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Dell (NASDAQ:DELL)

Q4 2013 Results Earnings Call

February 19, 2013 5:00 p.m. ET

Executives

Robert Williams - Director of Investor Relations

Brian Gladden - CFO

Tom Sweet - Corporate Controller

Analysts

Shannon S. Cross - Cross Research

Tony Sacconaghi - Sanford Bernstein

Brian Alexander - Raymond James

Keith F. Bachman - BMO

Katie Huberty - Morgan Stanley

Steve Milunovich - UBS

Maynard Um - Wells Fargo

Aaron Rakers - Stifel, Nicolaus

Jayson Noland - Robert W. Baird

Amit Daryanani - RBC Capital Markets

Brian White - Topeka Capital Markets

Operator

Good afternoon and welcome to the Dell Inc. fourth quarter and full year fiscal 2013 earnings conference call. [Operator instructions.] I’d like to turn the call over to Rob Williams, head of investor relations. Mr. Williams, you may begin.

Robert Williams

Thanks, Operator. In light of Michael’s involvement in the pending transaction, today’s call will be led by Brian Gladden, and he will be joined by Tom Sweet, our corporate controller. The web deck was posted to our website in advance of the call. I encourage you to review this and related materials for additional perspective.

Next, I’d like to remind you that all statements made during this call that relate to future results and events are forward-looking statements that are based on current expectations. Actual results and events could differ materially from those projected in the forward-looking statements because of a number of risks and uncertainties, which are discussed in our annual and quarterly SEC filings and in the cautionary statement and our press release and web deck. We assume no obligation to update our forward-looking statements.

Note that we will be referring to non-GAAP financial measures, including non-GAAP gross margin, operating expenses, operating income, net income, and earnings per share. Historical non-GAAP measures are reconciled to the most directly comparable GAAP measures in the web deck posted in the Investor Relations section at dell.com, and in our press release and 8-K filed today. I encourage you to review these documents. Also note that unless otherwise mentioned, all growth percentages refer to year-over-year progress.

As you know, the board of directors of Dell, acting on the recommendation of the special committee of independent directors, unanimously approved a merger agreement to take the company private subject to a number of conditions. Given the nature of this transaction, we are not going to address any questions on this matter in today’s Q&A.

Now, I'd like to turn it over to Brian.

Brian Gladden

Thanks, Rob. For the full fiscal year, our revenue was $56.9 billion, down 8%. Full year non-GAAP EPS was $1.72, down 19%. Our enterprise solutions and services business was $19.4 billion, up 4% from fiscal year 2012.

For the fourth quarter, we delivered revenue of $14.3 billion, down 11% and up 4% sequentially, which was at the high end of the 2-5% sequential growth outlook we provided last quarter. The ES&S business was up 6% to $5.2 billion, and now represents 36% of our revenue and well over half of our gross [unintelligible] dollars.

We continue to execute on our long term strategy. Our strong balance sheet and cash position have enabled almost $5 billion in investments in new capabilities and intellectual property and key assets such as SonicWALL, Wyse, and AppAssure.

I’ll refer to non-GAAP financial measures going forward. Our gross margin was 22.8%, and included an approximately $250 million benefit, primarily related to vendor settlements. We experienced a competitive pricing environment in our desktop and mobility products and utilized a portion of the settlement dollars to fund investments in some customer accounts that we feel will drive solid cash flow and profitability over the long term.

In addition, we did see some areas of elasticity, and we were able to hold or gain share in certain areas of the business. SG&A increased 40 basis points sequentially to the 14% of revenue, while R&D was up sequentially to 2.1% of revenue.

The dollar increase in SG&A was driven by recently closed acquisitions, strategic investments in sales capabilities, and expenses related to the merger transaction. The R&D increase was driven by recent acquisitions in software, predominantly the Quest business.

Operating income was $954 million, or 6.7% of revenue. Earnings per share were $0.40, which declined 22%. We generated cash flow from operations of $1.4 billion, partially driven by the sequential growth in our business and an improved payables cycle. Our cash and investments balance ended at $15.3 billion. For the full year, we’ve returned 34% of our free cash flow to shareholders in the form of our dividend and stock repurchase, at the high end of our stated range of 20-35%.

Turning to our lines of business, our server and networking business grew 18%, representing the 13th consecutive quarter of growth. As a reminder, this business includes Dell Software related to Quest, AppAssure, and SonicWALL.

Servers increased 5%, driven by strong growth in our hyperscale beta center solutions business, as we see continued strong migration to our 12th-generation servers. 12th-generation servers now represent almost 80% of our Dell PowerEdge server revenue at ASPs and margins that are a premium to our previous generation servers.

Our networking business continues to deliver strong growth, with an increase of 425 and over 100% growth in our Force10 business. Dell storage was down 8% to $424 million, while we’re seeing improved momentum as the business increased 12% sequentially, driven by a 20% sequential increase of Compellent and EqualLogic combined.

