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Dell pays price for cheap computers
Youve seen the ads offering cheaper and cheaper computers from the giant PC maker. Someday -- and maybe soon -- those bargain deals will cut into profits.
By Robert Walberg
For the second time this week, one of the technology industry's titans disappointed the street with its guidance for the upcoming quarter. First Cisco Systems (CSCO, news, msgs), now Dell (DELL, news, msgs).
After meeting the consensus earnings estimate of 38 cents for the second quarter on slightly weaker than expected sales of $13.43 billion, the world's largest computer maker forecast third quarter revenues of $14.1 billion to $14.5 billion, while Wall Street had projected $14.6 billion. Dell's third-quarter earnings forecast of between 39 cents and 41 cents also didn't sit well with analysts, who were predicting at least 41 cents a share. As a result, Dell's stock is likely to take a beating similar to Cisco's. Its stock dropped 8% in the aftermath of its earnings report.
This time, I understand the sell-off
Whereas I believe Wall Street overreacted to Cisco's disappointing forecast, the reaction to sell Dell's shares seems warranted to me, and I expect Dell's shares to fall even further. Here are three big reasons why:- Average selling prices for PCs and notebook computers continue to come down at an alarming rate, putting into question how much longer Dell can defend its profit margins.
- Growth in Dell's peripheral businesses was below estimates, rekindling concerns about whether Dell can transfer the success it enjoys in computer hardware to other markets. If it can't, the company will have a hard time meeting long-term growth projections.
- Overall PC sales growth, which has run well ahead of projections this year, might not be sustainable. If that growth flags, then Dell might struggle to hit sales targets without maintaining its aggressive -- and margin-crushing -- pricing plan.
In short, this highly successful box-maker has begun to box itself into a corner. Rarely does a day go by that my computer screen isn't flashing some ad for a Dell computer starting at $499, $399 or even $299. Now, most of us don't buy the stripped-down model hyped in the ads, but even when it can sell slightly beefed-up models, Dell is playing a dangerous pricing game.
Keeping high margins with low prices
Most analysts have glossed over this strategy, noting that Dell's efficient model has enabled it to steadily gain share through aggressive pricing. And on the surface, the strategy looks successful. IDC, an independent research group, recently noted that Dell continued to build worldwide market share. Additionally, though sales were a bit lower than expected in the second quarter, it wasn't because of the PC group.
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But as a Wall Street Journal article suggested, there comes a point when a company offers discounts so frequently that consumers begin refusing to pay anything but discounted prices. The Gap (GPS, news, msgs), General Motors (GM, news, msgs), Kohl's (KSS, news, msgs) are just a few brands that have discovered the long-term difficulties associated with constantly offering incentives to drive top-line growth.
This is Dell's conundrum. How do you continue to offer your core products at ever lower prices while maintaining margin and profit growth? You might get away with such a strategy when the industry is in a strong uptrend, but if the first few years of this decade taught us anything, it is that the PC industry is highly cyclical. During a downturn, when dynamic sales growth can't offset the pressure from discounted pricing, the company is going to deliver disappointments that make yesterday's report seem tame.
Holding on to market share
Don't get me wrong, there was plenty of good news in Dell's report. International sales remain strong; the company continues to make inroads in China; and notebook and PC sales were decent, as was revenue growth in the storage business. According to Gartner Dataquest, another independent researcher, Dell ended the quarter with a 32% share of the U.S. PC market.
Dell also possesses an excellent management team, a strong balance sheet and great brand identity.
But at about 24 times current-year estimated earnings, the stock is fully priced, especially considering that management admits that it was "too aggressive" with its consumer-pricing model. The problem the company faces is how to get that price genie back in the bottle. That is no easy task and one that needs to be solved before the stock becomes an attractive long-term investment.
It's almost certain that Dell will test its May low of $34.14. If it gets below that, $32 isn't out of the question.
At the time of publication, Robert Walberg neither owned nor controlled shares in any equities mentioned in this column.
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