Why This Well-Known Tech Stock Could Rally Another 50%

Sooner or later, every company’s growth prospects hit a wall. Companies that grow rapidly have an even tougher time, as the corporate culture is built around rapid expansion and growing market share as quickly as possible. Technology firms, in particular, face intense competition and short product-development cycles,  making it easier for rivals to  sell products that build upon another’s development success.

#-ad_banner-#But when growth investors dump the stock of a company that is no longer growing at a breakneck pace, value investors should take note — big profits could be on the horizon…

Computer firm Dell (Nasdaq: DELL) has gone through these growing pains in the past few years. It revolutionized the personal computer industry by focusing on build-to-order computers and lean, just-in-time inventory controls that kept costs low. Consumers fell in love with the products, as did businesses. Michael Dell was so confident in the company he built from his dorm room at the University of Texas in Austin, Texas, that he left as CEO in 2004 to pursue other interests.

Dell’s retirement didn’t last long. Dell’s market had become saturated with computers, while rivals including Acer and Hewlett-Packard (NYSE: HPQ) copied its direct model and found other efficiencies to lower costs and better compete with the market leader. HP soon took back its leadership position in computers. Three years later, Michael Dell returned to lead the company through a painful transition.

As the chart below illustrates, a down economy in the past couple years put a further hurting on Dell, and investors effectively left the stock for dead.

But lately there are tangible signs that Dell is finally succeeding in its turnaround. The company reported full year 2010 results a couple of weeks ago, and the its transformation is telling. Desktop PCs only accounted for 13% of sales, while laptops and related mobility devices represented only 14% of sales, meaning that computers now represent just over a quarter of Dell’s business, compared with 100% prior to the diversification strategy.

The acquisition of IT services firm Perot Systems in late 2009 has pushed service revenue to 36% of sales. Consulting on information technology projects and other service-related work is very lucrative and carries high profit margins. Software is also highly profitable and now accounts for 8% of sales. Server and networking now makes up 26% of sales. Storage products make up only 5% of sales, but Dell is confident it will help boost growth as the popularity of cloud computing catches on.  Archrival HP is also pushing into cloud computing, as are others in the tech industry.

Most of these new businesses are growing briskly. Last year, software grew 18% while services and storage grew 12%. Computers and laptops are also seeing a recovery as the economy improves, and although Dell is not focusing on these segments going forward, they are bringing in lots of cash — nearly $1 billion in cash flow based off 2010 results.

The company plans to grow its existing businesses and boost internal growth with acquisitions. Previously, Dell could rely on organic growth, but it must now also acquire smaller companies in order to gain market share. I mentioned the purchase of Perot Systems, but more recently Dell announced the acquisition of SecureWorks, a software-as-a-service (SaaS) provider in the cloud-computing world. Recently, Dell also announced deals to buy Insite One and Compellent, a health care cloud-computing firm and storage platform software provider, respectively.

The acquisitions should give a pretty clear picture of Dell’s focus going forward, which is to diversify into fast growing and profitable spaces in the tech industry to supplement its computer businesses. The latest financial figures serve to prove its strategy is working. For the full year of 2010, total sales grew 16% to $61.5 billion, while profits shot ahead 85% to $1.35 per diluted share. For the coming year, analysts project earnings of $1.69 a share, or year-over-year growth of about 25%.

Cash generation also remains strong. For 2010, free cash flow reached $1.79 per diluted share and cash on the balance sheet grew to $13.9 billion. Net of debt, cash is now nearly $4.50 per diluted share.

Action to Take —>
Dell has successfully transitioned from computers into a technology firm with a diversified and growing book of business. Continued growth could mean big gains for shareholders.

Dell’s stock has started to move lately and is nearly 40% above its lows in the past year. But it could easily move up even more as investors become more comfortable with the conclusion that it has returned to a period of steady growth. The stock’s valuation is also still very reasonable: the forward P/E is less than 9, as is the trailing free cash flow multiple.

I estimate a conservative multiple of 13 off 2012 earnings expectations of $1.77 a share. This suggests a stock price of $23, more than 50% above current levels.