Dell Inc.

Executive Summary

Based on our analysis of Dell's short term investment attractiveness, we are recommending a hold on the company's stock. This recommendation is based primarily on the fundamentals of the computer manufacturing industry, the current economic environment, and Dell's competitive position within the industry.

Dell is a direct-sales computer vendor that sells a broad variety of computers and related equipment ranging from servers and printers to switches and projectors. The main growth drivers involve diversification of the product portfolio and expansion into emerging markets. With more competition in its core product line, Dell has expanded to capture other areas of IT where it can exploit its core competencies. This includes more business focused products, a more diverse line of computers, and peripheral computer products that cater to particular segments of consumers.

The Company's primary competitors include IBM, Hewlett Packard, Apple, Toshiba, Sun Microsystems, and Lenovo. We believe that the general computer manufacturing industry does not have highly attractive investment dynamics. Within the industry, Dell competes as a low cost provider of Windows compatible machines whose competitive advantage lies in its ability to maintain low computer prices.

In addition, the current economic environment sheds a negative light on many equity investment evaluations. We believe that the stock market's volatility creates substantial investment risk, particularly in our recommendation's investment horizon of 5-6 weeks. Dell's reliance on consumer spending is an additional weak spot, given an economic environment that is widely believed to see slowing consumption.

However, our analysis suggests Dell may be one of the more attractive investment options within its industry. The company utilizes a unique build-to-order system and highly efficient supply chain management to keep costs low and to deliver quickly based on customers' needs. In addition, Dell's current ratio is 1.07 which indicates adequate liquidity.

The company is currently trading at $13.04 per share, which translates into a market capitalization of approximately $25.5 billion. Dell has LTM revenue, EBITDA, and net income of $64.1 billion, $4.3 billion, and $2.6 billion, respectively. This translates into LTM revenue, EBITDA, and net income multiples of 0.3x, 4.3x, and 9.7x, respectively. Comparing Dell's multiples to its industry competitors, we found that Dell was below the industry mean and median. However, once we removed Apple, the industry comparables were just slightly higher than Dell.

Note that an investment horizon longer than 5-6 weeks mitigates some of the shorter term economic risk that deters us from making a buy recommendation. This, coupled with Dell's relatively attractive business model and slightly lower valuation, gives us comfort in the additional upside potential of this investment decision.

The Business

Dell is a direct-sales computer vendor that sells a broad variety of computers and related equipment ranging from servers and printers to switches and projectors. Its customers include consumers and businesses of all sizes. It utilizes its build-to-order system and highly efficient supply chain management to keep costs low and to deliver quickly based on customers' needs. In addition to its product line, the company also offers a variety of supporting service packages.

The foundation for business operations is demonstrated through its choice in how to conduct direct selling. The company believes that the direct form is the most efficient method of providing products to the customer. This means that Dell is the sole party accountable, making the customer interfacing simpler as the consumer deals with only one person.

In supplying its products to customers, Dell utilizes a Just-In-Time inventory system in order to build what customers want, when they want it. It reduces costs since Dell can avoid maintaining an aging inventory, and satisfies customers by delivering the latest products cheaply. Furthermore, Dell emphasizes quality standards to garner customer loyalty and trust, promising support and repair services in the event of product problems.

The main growth drivers involve diversification of the product portfolio and expansion into emerging markets. With more competition in its core product line, Dell has expanded to capture other areas of IT where it can exploit its core competencies. This includes more business focused products, a more diverse line of computers, and peripheral computer products that cater to particular segments of consumers. As domestic growth opportunities in the United States falter, Dell is looking towards other countries for growth, especially as domestic companies start to tighten IT spending.

Dell's value drivers are its low-cost focus, standard of high quality, and ease of use for customers. Dell sustains these in several ways. First, Dell has situated itself to be the low-cost leader; a cheap source of easily orderable computers for consumers and businesses. Contemporaneously, it utilizes standards technology to ensure that products are reliable and timely in meeting customer technological needs, and Dell offers service packages in order to ensure that customers do not have problems. In other words, it drives value by offering reliable and advanced technology products at lower prices than competitors.

