Dell Scratching And Clawing For Share

By Stephen D. Simpson, CFA | August 19, 2013 AAA

The situation around Dell (Nasdaq:DELL) continues to churn, as the company scratches, claws, and fights for market share and relevance in its end markets, with Carl Icahn spearheading efforts to disrupt the planned go-private transaction. While Dell has shown that it can improve revenue by trading margin for share, it's unclear to me that the company can win over the long-term with this strategy. As I think management overestimates the extent to which customers will stick with them, and that there are competitors better suited to win on both the price/margin and feature/performance ends of the spectrum, I see Dell stuck in a long-term squeeze play that makes value creation very difficult.

Second Quarter Earnings Highlight The Tradeoffs
Dell produced a measurable top-line beat this quarter, and that hasn't been very common in consumer/enterprise tech. Revenue rose fractionally from last year (and 3% from the prior quarter), beating the average analyst estimate by about 2%.

Growth was led by the enterprise businesses, where revenue rose 8% on particular strength in servers and networking. Computing was down 5%, as improvements in desktop (up 2% and 8%) were offset by declines in mobile.

The down-side to the quarter came in part from how the company managed to generate the revenue growth. Dell has been trading margin for market share, leading to a three point year-on-year decline in gross margin and a one point sequential decline (on a non-GAAP basis). With that, operating income fell 46% from the year-ago level (while rising 2% sequentially) and the company's operating margin continues to slide.

SEE: A Look At Corporate Profit Margins

Is Dell Playing A Game It Cannot Win?
I understand that Dell wants to rebuild its share, and I understand the thought process that if they can re-establish their position in both consumer and enterprise markets, they can hold on to these customers for the long-term and rebuild the business. I understand it, but I don't agree with it.

Long term, I don't think Dell can win a margin/price competition-based strategy. Asian OEMs like Acer, ASUS, and Lenovo (Nasdaq:LNVGY) can play that game better on the consumer side, as seen in Lenovo's strong share growth over recent years. Although Dell (and Hewlett-Packard (NYSE:HPQ)) still do better in the high-end PC business, that's not large enough to offset the threats elsewhere in the business. In addition, Lenovo seems to be out-maneuvering Dell in the PC business in the emerging market, and that's the source of an increasing percentage of PC market growth.

I also see similar threats to the enterprise business. Lenovo has made it clear that they want to become a player in the server business, and with or without a deal for IBM's (NYSE:IBM) x86 business that is not a good development for Dell (or HP). At the same time, Dell has failed to establish a leadership position in hardware or software that can seriously challenge the likes of IBM on the high-end, high-performance side of the market.

SEE: Very Weak Q2 Earnings Outside Finance

More Drama To Come
With shareholders due to vote on the go-private offer from Silver Lake and Michael Dell on September 12, the end of Dell as a public company (at least for a few years) may be in sight. That said, Carl Icahn has vocally opposed this transaction, and he fully intends to go down swinging. Ichan has tried to instigate for a higher price for shareholders, arguing that the proposed deal doesn't give full value. Having made little progress in getting a higher bid, and with no outside bidders coming in with a better offer, Icahn has turned to the courts in an attempt to derail the vote and/or otherwise delay or stop the go-private transaction.

The Bottom Line
I don't fault Icahn for trying to get the best price possible for his shares, but this looks a bit like a game of chicken. It's certainly possible to argue that today's valuation on Dell shares (which is very close to the proposed go-private price) assumes virtually no improvement in the business, and that Dell could generate meaningfully better future cash flows by rigorously winnowing out noncompetitive products/business that don't generate adequate returns. On the other hand, I wouldn't underestimate Dell's fading competitiveness and the risk that performance could get much, much worse. To that end, I'd be inclined to go with the go-private offer at this point.

Disclosure – At the time of writing, the author did not own shares of any company mentioned in this article.

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