Dell's Much Needed Transformation Actually Increases Risk To Shareholders

| About: Dell Inc. (DELL)

Shares of Dell (DELL) ended the trading week with large losses of over 7%. The global personal computer producer reported its third quarter results on Thursday after the close.

Third Quarter Results

Dell reported third quarter revenues of $13.72 billion, down 11% on the year. Revenues fell short of analysts expectations of $13.9 billion.

The company reported an operating income of $589 million on a GAAP basis. Net income on a GAAP basis fell 47% to $475 million, with diluted earnings per share coming in at $0.27.

Non-GAAP income fell 31% to $679 million, with earnings per share falling to $0.39 per share. Non-GAAP earnings fell a penny short of analysts expectations.

Year to date, Dell has returned roughly $900 million to shareholders in the form of dividends and share repurchases, roughly 5.8% of the firm's market value.

CEO and Chairman Michael Dell commented on the results, "We are consistently executing our end-to-end solutions strategy for the benefit of our customers. In the quarter, we completed the acquisition of Quest Software which - along with other recent acquisitions like SonicWALL and Wyse - adds leading management, security, virtualization and cloud capabilities to our expanding portfolio of powerful solutions."

Segmental Information

The enterprise solutions and service revenues advanced 3% to $4.8 billion. The division remains a top priority of Dell in the future.

Dell's server and network and service revenues were up 11% to $2.3 billion. Growth was driven by leadership in hyper-scale infrastructure solutions and increased customer adoption of cloud solutions. Service revenues grew in support, deployment and security services.

Consumer revenue fell 23% to $2.5 billion on the back of weaker personal consumer sales. Lower PC sales, intense competition and a shift towards tablets are to blame. The division reported an operating loss of $65 million, 2.7% of total revenues.

Sales to corporations fell 8% to $4.2 billion. Discussions about the fiscal cliff results in lower corporate investments. Operating income came in at $325 million, for a net margin of 7.8%.


The challenging macro-economic environment continues to impact the company's results.

Dell expects sequential revenue growth of 2 to 5% for the fourth quarter. The outlook assumes fourth quarter revenues of $14.0-$14.4 billion. At the midpoint of the guidance, this assumes a year-on-year revenue decline of 11%. The revenue guidance falls short compared to analysts expectations of $11.48 billion.

For the full year of its fiscal 2012, Dell expects to earn $1.70 per share on a non-GAAP basis.


Dell ended its third quarter with $11.3 billion in cash, equivalents and short term investments. The company operates with $9.0 billion in short and long term debt for a net cash position of $2.3 billion.

For the first nine months of 2012, Dell generated revenues of $42.6 billion. The company net earned $1.84 billion, or $1.05 per diluted share for the period. The company is on track to generate annual revenues of $57 billion, on which the company could earn $2.2 billion, or $1.30 per diluted share.

After Friday's decline, the market values Dell at $15.4 billion which values operating assets around $13.1 billion. This values Dell at merely 0.2 times annual revenues and just 6 times 2012s projected annual earnings.

Dell currently pays a quarterly dividend of $0.08 per share, for an annual dividend yield of 3.6%.

Investment Thesis

Year to date, shares of Dell have lost some 40% of their value. Shares steadily rose from $15 in January to highs of $18 a month later. From that point in time shares lost over half their value on the back of weak earnings and the realization among investors that smart phones and tablets would structurally weaken Dell's personal computer business.

Shares are currently testing the lows of 2009 set during the financial crisis, after which shares recovered to levels around $15 per share. Between 2008 and 2012, Dell saw its annual revenues fall from $61.1 billion to an expected $57 billion. Net income fell slightly from $2.5 billion to an estimated $2.2 billion. The company retired over 10% of its shares outstanding during the time period.

Dell business remains in a transformation phase. The company tries to move away from a simple hardware producer and vendor into a software, networking and cloud business. Dell hopes to operate in a less volatile, higher margin business in the medium term future, thereby reviving the firm.

Despite the transformation phase, shares are down significantly. Personal computer and laptop sales are down faster than expected driven by faster adoption of tablets, price competition from Lenovo, among others, and macro-economic uncertainty. These developments are not impacting just Dell, but impact the likes of Hewlett-Packard (HPQ) as well.

Dell is trying to transform the company away, not just by internal investments, but also through acquisitions. In September, Dell announced the completion of the $2.4 billion acquisition of Quest Software, which generates $857 million in annual revenues.

The problem remains that this acquisition adds a merely 1.5% in annual revenues, and the deal values the firm at 2.8 times annual revenues, compared to Dell's 0.2 times annual revenue multiple. As such, the transformation goes slowly and is rather expensive, especially if Dell will use its own stock as a depreciated currency in the future to finance these deals.

I remain cautious regarding Dell's future despite the significant pullback in the shares. The company remains profitable until this point in time, but ironically most of the risk lies in the transformation strategy. While Dell needs to transform itself, I am afraid the company might take on significant amounts of debt over time in order to slowly transform the business, posing significant risk to shareholders. The company's net cash position has already deteriorated from roughly $7 billion to a mere $2 billion at the moment between 2008 and 2012.

I remain on the sidelines, keeping a close eye on the transformation strategy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.