Why Dell Eclipses Sun
By Martha Toll-Reed
Standard & Poor's rates the publicly-traded debt of six companies in the computer manufacturing sector. Some of these concerns -- including Hewlett-Packard (HPQ ) and IBM (IBM ) -- have a diversified product profile, with operations in software, services, components, and peripherals.
But two well-known names in the sector depend more heavily on computer-systems sales than others, giving them comparable business-risk profiles: Dell (DELL ) and Sun Microsystems (SUNW ). That similarity prompted us to put together a side-by-side comparison of these two technology giants. Dell carries a corporate credit rating of 'A-' from Standard & Poor's, while Sun's corporate rating is 'BBB' -- both investment grade.
Although Dell and Sun each have an "average" business profile (when compared to the universe of rated corporate industrial issuers of debt), Dell's is the stronger of the two because of its more cost-efficient operating model and low R&D investment requirements. That can be laid to its use of Wintel standards, which have enabled Dell to be highly competitive and yet preserve stable and more predictable profitability.
For its part, Sun has a good market position but more volatile revenue, earnings, and cash flow. In addition, Sun is more exposed than Dell to technology investment and product-development risk, because it relies on proprietary microprocessors and software.
While both companies have strong liquidity positions and balance sheets, Dell's above-average financial profile, vs. Sun's average financial profile, is bolstered by consistent profitability, stronger cash flow generation, and minimal debt levels.
KEYS TO SUCCESS.
The computer hardware sector has a higher-than-average level of business risk because of short product life cycles, intense price competition driven by new technology developments and declining component costs, often dramatic changes in growth rates, and potentially high investment requirements. All of these factors can lead to significant earnings and cash-flow volatility.
Given the industry's risk characteristics, investment-grade computer-hardware companies like Dell and Sun must possess several, if not all, of the following characteristics:
• Careful cost control. That's critical to maintaining profitability in an environment with ongoing price competition;
• Product development skills. Hardware outfits must producing the right feature set at the right time, and the right price. With short product cycles and an estimated 50% of product profits occurring in the first third of a product's market life, time is, quite literally, money;
• A diverse customer base. That applies to geography as well as customer segments (i.e. corporate, consumer, government);
• Open system architecture and interoperability. Those are essential for competing in today's multi-vendor user environment; and
• The ability to adapt. Complacency can be fatal in this dynamic industry. The evolving IT market requires computer companies not only to adapt their product offerings, but also to fine-tune their own internal practices and business models.
With fiscal 2003 revenues of $35.4 billion, Dell is the third-largest U.S. computer systems company, behind IBM and Hewlett-Packard. The company offers its customers a range of products that include: desktop computers, notebooks, workstations, network servers, and storage products. In addition, Dell markets a wide range of software, peripherals and services.
Sun is a leading manufacturer of network computing products and services. Product revenues, including desktop workstations, servers (from workgroup servers to large-scale department and data center systems), storage products, software, and microprocessors, comprise about 70% of Sun's total revenues. Support and professional services account for the balance of total revenues of $11.4 billion in fiscal 2003.
The collapse of the dot-com bubble, weak global economies, and a cautious IT spending environment severely affected computer hardware revenue growth and profitability in 2001 and 2002, particularly for midrange and high-end servers -- where Sun's market position has been strongest. As a result, Sun's revenues declined 31% in fiscal 2002, which ended Jan. 1, followed by an 8% decline in fiscal 2003.
Sun' margins, as measured by EBITDA (earnings before interest, taxes, depreciation, and amortization) similarly plummeted to a low of 5% in fiscal 2002, from a high of 15.6% in fiscal 2000. In contrast, Dell's efficient operating cost structure and market strength in PCs and low-end servers has enabled it to outperform all of its competitors (within comparable market segments) during the past two years. Dell's revenues dropped a modest 2% in fiscal 2002 and grew a robust 13.6% in fiscal 2003, with EBITDA margins consistently in excess of 8%.
THE PRICE OF R&D.
The ratings history of both companies has reflected their divergent performance. From 1998 until October, 2002, both companies were rated 'BBB+'. In October 2002, Dell's corporate credit rating was raised to 'A-' based on its strong operating performance and market-share gains, while Sun's corporate credit rating was lowered to 'BBB', reflecting weak profitability and less predictable operating performance.
