Upside to Dell Based on Long-Term Potential of Services & Software

Dell (NASDAQ:DELL) is trading in the $9-$10 range as of early October, down from about $18 in February.  Despite the significant decline in the company’s market price, we have a Trefis price estimate of $19 for Dell.  We believe there is significant long-term upside for Dell as the company’s business continues to shift to services and software.  Below we highlight why Dell’s stock has fallen significantly in 2012 and where we see the potential for upside.

See our full analysis on Dell

Dell Starts 2012 Strong, but Experiences Weakness

Dell started 2012 on a very strong note announcing on February 21 2012, that its previous year consolidated revenue was about $62 billion and cash flow from operations was $5.5 billion, up 39% y-o-y.  The EPS for the year was a record $2.13 and guided that it will be higher this year.  Dell also announced it will continue to focus on services aimed at enterprises stating that  the company is shifting its mix of revenues and margins, and that enterprise solutions and services businesses now account for 30% of its revenue, up from 24% three years ago.  Dell’s stock, which started 2012 at about $15, was now trading at $18 post the guidance release.

Services Growing While PC Loses Ground

Dell’s services business was growing rapidly due to a string of acquisitions, but its PC business has been losing ground to vendors like Lenovo and Acer Group. According to Gartner, Dell, with 12.6% market share, was the third biggest player in the PC market in Q4, 2011 behind HP and Lenovo and by Q2 2012 Acer Group had overtaken Dell, which was knocked to fourth place with 10.7% market share.

Revising Guidance Downward and Big Drop in Stock in May

On May 22 Dell’s stock was down from its $18 highs on news of lost market share and the European crisis.  The stock was trading at $15 when the company announced a lower than expected Q1 FY 2013 results.  For the quarter, revenue was $14.4 billion, down 4% y-o-y and was below the outlook issued by the company.  A slow quarter coupled with falling market share in the PC market sent the stock down to around $12.50 by May 23.

The company kept its acquisition spree going despite slower growth and announced the acquisition of Quest on July 2. Dell’s stock was trading at the $12.50 per share mark when it announced its quarterly results on August 21. This was a second consecutive quarter of slowing growth and the company lowered its outlook for the year by cutting EPS to $1.70, down nearly 20% from the earlier outlook provided. This news sent the stock down to the $10-$11 mark and the stock has been in the range of $9 to $11 since.

Factors That Suggest Dell May Have Significant Upside

1) Dell’s Focus on Services And Software Can Improve Margins

Dell is targeting $5 billion in software sales in coming years and it plans to achieve this by targeting key areas such as network security, cloud storage, systems management, business analytics, virtualization and thin client systems. The company expects security and systems management to be a billion dollar business in the next few years.  Services have higher margins and the associated contracts tend to be sticky and long term.  John Swainson, former chief executive of CA, is heading a newly formed software division and has laid out plans to target mid-sized companies that are under served by rivals such as HP and IBM. ^[1]

Dell is targeting mid-sized companies with 200-2,500 employees, which it feels is an under-served market, and it expects this market to generate $5 billion in sales in the next few years. To scale up quickly and meet demand, it has been using cash generated from its PC business to buy out companies in its areas of interest. It bought SecureWorks and SonicWall for its security business, and acquired Clerity, Wyse, AppAssure, Scalent and Kace for its systems management segment. Its most recent acquisition was the $2.4 billion buy-out of Quest. The company plans to combine hardware and software into pre-configured devices and sell them to mid-sized businesses and support them through its services arm. It also plans to sell Windows 8-based tablets with pre-installed management software to its institutional clients, making the tablets more useful for the customers.

Services and software contribute to nearly 30% to our price estimate for the stock. If software revenue were to reach $5 billion by 2015, as the company expects, we can see upside of nearly 20% to our current price estimate.

2) New Range Of Dell Hardware Will Sustain PC Business

We estimate that Dell’s PC business constitutes 20% of the Trefis price estimate for Dell’s stock.  The company has announced a new range of hardware that includes Ultrabooks, Thin Clients and Storage Products.

The Ultrabook is reviving the margins of the PC business, as it is a high value product, sold at a premium. We estimate that the gross margins for its PC’s are around 20%.  Another potential winner is the open-source Linux based Ultrabook which is aimed at capturing the web and mobile design and programming market share which is dominated by Macbooks.

Dell also released a range Wyse thin-client products by introducing a thin client designed to work on Microsoft’s Windows 8 OS. It will be tuned to work with the touch-based Metro user interface of the OS.  The touch interface is more interactive and intuitive and these thin clients are likely to be aimed at education, information kiosks and hospitality businesses. We expect this to open up new markets for the company and can give its hardware business a push.

3) Potential of Windows 8 Tablets

The Windows 8 tablet will be Dell’s second attempt at capturing tablet market share. The Dell Streak range of mobile devices failed to gain traction in the market. We expect Windows 8 to do better as Dell will leverage existing institutional customers, educational institutions and government contracts to cross sell its tablet range. We estimate that mobile devices and tablets constitute less than 2% percent of our current price estimate for Dell and we expect to see significant growth here if the Windows 8 tablet is successful.

4) Cash net of Debt Per Share of $3.50 Provides Downside Protection

Dell’s cash net of debt according to its most recent filing was $6.2 billion, which leads to a per share value of about $3.50. This means that just the cash is worth 35% of the stock price at its current market levels.

Where We Could Be Wrong

1) Rising Research And Development Expenses

We currently forecast that the R&D expenses as a percentage of sales will remain at its current level of 1.4% until the end of our forecast period. If diversifying its business leads to an increase in R&D expenses to 3.5% of sales by the end of our forecast period, we can expect a downside of up to 20%.

2) Rising Sales and Marketing Expenses

We currently estimate that the sales and marketing expenses as a percentage of sales will stay at 13.7% until the end of our forecast period. If this were to increase to 16% by the end of our forecast period, we can expect a downside of up to 25% on our current price estimate.

We currently have a $19 Trefis Price Estimate for Dell which is almost twice the current market price estimates.

Understand How a Company’s Products Impact its Stock Price at Trefis

1. Dell Pins Software Hopes on the Midmarket, www.pcworld.com, July 20, 2012 [↩]