The Dell dilemmaApril 6, 2012: 5:00 AM ET
Five years after Michael Dell returned to lead the PC maker he founded, Dell may actually be ready for a second act. The next several months will be dicey. Here's what to watch for.
By Kevin Kelleher, contributor
FORTUNE -- Is Dell finally turning a corner? Five years after Michael Dell returned to lead the PC maker he founded and transformed into a colossus, Dell may actually be ready for a second act. But the next several months will be crucial in determining how strong any recovery will be.
Between 1995 and early 2000, Dell's (DELL) stock enjoyed one of the biggest rallies -- even for the tech sector -- rising nearly 900% to $59 a share. The dot-com crash brought it back down to $16 share by the end of 2000, but the strength of its brand in the PC market helped Dell rebound to $42 over the next four years as Dell's reputation for efficient manufacturing and assembling customized PCs made it the market leader.
But in 2005, following the departure of Michael Dell as CEO, Dell's stock began to decline again, pushing the price back down below $20 a share in early 2006. Hewlett-Packard (HPQ) and Chinese manufacturers such as Acer began competing harder in laptops. Michael Dell returned as CEO in 2007, vowing to revive the company.
But as HP is learning, turning a tech giant around is a grueling process that can take years. In February 2009, the Great Recession brought Dell's stock down to $8 a share. After that, it rebounded to and hovered around the $15 mark for a few years. Meanwhile, netbooks and then the iPad and other tablets became hot items, slowing growth rates for PCs and laptops. The company that helped invent the modern PC company was suddenly living in a "post-PC world."
But this year, the company's stock is signaling that investors are starting to believe in Dell again. The stock rose to $18.33 a share in February, marking a 25% gain from the beginning of the year. The key reasons: Dell's efforts to rely less on PC and laptop sales and more on services, servers and storage are working. Meanwhile, the company is pushing harder into higher-end PCs so it doesn't have to compete with Apple's (AAPL) iPads and Amazon's (AMZN) Kindle Fires.
Over the past six fiscal years, PCs and laptops have shrunk from 65% of revenue to 54%. Meanwhile, servers have gone from 10% to 13%, while the services division, which includes consulting and handling IT for companies, has risen from 8% to 13%, partly through acquisitions of companies like Perot Systems, an IT services company, for $3.9 billion and Boomi, a cloud-computing company, for an undisclosed sum.
Over the past several months, Dell has stepped up the pace of its acquisitions in the services area. In February, it bought AppAssure, a backup software vendor. A month later it bought network-security firm Sonicwall. And in the past week, news emerged that it's buying Wyse, a maker of thin-client systems, for $375 million as well as Clerity Solutions, another IT services company for an estimated $1 billion.
These moves are encouraging because they show Dell is focusing on its areas of growth. In its last fiscal year, PC sales fell 4% while laptop and tablet sales rose 1%. Meanwhile, sales from servers grew by 10% and sales from its services division grew by 8%.
And despite all the talk of a post-PC era, Dell isn't doing too badly all things considered. In the last quarter of 2011, Dell's share of the PC market rose to 12.6% from 11.6% a year earlier. HP's share, meanwhile, fell to 16% from 18.8%, but Lenovo's share rose from 11.3% to 14%.
The company also managed to offset declines in its lower end laptops by pushing harder on its higher-end XPS line of notebooks. And the arrival of Microsoft's (MSFT) Windows 8 later this year will likely trigger a demand for new PCs and laptops, especially as companies upgrade to new the operating software.
Dell has also fought off a decline in consumer sales by focusing on businesses and governments, which make up 80% of its sales. Dell has had success in selling to big companies. Sales to consumers fell to 19% of its total revenue last year from 23% two years ago. But sales to big companies rose to 30% of total revenue from 27% in the same period. Those big-company sales lead to higher margins: Operating profit in that segment were equal to 10% of its sales, while the operating profit from the consumer segment was 2.7%.
As a result, Dell's total revenue grew by 17% over the past few years and its operating margin increased from 4.1% to 7.1% in the same period. The stock, however, still trades at only 7.7 times its earnings, about half of the 14.8 P/E for the S&P 500.
For all that, Dell has some challenges ahead that are keeping investors from feeling too bullish. For one, Chinese companies are starting to get aggressive in the low-end servers that has been an area of growth for Dell. Intel's (INTC) Ivy Bridge chip, which powers higher-end laptops, is facing a delay.
And the flooding in Thailand late last year disrupted the supply of hard disk drives, although one analyst, Jefferies & Co.'s Peter Misek, has said he thinks that all the talk about Thai floods is really "a smokescreen to mask underlying slower demand trends," such as the increasing popularity of iPads. The ability of Windows 8 to run on tablets could also pressure PC prices further, even as the components used to make PCs inch higher.
Those concerns have weighed on Dell's stock in recent weeks, causing it to drop 10% from its February high. Dell's turnaround has taken nearly five years to start winning over investors. It has at least a few more months of hazards to navigate in the PC business still at its core. But if it can weather them, the company's second act could be a strong one.