Sources:

http://www.dell.com/content/topics/global.aspx/corp/background/en/directmodel?c=us&l=en&s=corp

http://www.dell.com/downloads/global/corporate/vision_national/direct_model_poster.pdf

http://premium.hoovers.com.libproxy.usc.edu/subscribe/co/overview.xhtml?ID=ffffryrsyrrcyrhrsh

http://www.usnews.com/articles/business/2008/05/30/biz-buzz-dell-profits-starbucks-heads-south-spending-slows-and-other-business-news.html

http://www.usatoday.com/tech/products/2008-03-18-3042338457_x.htm

The Investment Profile

Stock Market Capitalization: $25.53bn

Current Share Price: $13.04

Current Dividend Yield: NA

Current P/E Ratio (LTM): 9.7

Exchange listed: Nasdaq

Note: figures as of market close on Friday, October 17, 2008.

P/E History

Date	LTM EPS	Closing Share Price	P/E
10/17/2008	$1.34	$13.04	9.73
2/15/2008	$1.31	$19.57	14.94
2/15/2007	$1.15	$24.38	21.20
2/15/2006	$1.56	$31.77	20.37
2/15/2005	$1.29	$40.20	31.16
2/15/2004	$1.01	$34.55	34.21

Source: AOL Finance - http://finance.aol.com/quotes/dell-inc/dell/nas

The Financials

11. What is the firm's liquidity? (Figures as of annual report, 2/1/2008.)

• Total Current Assets: $19.880bn
  
• Total Current Liabilities: $18.526bn
  
  • Current Ratio = $19.880 / $18.526 = 1.07 times
    
• Inventory: $1.180bn
  
  • Quick Ratio = ($19.880bn - $1.180bn) / $18.526bn = 1.01 times
    
• Cash: $7.764bn
  
  • Cash Ratio = $7.764 / $18.526 = 0.419 times
    

Dell's current ratio is higher than 1 which indicates that it is liquid, though not a highly liquid firm.

12. To what extent does the firm rely on debt? (Figures as of annual report, 2/1/2008.)

• Total Equity: $3.735bn
  
  • Total Debt Ratio = $0.587bn / $3.735bn = 0.157
    

A 15.7% debt to book equity ratio is low.

13. Is the firm profitable? Is the firm generating positive cash flow? (Figures as of annual report, 2/1/2008.)

• Net Income: $2.947bn
  
• Revenue: $61.133bn
  
  • Profit Margin = $2.947bn / $61.133bn = 4.8%
    
• Total Assets: $27.561bn
  
  • Return on Assets = $2.947bn / $27.561bn = 10.69%
    
  • Return on Equity = $2.947bn / $3.735bn = 78.9%
    

For every dollar that Dell generates, 4.8 cents is profit. Thus, Dell is profitable, although it's only a few cents on the dollar (subject to GAAP). In addition, Dell had positive cash flows from operating activities.

14. What is the firm's capacity to grow? What has been the firm's historical growth rate? Is the firm generating positive or negative external financing needs (EFN)?

• PE ratio = 9.75
  
• EPS = $1.34
  

A P/E multiple of 9.75 suggests decent investor sentiment about growth, but not terribly high. Investors are willing to pay nearly $10 for every dollar of current earnings, which indicates a positive outlook regarding Dell's future earnings, especially in the current environment.

• Assets (FYE 2007): $25,635m
  
• Revenue (FYE 2007): $57,420m
  
• Change in revenue from FYE 2007 to FYE 2008: $3,713m
  
• Profit margin for FYE 2007: 0.045
  
• Revenue (FYE 2008): $61,133m
  
• No cash dividends declared or paid
  
• Spontaneous liabilities in 2008: $11,591m (includes only Accounts Payable)
  

If we assume there is no increase in debt, the EFN from 2007 to 2008 can be calculated as follows:

= ($26,635 / $57,420) * $3,713 - 0 - (0.045 * $61,133) * (1 - 0)

= $1,722.322 - 0 - $2,750.985

= $(1,028.663) million

This indicates negative external funding needs.

By including spontaneous liabilities into this calculation (a figure we know was $11,591m), we subtract $749.519m and get $(1,778.182)m, which is also negative. So, the firm is not growing at the maximum growth rate that could be achieved without external equity financing.

Source: Dell Inc. filed 2/1/2007 and 2/1/2008 annual reports.

