Dell Stock Has Tripled on AI Hopes. Is It a Buy or a Sell?

Dell Technologies (DELL) stock has been staging a monster rally, riding the coattails of investor enthusiasm for technology stocks that stand to benefit from excitement for artificial intelligence.

So far in 2024, Dell’s stock price has risen 48.9% (31% in the past month alone), which follows a 93.8% gain in 2023. That brings the rally over the last 12 months to 213.3%. With the stock changing hands for around US$110 per share, this rapid climb has left the personal computer and data centre company trading at roughly double its previous peak of around US$56 in early 2022.

The catalyst for the rally has been optimism about the company’s sales of AI servers, which employ Nvidia’s (NVDA) powerful graphics processing chips.

However, Morningstar equity analyst William Kerwin thinks that despite this impressive growth, investors appear to be overestimating its potential benefit to the firm’s bottom line: “in my view, it’s more hype than it is material” to Dell’s profit outlook.

Key Morningstar Metrics for Dell Technologies

Fair Value Estimate: $55.00
Morningstar Rating: 1 star
Morningstar Economic Moat Rating: None
Fair Value Uncertainty: High
Forward Dividend Yield: 1.57%

Dell Stock Performance

Source: Morningstar Direct, Morningstar Indexes, March 12, 2024

Kerwin points out that about 60% of Dell’s business is PCs and monitors, which are a low-profit, essentially commodity business. He says the same goes for data centre infrastructure, such as servers and storage arrays, which are around 40% of the business. Within the data centre segment are GPU-enabled servers with Nvidia chips built into the systems. But Kerwin thinks that, critically for Dell’s outlook, these GPU servers are not the kind in heavy demand from AI powerhouses like OpenAI. They’re instead favoured by businesses looking to host smaller AI-based tools within their data centres.

In addition, while this business is growing fast, it made up less than 2% of Dell’s sales in the most recent fiscal year. Kerwin estimates that percentage could rise to 10% over the next five years, which he calls “really fast growth.”

At the same time, Kerwin notes that the GPU chips have a high cost that Dell can’t entirely pass on to clients, which dilutes the firm’s margins. “It is a growth driver, but by no means to the level that the stock is trading,” he says.

He says Dell has made some shareholder-friendly moves, such as instituting a dividend and increasing share buybacks. There are also hopes that the PC market will soon emerge from a downtrend. But all this is “nowhere near getting the stock up 200%.” Kerwin pegs Dell’s fair value at $55, meaning the stock is significantly overvalued.

The following are highlights of Kerwin’s current outlook for Dell and its stock. The coverage of Dell is available here.

Fair Value Estimate for Dell Stock

With its 1-star rating, we believe Dell’s stock is significantly overvalued compared with our long-term fair value estimate of US$55 per share, which implies a fiscal 2025 adjusted price/earnings ratio of 8 times and a fiscal 2025 enterprise value/sales of 0.6 times. The primary drivers of our valuation are the firm growing its infrastructure hardware, maintaining firmwide margins, and converting more than 100% of its net income to free cash flow.

We forecast 3% midcycle sales growth for Dell and model an uptick in fiscal 2025 revenue after a dismal fiscal 2024, which was affected by cratering demand and pricing for servers, storage, and PCs. Beyond the downcycle in fiscal 2024, we model the infrastructure solutions group growing 4% at midcycle and the client solutions group growing 2%. We expect a secular decline in consumer PC sales to hamper client solutions, but we believe Dell will more than offset this with a focus on the premium, enterprise, and gaming sections. We see solid medium-term demand for on-premises data centre infrastructure as enterprises leverage hybrid cloud and hyper-converged infrastructure. We also see Dell seeing growth upside from rising revenue from AI servers.

Dell Stock vs. Morningstar Fair Value Estimate

Source: Morningstar Direct, March 13, 2024

Economic Moat Rating

We do not assign Dell a moat. It’s a market share leader in its core businesses, but we view the markets in which it plays as mostly commoditized. PCs, peripheral displays, and IT infrastructure are price-competitive markets that offer negligible switching costs and erode economic profits for participants. We don’t see meaningful operating leverage on larger volumes leading to a cost advantage for these vendors either, even for a US$100 billion revenue gorilla like Dell. These vendors can benefit in strong pricing environments, like during the demand surge in 2021 and 2022, but they are ultimately prone to market cyclicality.

Dell holds top-three market shares in its core markets, but this does not inherently demonstrate economic profitability. Dell, Lenovo, and HP (HPQ) control nearly 60% of all PC sales, and their respective market shares shift each quarter. The market is consolidating around these top vendors, but it has highly competitive pricing and slim profit margins. Dell focuses on the highest-growth sections – commercial, premium, and gaming notebooks – but we see the same competitive pricing, with other vendors whittling away excess profits. We also see negligible switching costs and intangible assets in PCs. Original equipment manufacturers like Dell source critical components such as processors and memory chips externally, and Windows is a common operating system among the top three vendors. We see similar dynamics in peripheral devices like display monitors.

Financial Strength

We expect Dell to maintain strong free cash flow and prioritise using it to pay down debt and return cash to shareholders. We forecast the firm to average over $5 billion in annual free cash flow through fiscal 2028 with over 100% free cash flow conversion.

Dell’s shareholder return policy will be a significant capital obligation. The firm launched a quarterly dividend in fiscal 2023 and also conducts repurchases. Management stated a $1 billion annual dividend target in its first year and raised it by 12% for fiscal 2024. For fiscal 2025, Dell raised its dividend by 20%, supporting our belief that management is committed to shareholder returns and will maintain this policy even if it has to refinance debt. A more sour business environment that affects cash flow and interest rates could change this calculus.

Risk and Uncertainty

We assign Dell a High Uncertainty Rating. We believe its greatest risks are long-term secular threats in its core markets, staunch competition for commoditised products, and its concentrated ownership structure.

Dell’s core markets of PCs and on-premises data centre hardware have low switching costs, low differentiation, and staunch price competition with a consolidating list of competitors. While the firm holds admirable market positions with its core businesses, maintaining this leadership is paramount to its performance. These markets are also prone to cyclical downturns that can shrink Dell’s top line and margins.

We see substantial threats to Dell’s core offerings, but we don’t expect them to significantly harm its performance in anything short of the long term. Consumer PCs face an existential threat from tablets and smartphones, though Dell’s business PCs aren’t as threatened. Public cloud expansion could also eat into growth for on-premises data centres and subsequently Dell’s infrastructure hardware. Still, we think hybrid cloud arrangements will continue to make sense for many enterprises in the long run.

DELL Bulls Say

• Dell is an enterprise IT hardware behemoth, with top market shares across personal computers, peripheral displays, x86 servers, and external storage arrays.
• We expect Dell to continue generating considerable free cash flow, and applaud the company’s prioritisation of sending it back to shareholders via its dividends and buybacks.
• Dell’s debt is now investment-grade, and its balance sheet is better positioned to give it operational flexibility.
  
  

DELL Bears Say

• Dell’s core businesses compete in commoditized and cyclical markets that erode economic profits.
• CEO Michael Dell holds a controlling position in the company, and his interests could deviate from those of minority shareholders.
• Dell’s need to refinance some debt could limit its organic investment or shareholder returns, and it may face an unfavourable rate environment in which to do so.