had just closed a tremendous year. After bottoming
out in the $11 1/2 in January of 1996, shares had soared 345% from its lows.
As personal computer manufacturers had historically traded at only 11 to
12 times forward earnings, many investors were pretty skittish about Dell
going into the new year.
Although the company had ratcheted up asset turnover, increased return on
invested capital, and was buying back stock like it was going out of style,
the weight of history was against it. The received wisdom of PC stock investing
over the past decade was flashing the "sell" alert, and more than a few astute
investors took advantage of it. "It's a bubble," they muttered. Six months
later, it is hard to definitely say that Dell's 1996 was not a bubble, but
with the stock up another 134% since the year began, we can conclude those
folks selling at the beginning of the year missed the high water mark by
quite a bit.
When investors are told that the main reason that a company's stock is overvalued
is because it is above its historic norms, it is okay to treat this comment
skeptically. Sure, personal computer companies have historically made relatively
low margin devices subject to ruthless price competition and shifts in market
share. However, when Dell Computer decided to improve asset management and
make higher margin devices like servers or workstations, this was a change
in the company's basic business that investors would eventually have to
recognize.
When the actual business changes in some way that will profoundly affect
future cash flows, it is reasonable to conclude that the way investors choose
to value the stock could also change. In Dell's case, its
price/earnings ratio
has expanded to more than 30 as the company has improved its inventory turns
and reduced
days
sales outstanding. When Dell started to convert its sales into cash almost
immediately, it was clear that something had changed.
MICROSOFT <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MSFT)") else Response.Write("(Nasdaq: MSFT)") end if %> also has undergone a significant change in
its basic business since the company first came public in 1986. After 1992's
successful introduction of Windows 3.1, the company came to absolutely dominate
a market that was growing at an exponential rate. If investors had dismissed
the success of Windows 3.1 as a bubble, 1995's introduction of Windows 95
as a product for the mass market might have signaled a shift. The complete
collapse of its main competitor APPLE COMPUTER <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: AAPL)") else Response.Write("(Nasdaq: AAPL)") end if %> around
the same time has given Microsoft more than an 80% market share, even as
it has inked deals with the likes of Digital Equipment and Tandem to put
Windows NT on high-end systems for businesses.
While one might quibble with the current valuation relative to next year's
earnings, the Microsoft franchise is certainly entrenched. With Coca-Cola
trading at 46 times earnings growing at 15% annually, Microsoft trading at
57 times trailing earnings growing at more than twice that rate argues that
on a relative basis, Microsoft could be viewed as more attractive. At $81
5/8 where it began the year, the company was a trading at a more reasonable
35-40 times trailing earnings.
Whereas Coca-Cola has only 48% of the soft drink market, Microsoft has more
than 80% of the operating system market. Whereas Coca-Cola must make all
of the syrup it sells from scratch, Microsoft gets to make its software once
and then sell it many times. As the Internet has allowed the company to provide
products and support at a lower cost, the company now does not report inventories
as a separate current asset because they are so small relative to everything
else.
One can debate ad naseum whether either company deserves its current valuation.
However, in the last year or two when the basic business models of both companies
changed in a positive way, a clear-headed investor not imprisoned by the
tyranny of what has been could have seen that eventually these changes would
result in a change in how the companies are valued. Investors now pay as
much attention to the return on invested capital at Dell as they do to its
earnings growth rate and profit margins. Investors in Microsoft now look
at its robust cash flow devoid of any significant working capital needs as
much as they look at its earnings growth rate. Both of these changes were
telegraphed by a few quarters that showed the change as it happened, giving
the savvy investor plenty of time to act. |