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Will Dell Go from Sizzling to Middling?

By Olga Kharif No doubt about it. Dell, the world's No. 1 PC maker, is going great. In its latest quarter, ended Aug. 1, year-over-year sales grew by 16%, to $9.8 billion -- while the overall market expanded at a single-digit pace. Product shipments were up 27% compared to last year, more than four times what competitors did.

Performance like that has helped send Dell's (DELL) shares up 37% over the past 12 months, to around $34 as of Sept. 30. Is it too late to get in and ride the wave to more gains? The bulls say the stock is still undervalued against the benchmark NASDAQ index. Yet concern is growing that optimism about Dell's prospects is overdone. It's trading at 28 times next year's earnings estimate, the highest number since the dot-com bubble. Even if the stock is near fair value, which many analysts say it is, the risk of disappointing investors is high, the bears say.

The bulls point out that Dell is diversifying, ramping up efforts in fast-growing consumer-electronics markets. On Sept. 25, it said it'll launch an online music store and begin selling MP3 players and flat-screen TVs in the fourth quarter. The stock rose 1.4% on the news that day, to $34.37. Analysts say Dell's move into this arena could be impressive over the long term -- but it may not be a trustworthy indicator of what to expect in the days ahead.

SMALLER GAINS? "Investors make too big a deal of [consumer electronics]," says Vincent Colicchio, a portfolio manager at U.S. Global Investors managing $1.1 billion in assets. (He recently sold a chunk of Dell shares.) "I discount it," since it could take several years for the new product lines to add up to significant revenue, he says.

In the short term, the PC market may not expand as quickly as investors hope. Despite an economic recovery, industry revenue growth could stay in the single digits through 2004, says Rob Enderlee, principal analyst with tech consultancy Enderlee Group, partly due to the continued price drops on desktops and notebooks.

Dell's revenue growth is expected to fall from 15% this year to 12% next year and 10% the year after that, estimates Standard & Poor's analyst Megan Graham-Hackett. She thinks the "largest market-share gains in the PC industry" - Dell holds 17.8%, up from 14.9% a year ago -- "are behind the company." Going forward, half of Dell's expected growth is to come from increased share, below what it has been, figures Sameer Bhasin, an analyst with the $500 million Okumus Capital hedge fund in New York.

RECOVERY BACKLASH. Growth in Dell's other businesses might cool down too. Servers and storage hardware, which account for 28% of sales, could be constrained by Dell's meager spending on research and development and by likely shifts in corporate info-tech outlays that favor Dell's rivals, says Graham-Hackett.

Dell spends 1.2% of sales on R&D - one third of what Hewlett-Packard (HPQ) spends on comparable products, says Jeff Clarke, former chief financial officer at Compaq and now executive vice-president of global operations at HP. During the downturn, that frugality - and Dell's focus on smaller-capacity servers for small to midsize businesses - worked in its favor, since corporate spending on massive, expensive machines had dried up.

In a recovery, "spending will shift back to other systems and companies," says Mark Melenovsky, director of storage research at tech consultancy IDC. "It's going to be more of a challenge for Dell to keep gaining share." It gained 0.8 percentage points of server share from rivals like Sun Microsystems (SUNW) in the second quarter vs. the same period of 2002, bringing its total to 9.2% of worldwide unit shipments, according to IDC.

TV TIME. Dell believes its strategy of delegating R&D to partners like Intel (INTL) and software companies Microsoft (MSFT), Oracle (ORCL), and Red Hat (RHAT) works. Moreover, "the lesson of the 'boom vs. the bust' has taught us that value is always a customer's No. 1 priority. We don't see this changing no matter what the economy is doing," says a spokesman, who adds that Dell believes in clustering simple and cheap systems instead of building $1 million machines. For instance, its CX200 storage product can be expanded from a $20,000 basic unit to a $500,000 setup by adding parts.

Dell's new forays into markets such as flat-screen TVs could take several years to generate meaningful revenues - and it will face intense competition here, too. Gateway (GTW) and HP have started major consumer-electronics pushes in the past year. And they're all running against entrenched players like giant Sony (SNE), which could pressure margins, figures Colicchio.

For now, though, the bulls applaud Dell's continued share gains from weaker PC rivals like Toshiba, where notebook sales fell 12% in the latest quarter. "Dell could double its revenues in three to five years," says Eric Rothdeutsch, an analyst with Friedman, Billings & Ramsey. And margins could increase from last quarter's 8.5% to 10% or 11% through cost cuts, says Brent Bracelin, an analyst with Pacific Crest Securities. That would justify a higher stock price.

WAIT AND SEE. The bears are skeptical. Double-digit declines in PC component prices have slowed, and Enderlee says most vendors already sell at cost. PC makers have historically reduced costs by deploying new technologies, but most advances have been implemented, except in certain chips allowing laptops to connect wirelessly to the Internet, he adds.

Clearly, Dell remains a formidable force in the PC industry, and if it can do in consumer electronics what it did in computers, it's probably a solid long-term buy. The near term, though, may be a different story. Kharif writes for BusinessWeek Online in Portland, Ore.

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