The services business was down 3% and flat sequentially at $2.1 billion. Support and deployment was flat. Infrastructure, cloud, and security services were up 2%, led by our security business, which increased 17%.

We had a 22% decline in our apps and BPO business, driven by select contract expirations. Our services backlog and deferred services revenue increased 3% to $16.3 billion. New services signings increased 9% to $2.1 billion on a trailing 12 month basis.

Our third-party software and peripherals revenue was down 11%, driven by a continued decline in desktop and mobility-related products and a contraction in our imaging business. We saw good results in our Dell software business, led by Quest, which delivered revenue over our stated target of $180-200 million for the quarter. We also saw good sequential growth in our security software business, and continued to add customer-centric software solutions to address critical customer needs.

Our desktop and mobility business was down 20%, and up 3% sequentially. Our desktop business gained sequential share while notebooks lost share and continued to be challenged. We made the decision to improve our relative price position, and we believe this will benefit us going forward.

We expect the market competitiveness and margin pressure to continue, which reinforces the importance of executing on our greater than $1 billion cost-out initiatives specific to this business.

Clearly understanding the dynamics of the desktop and mobility environment, we continue to innovate and emphasize alternative compute models, as evidenced by continued strength in our Wyse business. In the fourth quarter, we saw orders in this business increase over 25%, including [tied to] enterprise solutions.

Turning to our business unit results, I would remind you that these numbers are not adjusted for the benefit of the vendor settlements. Large enterprise revenue was down 7% to $4.7 billion. . ES&S grew 10%, including 25% growth in servers and networking. Operating income was up 60 basis point sequentially to 8.4% of revenue.

Our public business was down 9% to $3.5 billion. We continue to see a challenging spending environment in the U.S. federal business as the budgetary uncertainty has impacted IT spend and delayed contract awards.

Overall, the public business saw good growth in servers and networking, at 11% growth. The decline in revenue, combined with higher opex, resulted in op inc of 6.8%, which is down 130 basis points annually and 240 basis points sequentially. Given the budgetary issues in many of these customers sets, there are fewer desktop and mobility deals, and those that were awarded were typically very competitive.

SMB revenue declined 5% to $3.4 billion. Similar to large enterprise, we saw strong ES&S growth of 9%, including 17% growth in services and 13% in servers and networking. Operating income was up 70 basis points sequentially to 11.3% of revenue. ES&S revenue mix of 39% has improved for seven consecutive quarters in SMB.

The consumer business continues to be challenging, with revenue down 24%. Operating income was $8 million, or 0.3% of revenue. Growth in this space continues to occur in tablets and in the low-value desktop and notebook space. We’re seeing good adoption of touch and the supply of touch panels improved throughout the quarter.

Given our pending merger agreement, we’re not providing an outlook for fiscal year 2014 or our first quarter.

Finally, I want to remind you that the 8-K that we filed January 10 we’re going to replace our customer segment reporting structure with a product and services group based structure for our first quarter of fiscal year 2014.

The new reporting groups will be as follows: end user computing, which will include desktops including thin client, notebooks including tablets, third-party software, and client related accessories; enterprise solutions group, which will include servers, networking storage, converged infrastructure offerings, and ESG-related accessories; Dell Services, which will include a broad range of IT and business services including support and deployment services, infrastructure, cloud, security services, applications, and business process services; and the Dell Software group, which will include systems management, security software solutions, and information management.

We will restate segment reporting for comparability purposes for fiscal year ’12 and fiscal year ’13 at the time of our first quarter earnings release. This aligns with how we deliver our strategy and is a natural step to better solutions for our customers.

Now, I’ll turn it back over to Rob.

Robert Williams

Thanks, Brian. For those of you in the queue, please limit your questions to one with no follow ups. Operator, can we go ahead and have the first question?

Question-and-Answer Session

Operator

[Operator instructions.] Our first question will come from the line of Shannon Cross with Cross Research.

Shannon S. Cross - Cross Research

Brian, I just had a question on the vendor settlement. $250 million is a pretty significant amount. Was that one vendor, or multiple? And then also, if you think about the reinvestment you did, was that part of the pricing you talked about on the PC side?

Brian Gladden

Yeah, it was a series of settlements that made up that amount in the quarter. And really, the way we thought about it, we had visibility to the settlement early in the quarter, and we were able to use that to selectively get more aggressive in pricing in some parts of the business. That’s how we thought about it in the quarter.

Operator

Our next question will come from the line of Tony Sacconaghi with Sanford Bernstein.

Tony Sacconaghi - Sanford Bernstein

You talked about the incremental price aggression that you had begun in the quarter, and I’m wondering if you could provide some color on when that was taken and how significant. And related to that, you talked about the imperative to really get the $1 billion in cost out in the client business. Maybe you could help us understand where you are in that process, how much do you think you’ve taken out, and how investors should think about that?

