Is Dell as Cheap as it Seems?

By Steve Symington - November 26, 2012 | Tickers: AAPL, DELL, HPQ, IBM, SSNLF | 0 Comments

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As a starting point in my continuous search for new ideas, I often look for companies with high earnings yields and great returns on invested capital.  Why?  Companies with high returns on invested capital generally possess durable competitive advantages and demonstrate a knack for creating value for shareholders.  When these companies also sport high earnings yields, they represent great potential opportunities for investors to beat the market.  

Skeptical?  You don't have to take my word for it; I'm certainly not the only one who believes in the merits of using this methodology.

The Stock

This in mind, Dell (NASDAQ: DELL) has finally piqued my interest.  Of course, Dell isn't exactly a new idea; the perennially-undervalued company has occupied a spot in my screens for the better part of 2012 and has frustrated otherwise-patient investors for the last several years.

Before we dig further, let's take a look at some of Dell's key metrics next to a few of its peers:

 While Dell can't match Apple's (NASDAQ: AAPL) cash-rich, debt-free balance sheet, both its debt-to-equity ratio of 0.87 and current ratio of 1.3 reflect manageable debt levels.  In fact, Dell's numbers are better than the debt-to-equity and current ratios of competitors Hewlett Packard (NYSE: HPQ) and Berkshire favorite IBM (NYSE: IBM).  In addition, while Dell's 19.4% ROIC isn't as strong as the 35%+ offered by IBM and Apple, it still illustrates the company's respectable ability to create shareholder value with its invested capital.  Dell also recently announced its first quarterly dividend of $0.08 at a conservative payout ratio of 5% in an attempt to give long-term investors another reason to stick around.  Finally, and perhaps most surprisingly, Dell's current P/E ratio sits at an amazingly-low 6.5, giving it an enviable earnings yield of 15.38%.  

So What Gives?

Why, then, should investors shun a company with a high earnings yield, reasonable debt levels, strong returns on invested capital, and a healthy quarterly dividend?

To put it bluntly, investors fear Dell is slowly falling into obsolescence.

I shouldn't need to point out the irony in a statement from the company's CEO and Founder, Michael Dell, in November, 2000, when he said “It's customers that made Dell great in the first place, and if we're smart enough and quick enough to listen to customer needs, we'll succeed." 

Now, more than a decade later, Dell's Consumer business posted a $65 million loss during its most recent quarter as it struggles to keep pace with a rapidly-changing consumer electronics market.  Nobody's saying Dell hasn't tried, but the consumer response to its mobile and tablet offerings have been tepid in the wake of more popular devices like Apple's devices, Samsung's Galaxy series phones and tablets, Google's Nexus products, and even Microsoft's Surface Tablet.

During its Q3 earnings conference call, Dell management repeatedly blamed the macro-economic environment and the impending shift to Windows 8 as primary reasons for stagnant PC sales., insisting their situation would get better over time.  This, in my opinion, is the biggest risk attached to Dell, and its shares could see more downward pressure if the company's consumer segment doesn't show marked improvement over the next few quarters.

The Bright Side

Despite the $65 million loss on the consumer side, Dell still managed to post quarterly net income of $475 million thanks to relatively stable results from its Enterprise Services and Business segments.  In fact, with server and networking revenue up 11 percent for the quarter, Dell was the "only top-3 server provider to have positive unit growth in the quarter," according to its most recent earnings announcement.  

As analyst Benjamin Reitzes of Barclays Capital pointed out, Dell was also "one of the first companies to [...] put out some realistic numbers" for the deceleration of its bread-and-butter PC sales and thus began shifting its strategy to depend more on high margin enterprise solutions, servers, and cloud services.  In other words, Dell saw this coming and is actively taking steps to mitigate the consumer segment damage.  While there's certainly risk in placing themselves further into the competitive crosshairs of other enterprise and services-oriented companies like IBM, Dell is making the right call in diversifying its operations away from the dying PC market.

The Bottom Line

While Dell may not be able to win the consumer war, I'm convinced the company's other pursuits will ensure its long-term success.  Even so, shares of DELL are trading near four-year lows despite strong metrics and the company's repeated attempts to ensure shareholders everything is under control.  

In the end, if Dell can continue to successfully execute its plans over the next few years, patient investors will be richly rewarded as it returns to normal valuations.

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