Dell Proves To Be A Laggard In A Weak Market

By Stephen D. Simpson, CFA | November 19, 2012 AAA

For whatever optimism Cisco (Nasdaq:CSCO) and NetApp (Nasdaq:NTAP) generated with respectable quarters, Dell (Nasdaq:DELL) rained on the parade with another weak result. Not only did Dell miss again, but the company seems to be badly lacking momentum in any of the sort of markets that would excite investors. While there is (and has long been) underlying value in this business, it's anybody's guess as to when the bleeding is going to stop.

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Third Quarter Results Fairly Depressing
There was no reason to think that Dell was going to have a great quarter, but it was still worse than expected and that's been a theme at Dell for far too long now.

Revenue fell 11% from last year's third quarter (which was flat from the year before that), and down about 5% from the second quarter. Declines were led by a feeble computer business that was down 18% (with notebooks down 26%), while software/peripherals were down 11% and storage was down 16% as reported (and down 3% looking through to Dell-owned IP). Servers and networking was the lone bright spot, up 11% as reported or 5% on an organic basis.

Dell also continues to struggle with its margin leverage. Non-GAAP gross margin fell a point from last year and about 60 basis points from the second quarter (GAAP performance was somewhat worse), even with the inclusion of Quest's significantly higher margins. Non-GAAP operating income fell almost one-third from last year and more than 20% from the second quarter.

SEE: Understanding The Income Statement

The Song Stubbornly Remains the Same
I suppose that Dell's performance with desktops and notebooks shouldn't be much of a surprise. It's not as though Hewlett-Packard (NYSE:HPQ) has been strong either, but I'm nevertheless surprised at the relative performance of Dell and Lenovo.

I understand that mobile devices from Apple (Nasdaq:AAPL) and Samsung have changed the computing world forever, but Dell has had time to adapt and has so far failed to do so. That also makes me wonder if Dell's server/networking momentum could ultimately be vulnerable to Lenovo down the line.

Dell also continues to struggle with its storage business. While its adjusted performance was better than IBM's (NYSE:IBM) 10% decline in the third quarter, there's nothing here to suggest much momentum relative to EMC (NYSE:EMC) or NetApp , and I believe that Dell will likely have to invest more resources (another acquisition?) to really compete.

SEE: Analyzing An Acquisition Announcement

On the software side, I don't believe Dell is done yet. Quest was a good deal and an underappreciated company, but I don't think it's enough to really give Dell a solid platform for enterprise software customers.

Is the Customer Concentration Deleveraging the Business?
As part of the company's revenue reporting, Dell announced that revenue from large enterprise customers was down 8%, while public revenue fell 11%, and consumer plunged 23%. In contrast (and continuing something of a trend), the small/mid-sized business (SMB) category saw only a 1% decline.

SMB has been an area of strength for Dell before this quarter, but I do wonder about the cost. It's more expensive to serve this niche/category, and I wonder if that's part of the margin compression problem. Said differently, Dell can't succeed without better performance in large enterprises and government verticals.

The Bottom Line
Dell clearly cannot continue on this path. Year-to-date free cash flow is down by about half, and investors seem to have largely lost confidence in the Dell business plan. At a minimum, management needs to stem the year-on-year profit declines and then formulate a long-term plan that's consistent with the realities of the IT world.

At the risk of stating the obvious, a lot of Dell's fair value today revolves around how much worse things get before the company stabilizes. If you assume that Dell's free cash flow declines from the fiscal 2012 level at a 15% compound rate for a decade (and 5% thereafter), that gets you to a fair value a bit over $9. Obviously, then, Wall Street is factoring in a lot of pessimism, but anybody buying shares today on a value/turnaround call had better be prepared to wait, because the Street clearly doesn't believe that Dell has a workable plan today.

At the time of writing, Stephen D. Simpson owned shares of EMC since 2012.

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