DELL (I): a disappointing quarter for a company restructuring itself

My look at DELL last week

I haven’t paid much attention lately to DELL, one of the great growth stock stories of the Nineties.  I knew that Michael Dell returned in early 2007 to take over the reins of a struggling firm.  My family and I experienced first-hand the slippage in DELL’s product quality and customer service–so much that two of us (including myself) are now using Macs and another has an IBM laptop.

I haven’t owned the stock in this decade and felt no great compulsion to buy shares.  But I couldn’t help noticing last week that DELL reported disappointing earnings after the close on Thursday and the stock dropped 10% in trading on Friday.  A real contrast with other tech names!  So I decided I’d look at the numbers and listen to the earnings conference call to figure out what had been so surprisingly bad.

Two posts

The result is two posts, today and tomorrow.  This post will deal with the conference call and my assessment of the near-term situation with the stock.  Tomorrow I’ll  write about what I think the structural issues with DELL are.

Framing the DELL quarter

DELL reported revenues of $12.9 billion for the three months ending in October and earnings of $.17 a share.  Adding back in $.06 in unusual losses, earnings per share were $.23.  This compares with revenue in the August quarter of $12.8 billion and eps, also adjusted for unusual expenses, of $.28.  In other words, sales were flat but profits were off by close to 20%.

company guidance

In the August quarter earnings announcement, DELL’s management suggested to investors that they should expect a seasonal pickup in consumer business during the October quarter and cautioned about possible weakness in sales to its large corporate customers.

the consensus estimate

The Wall Street analysts’ consensus, with this general guidance in mind, seems to have formed around revenues of $13.1 billion or so and eps of $.28.  Just using the back of an envelope–with plenty of room left over for revisions, or doodles–I might have come to the same conclusion.  Roughly speaking, enterprise weakness and consumer strength might well offset one another in both revenue and profit terms.  Given that the late summer and early fall were a booming time for consumer PCs, I could easily wind up a little low.

Looking to the past, the third quarter is normally a bit stronger than the second, though.  Considering that, and after seeing most companies with September quarter ends report slightly lower than expected revenues but surprisingly strong profit growth, I might shade my revenues a little lower and bump the eps number up a penny or two.  On the other hand, trade figures have been showing that DELL has been losing consumer market share.  So maybe, I’d just stand pat.

the actual results

As the eps number above shows, the quarter didn’t quite pan out as management expected.  The operating profit results, by segment, were as follows:

———-3Q fiscal 2010———2Q fiscal 2010

consumer    $10 million     $89 million

smb             $282 million     $246 million

public            $352 million     $383 million

enterprise     $174 million     $172 million.

(smb = small- and medium-sized business)

Another way of assessing these numbers is to compare them with the year-ago quarter.  Those results are:

consumer      $142 million

smb           $374 million

public          $361 million

enterprise     $254 million.

These figures show the extent of the  year over year falloff in enterprise and smb segments.  Smb has begun to bounce back.  Enterprise probably won’t begin to recover until next year (if then).  The most important question, though, is why consumer profits disappeared for DELL at a time when overall consumer sales of PCs were strong.

The conference call

Oddly, DELL didn’t talk at all about the consumer  or why the October quarter ended up weaker than expected.  The company may have assumed (incorrectly, for me) that the numbers were self-explanatory.  But it gave no insight as to what was behind the poor showing or when the situation might change.  The analysts on the call tiptoed around the issue; none asked.  DELL provided lots of disjointed facts, delivered in corporate jargon, but no sense of strategy.

DELL did say it didn’t like selling netbooks because there was so little profit for it in DELL.  Otherwise, nothing.

DELL does believe the cyclical low point for its business came during the summer.  Each month of the October quarter was better than the previous one.  November is shaping up to be better than October.  Smb business has turned up for the first time in almost two years.

US business was a bit soft.  The rest of the world was strong.

DELL, like everyone else in the industry, is experiencing upward pressure in component pricing.  Shortages are emerging in some areas especially memory and LCD panels.

My reactions

1.  DELL has been an exceptionally strong stock since the low in March, matching its much sounder rival HPQ in performance before fading a bit since mid-September.  What must the market have been thinking for the reported earnings to have triggered such a negative reaction in Friday trading?

To me it looks like some investors were making the simple argument that, just as second-tier companies suffer most in a downturn, these same companies bounce back the most when business gets better.  That’s true in a normal inventory-cycle recession, and to some extent even now.  But for DELL, structural change in the IT industry is a more important factor.

In this recovery, I think, there won’t be enough demand to create the rising tide that lifts all boats.  Instead, the market story over the next year will likely be one of separating winners from losers.  It seems as if not everyone has caught on to that yet.  To me that’s a big surprise.

3.  One of Dell’s historic strengths has been its ability to operate a negative working capital business model.  It gets paid by its customers on average 36 days before it has to pay for the materials and labor it uses to create its products.  For a negative working capital business, the eye-catching feature is the large amount of cash often on the balance sheet.  But it’s important to look at the working capital figures as a whole very carefully, because the cash may give an impression of greater financial strength than a company possesses.

More on this in my next DELL post.

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