The Market Valuation

Current Metrics
	Enterprise	LTM	LTM		LTM	Share	Shares	Book value
Company name	value	Revenue		EBITDA	EPS	price	outstand. (1)	of equity
IBM	$ 146,030	$ 104,306		$ 21,897	$ 8.11	$ 90.78	$ 1,355	$ 28,264
Hewlett-Packard Co.	$ 92,626	$ 113,054		$ 13,347	$ 3.23	$ 39.71	$ 2,446	$ 38,495
Apple Inc.	$ 65,510	$ 30,801		$ 6,325	$ 5.12	$ 97.40	$ 886	$ 19,622
Toshiba Corp. (2)	$ 27,622	$ 75,688		$ 6,530	$ 0.28	$ 3.54	$ 3,236	$ 10,393
Sun Microsystems Inc.	$ 2,721	$ 13,880		$ 1,452	$ 0.49	$ 5.58	$ 752	$ 5,588
Lenovo Group Ltd.	$ 807	$ 16,751		$ 735	$ 0.05	$ 0.34	$ 9,202	$ 1,662
Dell	$ 18,473	$ 64,146		$ 4,293	$ 1.34	$ 13.04	$ 1,960	$ 2,823

Current Multiples
	Enterprise value /			Equity BV
Company name	Revenue	EBITDA	P/E	per share
IBM	1.4 x	6.7 x	11.2	20.9
Hewlett-Packard Co.	0.8 x	6.9 x	12.3	15.7
Apple Inc.	2.1 x	10.4 x	19.0	22.2
Toshiba Corp. (2)	0.4 x	4.2 x	12.9	3.2
Sun Microsystems Inc.	0.2 x	1.9 x	11.4	7.4
Lenovo Group Ltd.	0.0 x	1.1 x	6.5	0.2
Mean	0.8 x	5.2 x	12.2	11.6
Median	0.6 x	5.4 x	11.8	11.6
Dell	0.3 x	4.3 x	9.7	1.4

Forward Multiples
	NTM	NTM	NTM	Enterprise value /		NTM
Company name	Revenue	EBITDA	EPS	Revenue	EBITDA	P/E
IBM	$ 105,169	$ 22,331	$ 9.06	1.4 x	6.5 x	10.0
Hewlett-Packard Co.	$ 135,375	$ 16,972	$ 3.97	0.7 x	5.5 x	10.0
Apple Inc.	$ 37,119	$ 7,291	$ 5.46	1.8 x	9.0 x	17.8
Toshiba Corp. (1)	NA	NA	NA	-	-	-
Sun Microsystems Inc.	$ 13,731	$ 1,291	$ 0.45	0.2 x	2.1 x	12.3
Lenovo Group Ltd.	$ 17,098	$ 751	$ 0.04	0.0 x	1.1 x	8.3
Mean				0.8 x	4.8 x	11.7
Median				0.7 x	5.5 x	10.0
Dell	$ 67,430	$ 4,259	$ 1.45	0.3 x	4.3 x	9.0

Sources: Filed 10-K and 10-Q financial reports and Capital IQ. As of market close on October 17, 2008. U.S. dollars in millions, except per share data.

(1) Common, non-diluted share count.

(2) Enterprise value includes minority interest of $3,780.5 million. Converted from Japanese Yen at an exchange rate of 0.0099 USD / JPY.

Above are a number of market valuations, including revenue, EBITDA, earnings, and book equity multiples. They indicate a relatively low valuation – the figures are below average multiples. Typically, 4.3 times EBITDA and 9.7 times earnings are very low multiples. These figures suggest that investors expect, by owning the stock, to receive more than 4.3 times EBITDA in present value terms. In addition, Dell's 0.3 times revenue and 1.4 times equity book value point to low investor expectations.

We compared Dell to a set of comparable companies, including Apple and HP. The comparable set boasts slightly higher valuations, but are held up mainly by Apple's presence. Removing Apple yields a similar average valuation to that of Dell. This suggests investors have less faith in Dell's ability to deliver earnings, as compared to the average of the other companies listed. However, in the long run, Dell will almost certainly deliver 4 times its EBITDA (in present value terms) to investors, along with earnings in the other aforementioned metrics.

Is the stock "correctly" valued? The answer depends on what constitutes a "correct" value, but these comparable valuations demonstrate investors' low faith in Dell. However, given the current market climate, this is not surprising.