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2/21/2003
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Taking Stock: Dell Succeeds Where Competitors Lag

The PC maker increases gross margins, even in these competitive times

Like most weekend couch potatoes, I can't help but notice the Best Buy and Circuit City ads. All right, I read the ads and throw away the newspaper -- who wouldn't with all the bad news lately? I'm sure more than a few CIOs have noticed how fast the new Pentium 4 PCs are dropping in price. Fully loaded units are going for less than four figures. But despite the great prices, there doesn't seem to be a big push among businesses to replace older desktop units. Low prices aren't the driving force they once were. I'm sure companies such as Dell Computer, Hewlett-Packard, and others would love to know when business demand for PCs will pick up. There once was a time when new applications and ever-evolving operating-system demands required hardware upgrades. Not anymore. It's clear that the new Pentium 4 PCs running at 2 GHz or more with Windows XP are overkill for most available desktop and network applications. In fact, for E-mail, word processing, and spreadsheets -- the primary uses of most business users -- we could go back to the Pentium III without much difficulty.

But at some point, physical wear and tear will require replacement of hardware. Disk drives wear out, memory needs to be expanded, and eventually it will be cost-efficient to replace rather than repair. Because the replacement PC cycle has been deferred by many companies, it's not too surprising to see that Smith Barney estimates that worldwide PC unit shipments will rise 6% in 2003 over last year. More important, it estimates shipments of desktop units will grow 3%, but notebooks will jump 17%.

My initial reaction was that these estimates may be too high in a weak spending environment, but after listening to Dell's earnings call last week, the overall PC demand numbers don't seem that absurd. Dell (DELL -- Nasdaq) reported revenue of $9.7 billion for its fiscal fourth quarter, ended Jan. 31, up 21% year over year and up 6% quarter over quarter. Earnings per share came in at a reasonably solid 23 cents. However, total unit shipments grew by 25% year over year, substantially ahead of the rest of the industry, according to Dell, which saw unit volume growth estimated to be 0% to 1% year over year. The company continues to gain share in most markets. Even within the highly penetrated U.S. market, Dell saw PC retail sales go up 38% year over year.

What amazes me is that Dell can continue to increase gross margins in a tough and competitive environment. It had a gross margin of 18.3% for its fourth quarter (Gateway's comparable gross margin is 12.3%) as it continued to pressure its component suppliers. One way Dell squeezes additional profits from suppliers is to delay paying its bills. In fact, Dell is one of the few companies that has a cash-conversion period of -40 days. It actually ends up receiving the cash from its customers 40 days before it pays its own vendors. The company also is excellent at keeping its operating costs down; operating expenses, including research and development, as a percentage of revenue were 9.9%, less than half of Gateway's 23.6%.

Dell trades at 22.6 times Wall Street analysts' fiscal 2004 estimates of 99 cents per share. Though the company's stock isn't cheap, given its strong competitive position, above-average industry growth trends, and ability to turn over assets quickly, the company is no longer grossly overvalued.

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