Why Dell Is Part of Our Ultimate Portfolio

I regularly follow several well-established investment managers, hoping to glean new insight for my portfolio by tracking both their holdings and investment themes. The problem with this approach historically has been assessing the real-time attractiveness of each name in these managers' respective portfolios, given that their filings are always somewhat delayed. However, by taking a cross-section of these portfolios with Morningstar's proprietary metrics and rating for stocks, I've been able to uncover current investment ideas that otherwise may have not been immediately apparent. (Note: Our trading policy prohibits us from trading stocks based on information gleaned from manager interviews.)

We've created a portfolio based on this methodology, which we introduced as The Ultimate Stock-Picker's Portfolio in a recent article. One of the more controversial names in the Ultimate Stock-Picker's Portfolio has been  Dell , which has proved to be a value trap for some investors over the past year. We've shared in some of this pain, as the stock has been relatively flat for the Ultimate Stock-Picker's Portfolio since its inception last year. I thought it would be a good time to sit down with our Dell analyst, Rick Hanna, to get a sense of what has happened to the company and what the future might hold.

Rick, it seems like it's been years since Dell was viewed as a stock market darling. In a nutshell, what happened?
Both external market factors and internal factors have affected Dell's stock performance. On the external market front, overall industry growth is slowing, particularly for enterprise desktops in the U.S., where Dell has been strongest. The market is becoming increasingly competitive, primarily from  Hewlett-Packard (HPQ), but also from more regional competitors such as Acer (Europe) and Lenovo (China). The competitors have narrowed the cost difference with Dell and are better able to compete, particularly in areas where Dell was not as entrenched, such as with consumers and notebook computers. Internal factors include not only the accounting issues (Dell has acknowledged evidence of misconduct) but also customer service complaints and the battery recall for notebook computers.

You mentioned that Hewlett-Packard and others have been eating Dell's lunch recently, but do you think Dell's direct business model is really broken?
No. The direct model will continue to be a core strength of Dell. The direct model benefits Dell in the following ways. First, it is a core driver of its cash engine. By distributing directly to customers, Dell collects cash before it pays suppliers, generating negative working capital. Second, the direct model cuts out the cost of a distribution channel. This advantage is less than what it once was due to declining prices and margins, but it still gives Dell an advantage, particularly in the enterprise market. It has been alleged that the direct model is inferior to retail in its ability to reach consumers, one of the hottest growth areas in the market recently. However, Dell's lack of consumer growth has had less to do with the direct model and more to do with corporate strategy: Enterprise customers are more profitable than consumers, and Dell did not place a high focus on consumers until recently. Dell is experimenting with retail kiosks to capture the consumer opportunity, but still achieve the benefits of being direct.

Some have said that investing in Dell is not really investing in a personal computer company but rather investing in a logistics company that can easily add new products to its lineup. What's your take on this?
I don't completely agree with that assertion. First, some of its new products have not been wildly successful, such as consumer electronics (HDTVs) and printers to a certain extent. To be successful, the company needs more than just a great logistics operation. It also needs great technology, streamlined (low-cost) operations, and great customer service. The company has faltered when it didn't have these elements working together.

Let's talk valuation. Briefly walk me through how you arrive at your fair value estimate.
Our fair value estimate for Dell is $34. This assumes modest 6% revenue growth driven by international growth, notebooks, and services. Operating margins will be constrained in the short term by increased investments in customer service and research and development. I forecast operating margins to reach 7% in 2011 through an improved mix of products and additional cost-cutting. The negative cash conversion cycle will continue to be a strong company asset, but it will decrease slightly due to geographic expansion and business mix, in my opinion.

What do you think are the downside risks and upside potential to your fair value estimate? How would you handicap these potential outcomes?
The biggest risk to the fair value is from declining profit margins. The company's recent efforts to boost sales by simply lowering prices were not successful and ended up shrinking margins. The company has recently pulled back from heavy promotional pricing, and margins have improved, but sales have also stagnated. The company will need to find the right mix of product design, smart pricing, and low-cost operations to maintain margins and growth. To the extent that the company needs to permanently increase its research and development and selling, general, and administrative costs to compete, and the market becomes more price competitive, there is indeed a risk for further margin erosion. Such a possibility is fairly likely in the near term (the next two to three years), but ultimately will lead to further industry consolidation and a firming in margins. I wouldn't be surprised at all to see a major acquisition in the industry within the next six to 12 months in an effort by the industry titans to improve their competitive position.

Dell's Short and Long-Term Potential
To be sure, accounting restatements and management turnover should make investors pause when considering any potential investment, and as Rick points out, Dell's shares have come under pressure because of these types of issues. To make matters even worse, though, these missteps surfaced just when Dell was losing some ground to its largest competitor, HP, whose business appears to be revived under new CEO Mark Hurd. In my view, the timing of these issues has created a perfect storm of sorts for Dell shareholders, who have been sitting on relatively dead money for some time now.

I find this somewhat ironic, because just a few years back, when Dell's direct distribution model was all the rage, many postulated that HP was in a flailing business with little potential for improvement. In fact, many may have said that an investment in HP would have amounted to little more than dead money a few years ago. How things can change, and change rather quickly. The more likely scenario of what really happened was that investors overly penalized HP's share price given the issues surrounding its business and management missteps, while the actual business was still creating value and being positioned for future growth. Could the same thing be happening to Dell today?

I think it's certainly possible. You'll notice that even Rick doesn't have an overly optimistic view of Dell (you might even say a bit negative in the short term), as he believes that an eventual recovery could simply take time. That said, he doesn't believe that the company's competitive advantages have been materially eroded either, and he thinks that over time, Dell will still be able to leverage its direct distribution model into other products and geographies, and that it will continue to be the low-cost leader in its industry. This is important, because it indicates that he believes the problems Dell is presently experiencing are fixable, and that once they are repaired, shareholders will still benefit from the firm's strong competitive positioning. Presently, though, Dell's share price seems to indicate that its economic moat has been permanently bridged, creating what I think is an attractive opportunity for long-term investors.

Similar to Rick's view, in a recent shareholder letter, Mason Hawkins and Staley Cates--the managers of the Longleaf Funds--recently commented about their position in Dell, "...Earnings over the last twelve months were disappointing and there is a question of whether some numbers will be restated. However, we believe Dell's direct sale model is the most competitive over the long run, and that the operating problems related to consumer support and gross margins are less relevant than their strength in the corporate world and their rapid growth in foreign operations. Our corporate partners are both significant owners and smart capital allocators. Although we lowered our appraisal to reflect the last year's troubles, we think the company's normal earnings power is much higher than recent numbers, and the true value could be well above the appraisal we use."

I'll further note that Dell remains the  Longleaf Partners Fund's (LLPFX) largest holding.

At Morningstar, we also lowered our fair value estimate at the beginning of the year, but you shouldn't take this as a sign that we don't think Dell's stock is still a bargain. You'll notice in the interview above that Rick isn't using any grand revenue growth or gross margin forecasts to arrive at his $34 fair value. Rather, by using relatively conservative assumptions, his analysis still indicates that despite its woes last year, Dell's stock remains cheap. This gives me comfort with what I think is the somewhat limited downside risk left in the stock, while I believe it still indicates the substantial upside potential in Dell, presently available to prospective investors. Even though it is very difficult to predict when Dell's valuation will eventually improve, I think that given the market's current discount to intrinsic value, patient investors should be justly rewarded to wait for this gap to eventually close.

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