Both Sun and Dell have a hardware-centered strategy and approach to the market, which is reflected in Standard & Poor's average business profile for each. However, Dell's strategic and market strength lies in its ability to apply a low-cost operating model to high-volume, standards-based technologies. Dell effectively leverages the R&D investment already reflected in industry-standard technologies, both in hardware (Intel processors) and software (Microsoft operating systems), thereby minimizing its own R&D outlays to 1%-to-1.5% of revenues, and reducing product development risks.
In contrast, Sun relies on its ability to develop a competitive, cost-effective "solution" of hardware, software, and services products. Sun's market position is supported by strong and consistent product-development skills, but that comes at a price: heavy R&D expenditures. R&D as a percent of revenues historically averaged about 10%, but that jumped to 16% in fiscal 2003 as Sun's revenues declined. Partially offsetting its high R&D expenditure level, Sun uses partnerships to minimize fixed-asset investments and maintain a relatively low-capital-intensity operating model.
BETTING ON LINUX.
Sun has maintained its market share lead in terms of revenues, based on data from IDC, in the worldwide Unix market. However, Unix-based servers as a percentage of the total server market has declined to less than 40% in mid-2003 from a peak of 50% at the end of 2000. As a result, Sun's revenue decline has been proportionally larger than the overall server market decline.
Dell, on the other hand, has a successful track record of applying its low-cost operating model to an expanding portfolio of products, including servers, storage, and networking equipment. Sun's recent strategic expansion into lower-cost Linux-based servers should help offset declines in the Unix market. However, to the extent Sun's growth occurs in low-cost segments such as Linux-on-Intel, the company will find it relatively tougher to earn a return on its software and systems R&D investments. While Sun's Linux strategy is not without risk, the company is otherwise also at risk of being confined to a Unix market that has been shrinking in proportion to the total market opportunity.
In addition to a low R&D expenditure level, Dell's direct sales model reduces sales and channel distribution costs. With its efficient cost structure -- operating costs (excluding depreciation and amortization) average about 10% of revenues–-Dell has been able to compete effectively on price and to gain market share throughout the technology spending cycle. In contrast, Sun's operating costs were 29% of revenues in fiscal 2003.
MODEL OF EFFICIENCY.
At approximately 30% of total revenues, Dell has a smaller international presence than Sun and its other leading competitors. Although Dell continues to gain global market share, it is relatively more exposed to North American economic and IT spending trends. However, Dell's narrower geographic profile has not had a material effect on its business risk profile.
Dell's financial profile is above average (when compared to the universe of rated corporate industrial issuers of debt), supported by consistent profitability and cash flow, despite extremely competitive industry conditions. EBITDA margins have been 7% to 9% in each of the past nine quarters (before nonrecurring charges). Dell is expected to maintain good profitability, based on low manufacturing costs, efficient asset utilization and cost cuts. Dell's asset efficiency and profitability have translated into a return on permanent capital in excess of 40% in each of the past three years.
Sun's financial profile is average, based on a strong balance sheet but diminished earnings and predictability. Although Sun's revenues continued to decline by 8.5% in fiscal 2003, the drop moderated from the 31.5% decline in fiscal 2002. EBITDA margins (adjusted for capitalized operating leases) improved to more than 7% in fiscal 2003 from 5% the prior year because of restructuring and cost-reduction actions but remain significantly below historical levels. Competitive pressures and continued weakness in the Unix and high-end server market are expected to limit EBITDA margin improvement for the near term.
Dell has maintained a strong balance sheet with ample liquidity. Leverage levels are minimal and cash and total investments are in excess of $8 billion, while total funded debt was $506 million as of May 2, 2003. The company does not maintain a credit facility. However, Standard & Poor's expects Dell to preserve a strong liquidity profile based on free operating cash flow in excess of $3 billion annually, cash and investment balances, and low debt levels.
Dell has used its strong cash flow generation to repurchase more than $2 billion of stock in each of the past three years. However, share repurchases funded with discretionary cash flow are not expected to impair credit quality.
Offsetting Sun's weaker and less predictable profitability are its strong liquidity position and moderate debt levels. Cash and investments have remained in excess of $5 billion since fiscal 2000, more than 3 times funded debt levels of $1.5 billion. Free operating cash flow has remained positive since the March 2002 quarter, and near-term debt maturities are modest.
Over the past couple of years, Sun has made a number of modestly sized acquisitions aimed at enhancing its technology and software portfolio. Although acquisitions are expected to continue, they are not expected to significantly alter Sun's strategic direction.
Toll-Reed is a credit analyst covering the computer-hardware industry for Standard & Poor's Ratings Services