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It's the Dell effect, dude
Here's why Dell fans are betting on a major PC upgrade cycle in the coming months, despite the rough economy.
By Michael Brush
Given the number of dudes gettin a Dell these days, youd think a return of the golden age of desktop computer sales was just around the corner.
While tech casualties piled up everywhere this fall, Dell Computer (DELL, news, msgs) dazzled investors last week with third-quarter profit growth of 31% over last year. Thats helped Dell shares hang on to 30% gains from lows touched last summer, staying aloft recently near $29.
Investors still bullish on Dell shares are right to think the company's cost-cutting prowess gives it an edge in ongoing price wars with competitors Hewlett-Packard (HPQ, news, msgs) and Gateway (GTW, news, msgs).
But Dell fans are also placing a more questionable bet that a major personal computer (PC) upgrade cycle will unfold in the coming months -- even in the face of a rough economy. Heres their thinking.
Why dudes want PCs
First, consumers are catching on that using computers to produce digital versions of their home videos and photos is easy and fun. But the George Lucas wannabes are discovering that if theyve neglected to upgrade their computers for a few years, they need to trade up to more powerful models to run the software that puts them in the directors chair.
Holiday discounts over the next several weeks may be all it takes to get many holdouts to make the upgrade, says Robert Turner, a portfolio manager at Turner Investment Partners in Philadelphia.
On the business side, Dell bulls believe a fresh round of buying could be on the way as the elusive corporate upgrade cycle finally kicks in. Back when companies were inoculating themselves against the Y2K bug in the late 1990s, most installed new desktop PCs as part of the bargain. Now, the leases on those computers are running out.
If this truly spurs companies to trade up to better computers -- as opposed to staying with whats still on the desktop -- the potential for growth in PC sales is huge. An estimated 180 million desktop computers were installed during the Y2K scare. Thats far more than the roughly 90 million or so new computers that change hands per year these days.
Trading up will make sense for many companies because it can be cheaper than the fees they have to fork out to renew old service maintenance contracts, says Turner, whose firm holds shares of Dell. Newer operating systems allow help desks to diagnose problems from remote locations, which brings down service costs.
Expiring customer support is another factor that should push companies to upgrade desktop computers, says John Parkinson of the consulting company Cap Gemini Ernst & Young Americas. (His company knows the thinking inside corporations well because it advises companies on technology needs.) Over the next 12 months or so, Microsoft (MSFT, news, msgs) will be phasing out support for the Windows 95 and Windows 98 operating systems, as well as NT 4.0, a system widely used in office settings. (Microsoft owns MSN Money.) Many companies will have to get more powerful computers that can handle the newer operating systems theyll need to buy.
Together, these trends paint a reasonably bright outlook for PC demand. In the corporate space, it looks to me as though we are probably just about starting a 15-month refresh cycle, says Parkinson. The stuff is getting old. It was not built to last forever and the operating systems are coming off support.
Among smaller companies, the same story appears to be unfolding. I dont think it will be an avalanche, but we are facing a refresh cycle, says John Scheaffer, the chief executive of Sysix, a Chicago area computer hardware distributor serving small- and midsized companies. Customers have held off over the last 18 months on the desktop refresh, and they are going to have to do something.
Another source of potential PC sales growth comes from strong demand in markets outside the U.S., such as India, China, Japan, Eastern Europe and Latin America, vendors say.
The risks at hand
As compelling as the bull case for PC demand sounds, one obstacle could have shareholders of Dell and many other PC-related companies seeing the blue screen of death soon enough: What if the economy continues to sputter?
A spike in unemployment would send consumer confidence back down, forcing companies to put off spending on big-ticket items like new computers. Even if employment stays steady, there is not much room for consumers to keep tapping the value of their homes for cash with more mortgage refinancing; interest rates have fallen nearly as low as they can go.
On the corporate side, companies arent really likely to loosen their grip on capital spending as long as profit growth remains elusive. I dont see an uptick in capital spending until there is incontrovertible evidence of profit growth, and that wont happen before the middle of next year, said a technology analyst at one fund company. Instead, potential buyers will keep doing what theyve done for the past two years. Theyll find excuses to hold off just a little bit longer.
Easy as price wars
A faltering economy would be bad for all the computer vendors, but at least Dell would suffer less for a simple reason. The company keeps inventories and costs far lower than its competitors do. This savings is key, especially in a sector where companies sell a commodity product -- such as personal computers. Since their goods are more or less interchangeable, PC vendors constantly have to scuffle for market share by cutting prices. So cost controls are essential to being able to play the game and still turn a profit.
A big part of Dells advantage stems from its direct sales approach -- in which it builds computers after orders are placed. While competitors have to stock warehouses with parts that fall in price every week -- its technology after all -- Dell buys components at the last possible moment, when they are cheaper. This also means Dell has hardly any finished computers sitting around waiting for buyers. Thats another big plus, as this is a sector where costs are constantly falling amid price wars.
All this means Dell has been able to take market share from competitors and increase revenue and cash flow during the downturn. "Dell's direct model provides a sustainable advantage over vendors that rely on traditional distribution channels, like Hewlett-Packard and IBM (IBM), says Roger McNamee, a partner at the tech investment firm Integral Capital Partners in Menlo Park, Calif. The difference between those two models is the difference between success and failure in the PC business.
Among the other PC makers, Apple Computer (AAPL, news, msgs) has several brick-and-mortar retail outlets, which add to overhead. Gateway may have the biggest problem on this front. It also sells relatively little to corporations -- one of the big sources of expected PC demand.
Having taken the lead in PC sales, Dells next challenge is to pull the same trick in other business segments. As products in areas such as servers, storage, switches and routers turn into commodities, Dell will have to prove it can use its direct sales approach to step in and beat up competitors.
As for the stock, technical analysts are watching for a decisive move through the $30 range to indicate Dell is on the way. That level has served as a nagging obstacle for the past two years.
PC component makers
The outlook for component suppliers such as Western Digital (WDC, news, msgs) and Maxtor (MXO, news, msgs) is also closely linked to the long-awaited -- and still elusive -- PC upgrade cycle.
Given that the shares of both companies have doubled or more in the past six weeks to pass through sell-side price targets, they look vulnerable to any bad news on PC demand. At least executives at both disk drive makers still tell me their former nemesis -- excess supply that destroyed pricing in the past -- is no longer a threat.
But if weak demand fuels a new breed of price war, there could be severe downward pressure on the prices for microprocessors made by Intel (INTC, news, msgs). Micron Technology (MU, news, msgs), which makes commodity dynamic random-access memory, or DRAM, has other problems. DRAM pricing will continue to stay weak because of excess capacity in Asia.
But one niche player in the personal computer space looks safe for now, regardless of PC demand. Thats Genesis Microchip (GNSS, news, msgs), which supplies chips used in popular flat-panel screens. The companys shares crashed from $70 to $7 recently, in part because Asian competitors had started selling similar chipsets, says John LaForge, an analyst with the Phoenix-Hollister fund company in Sarasota, Fla. Another problem: shortages of the glass used in flat panel displays.
Since then, glass supplies have increased, and Genesis has filed patent infringement cases against some Asian competitors. This has driven business back to Genesis, pushing its shares over $15 yet again. Meanwhile, the prices of flat-panel computer screens continue to drop. So the dudes who cant afford new PCs at least will be buying cool new flat-panel screens with Genesis components.
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