It may be hard to believe, but there was a time, not all that long ago, before Apple () was “the” computer company. In 2003, Dell () was popular due to both its customizable computer options and its catchy “Dude, you’re getting a Dell,” slogan. However, around 2004, when Dell peaked, Apple released the iPod and began its steady climb to the top of the consumer-electronic world. We think the combination of Apple’s rise and Dell’s transition in its business model has created an interesting opportunity in shares of the computer maker.
Over the past few years, prominent investors including David Einhorn, Whitney Tilson, George Soros and Joel Greenblatt have all taken positions in the beleaguered PC maker. We can see why, as the company currently trades at approximately 6x its fiscal year 2013 earnings, after generating $5.5 billion in operating cash-flow in its 2012 fiscal year. Further, over the past 5 years the company has grown earnings per share by 44% while shrinking its float by nearly 18%. Over the same 5 years the stock has fallen 55%, suggesting that investors think Dell is undergoing a long, steady decline. Dell even declared its first dividend, which amounts to $0.32 a year and a yield of roughly 2.7%.
We do agree that Dell’s highly visible consumer segment is in for a long, slow decline. Some may blame Microsoft () for its failure to enter the mobile market promptly or for its failure to continually innovate its operating system. However, we think this decline is a result of how well Apple continues to execute and capture the mindshare of consumers than anything else. Apple’s hardware presentation has been well ahead of Dell, Sony (SNE) and HP () for some time. Unfortunately for Dell, we aren’t sure that the firm can compete effectively with Apple because Apple’s higher pricing structure and bargaining power over suppliers allow it to use higher quality inputs and maintain an elevated gross margin. Further, with other low-cost competition like Acer and Lenovo, Dell is stuck between not-quite-cheap-enough and not-quite-nice-enough.
These results were reflected in Dell’s consumer segment, which saw revenues fall 4% to $11.9 billion in 2012. Revenue from the US fell a staggering 18%, but revenues in this segment from outside of the US managed to increase 10%. Dell should be able to mitigate some of its struggles in the US with a combination of a new tablet that runs Windows 8 and continued growth in emerging markets that are not quite wealthy enough to afford Apple products.
Regardless, the consumer segment may languish, but it represented just 19% of the company’s total revenues in 2012, meaning that around 80% of revenues come from public (government) organizations and businesses. We believe the future of the company lies in the enterprise market. The company will have to make a shift similar to IBM (), which went from a big hardware maker to an enterprise software and hardware solutions company. CEO and founder Michael Dell acknowledged as much during the company’s recent analyst day, where he emphasized that the company will focus on the enterprise solutions business, which it expects to grow at a 10% annual pace until at least 2016 (posting 13% segment operating margins along the way).
Michael Dell also acknowledged that the company must continue to acquire strategic intellectual property to grow its software solutions business. The firm has acquired 8 companies over the past year, including SonicWALL, an IT security firm. This reminds us of how Best Ideas Newsletter holding Intel () acquired McAfee to boost its software business (albeit more consumer-focused). We think software is a very attractive business thanks to its low marginal cost, stickiness, and less-commoditized position.
Undoubtedly, Dell faces some difficult competitors in the enterprise software space, including IBM and Microsoft; however, the company may be able to successfully integrate hardware and software sales. Additionally, we applaud the firm for exiting the smartphone space and focusing on supporting iPhones and Androids () rather than competing with such popular products. We’ve expressed many times that we think Android’s market position is vulnerable, but we strongly believe Apple will be able to maintain its dominance in the software space. Thus, supporting Apple’s mobile offerings will be necessary for most players in the enterprise security space.
Of course, Dell will have still face many challenges. As we mentioned in an earlier piece (click here), Apple may be able to challenge Microsoft’s enterprise dominance (though that’s far from certain). Additionally, Dell must be able to allocate capital to value-creating acquisitions and avoid overpaying for software, which has been difficult for many large tech companies with billions of dollars to do. Still, HP, which should be one of its top competitors, is struggling to find its identity and doesn’t appear to be providing Dell with much competition in the consumer space.
Though the plan is in place, the future relies very much on sound execution. However, with management committing to return 20-35% of free cash flow to shareholders, $18 billion in cash on its balance sheet, and a 2.7% dividend yield, we think Dell looks attractive at its current valuation. The market is focusing too much on the company’s consumer operation, in our view, while instead investors should focus on the company’s growing enterprise software segment. However, since we already have significant tech exposure, we likely won’t add Dell to our Best Ideas Newsletter portfolio at this time, despite its attractive valuation and reasonable turnaround strategy.