Michael Dell is surely heaving a sigh of relief. His efforts to revamp his namesake computer company had received little respect on Wall Street, but since last Labor Day, analysts are finally warming up to the stock. Shares have risen more than 30%, and some analysts speak bullishly about further gains ahead. Yet a deeper look reveals a still-troubled company, and there’s a solid chance that shares will return back to those Labor Day levels once the near-term sheen wears off.



Dell has been surging due to several reasons:
 

• The company has been on an acquisition spree to beef up offerings in data storage, services and other areas, creating an enterprise-focused platform that is increasingly prepared to battle stronger rivals such as Hewlett-Packard (NYSE: HPQ) and IBM (NYSE: IBM).
   
• Dell’s PC business is posting impressive margin gains thanks to firm pricing and quickly-dropping costs for components such as hard drives and memory.
   
• The company’s massive share buyback program should remove $2 billion from the share count in 2011.

#-ad_banner-#Those share buybacks are surely impressive, but the first two factors invite greater scrutiny.

Another soup-to-nuts platform?
Michael Dell belatedly realized if his company is to be taken seriously among corporate customers, then he’d need to offer a far broader set of products and services. IT managers like to deal with as few vendors as possible. It’s a key selling point for companies like HP and IBM.

So Dell went out and bought a half-dozen hot young companies (including Perot Systems, Compellent Technologies, Exanet, Ocarina and SecureWorks) and quickly set about to integrate them. Still, those acquired companies amount for just 3% to 4% of sales. For Dell to really make its case with large IT buyers, the company needs to heavily invest in its solutions-based sales force as well as start developing leading edge products through heavy research and development.

Investors are likely underestimating just how big a task that is. In each of the past four years, Dell has spent about $600 million on R&D, or about 1% of sales. In contrast, HP has spent about $3 billion annually (or about 2.5% of sales), while IBM has spent a hefty $6 billion (6% of sales) annually. This means Dell will need to likely spend another $1 billion a year — at least — in stepped-up R&D just to compete. That extra spending is worth about $0.50 a share. Dell will also need to sharply boost investments in its sales force, further crimping margins.

Unless Dell is willing to spend serious dough on R&D, the sales force and more acquisitions, the company may remain an also-ran in the IT space. Sterne Agee’s analysts note “the reality is that this is still a very PC-centric company where we estimate about 70% of its business is PCs and related areas.”

Trouble is, the PC business may look especially good right now, but major problems loom. As noted earlier, a drop in costs for key components has enabled Dell to recently boost profit margins on every PC and laptop sold. This is a key factor behind the recent stock surge. Goldman Sachs, though, is taking away the punch bowl: “Current gross margins remain temporarily inflated and are set to trend downward later this year.”

This could spell trouble for those who are expecting recent results to mirror future results. “The gross margin re-set, coupled with the 220 basis point increase in the (operating expenses) ratio since (the first quarter of fiscal 2011) could quickly push operating margins and earnings far below the consensus,” conclude the Goldman analysts. While the consensus forecast calls for Dell to earn $1.91 a share in fiscal (January) 2013, Goldman pegs that figure at just $1.43.

Also worth noting is that profit margins for PCs and laptops are not just related to component costs. You need massive volume to gain scale economies in terms of purchasing and manufacturing. But you have to wonder what Dell’s volume will look like in a year or two as tablets take an even bigger bite of the market. Apple’s (Nasdaq: AAPL) iPad is surely a juggernaut, but Samsung is off to a good start with its revamped Galaxy tablets, and Google (Nasdaq: GOOG) is gearing up for a major push with its “Chromebooks” that strip out a lot of hardware and leave much of the computing to the Internet.
 
Dell made a half-hearted attempt at the tablet market with its Streak, but seems to be otherwise ignoring this tectonic shift taking place in the industry. Dell’s PC business has delivered good results in the face of the tablet onslaught, but how long can that last?
 
Action to Take –> Make no mistake. Dell has delivered an impressive set of recent quarters, surging past profit forecasts by at least 25% each time. But as analysts are now sharply raising estimates, the rules have changed. It’s no longer sleepy little Dell that investors tend to under-estimate. Instead, it’s a resurgent company with lofty expectations (per-share profits are expected to rise 20% this year).

A deeper look finds a company with the same set of problems that dogged it in years past. A return back to the low teens looks to be in the cards for this recent highflyer. This would be a near-term loss of about 15%, but if you hold this stock, then you have to wonder if you’re sitting on dead money.

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