Brian Gladden

Early in the quarter, we had visibility to the settlement, the multiple settlements in the quarter, and we really did thoughtfully think about where we wanted to apply that in some markets, and throughout the quarter, continue to test the elasticity, places where we found the elasticity, and good long term profitable in accounts. That’s where we would have gotten more aggressive. And we did that primarily in the commercial business, really throughout the quarter.

Regarding the billion dollars, it’s really part of what Jeff Clark had talked about last year in the June analyst meeting. I would say, as we’ve consistently talked about on this, it’s a long term program. This is something we’ve talked about relative to three years.

As you look at fiscal year ’14, we will begin to ramp some of those benefits, I would say, early on. Much of that will be in COGS. And as you get later into the program, there will be more opportunities around opex. But clearly, around three years, and ramping throughout that period.

Operator

Our next question will come from the line of Brian Alexander with Raymond James.

Brian Alexander - Raymond James

Brian, just to follow up on the pricing, could you be maybe a little more specific about which parts of the business you got more aggressive, and where you think you gained share by customer segment, by region, or maybe by vertical? And more importantly, do you view this as a lasting change in Dell’s pricing philosophy in the client business? Or should we view it as more temporary given the vendor settlement benefit that you had visibility into?

Brian Gladden

We said it last quarter, and I think we’ve talked about it for really a couple of quarters. We looked at the markets, and clearly there were places that we needed to get more aggressive. I think this gave us an opportunity to do that. I think we did capture some business and some of those are larger, kind of long term relationships that we think will pay off for us in terms of profitability and revenue growth going forward.

I’m not going to be specific around where we did that. But clearly, our focus has been on commercial and really across the board in the commercial business. And specifically, around client, obviously, has been our focus.

So I think it’s going to continue to be a competitive market. No question. And I think part of what we had to do is get ourselves in the right price position in some of these segments.

Operator

Our next question will come from the line of Keith F. Bachman with Bank of Montreal.

Keith F. Bachman - BMO

Could you talk a little bit about federal? The margin there was down quite a bit, and you mentioned the volumes were weak. Is that to suggest that the federal business will remain at these margin levels given all the noise coming out of the various sectors there? And I think you mentioned clients, was that where the most change was, or across the board?

Brian Gladden

Yeah, I think it is. It’s going to continue to be challenging. This is on the very, very low end of profitability we’ve seen in this business. We’ve seen good progress in that business around enterprise, and there continues to be a good pipeline.

And remember, it’s not just federal. This is a broad public business that has exposure to healthcare and education and a broader global exposure to government. But I think you’ll see us continue to work to grow the enterprise mix in this business, and that’s our focus to really improve profitability here.

But I do expect, as you see the government spending continue to be somewhat constrained, that this will still be a challenging business for us.

Operator

Our next question will come from the line of Katie Huberty with Morgan Stanley.

Katie Huberty - Morgan Stanley

Just curious whether you think the elasticity that you saw in the PC business and the linearity in the quarter give you any confidence that enterprise IT budgets are stabilizing.

Brian Gladden

We’ve talked about the Windows 7 refresh, and the fact that all the data that we’ve seen, all the conversations we’ve had with customers, would lead us to believe that there’s still a significant refresh activity that has to happen in the next 12-14 months. Customer conversations would reinforce that.

I would say, as we sort of looked at the back half of the quarter, I think we got a little bit more comfortable with overall corporate IT spending, and would hope that as we head into the year that IT spending will be a bit stronger in this fiscal year than what we saw last year. And I think that’s a broad comment across the portfolio, the data center as well as the client environment.

But clearly, we are still of the belief that there’s a broad Windows 7 based refresh that will continue to play out as we move toward April 2014 with the transition with Microsoft.

Operator

Our next question will come from the line of Steve Milunovich with UBS.

Steve Milunovich - UBS

Your growth businesses aren’t growing. They were down 11%. Could you comment on what’s causing that? Is that mostly PC-based? And specifically, China was down again. Do you expect a reversal there?

Brian Gladden

You know, I think when you look at them individually - and I talked about China, India, Brazil - China I would say has begun to stabilize, and we’ve seen the market improve over the last three to four months. There’s still, I would say, not what we’ve seen over the last couple of years in China, but it’s picking up and we would expect to see growth as we head into fiscal year ’14 in China. I think Brazil, India, on the other hand, have been tougher.

And I think the currency situation there has really compressed both of those markets, and I think they were significantly down. China, on the other hand, was closer to flattish.

Operator

Our next question will come from the line of Maynard Um with Wells Fargo.

Maynard Um - Wells Fargo

I have a question around the elasticity benefit. If I take the $250 million out of the product margins, the product gross margins dropped about 16.5%. They were about a little over 17% last quarter. So while it may have been revenue accretive, it looks like it was gross profit dilutive, or maybe neutral at best.

Can you just talk about the strategy of revenue versus profits? Or maybe how much of the aggressive pricing is a function of having to maintain your unit volumes to keep the supply chain scale benefits. Because it definitely sounds like we should maybe expect this level of gross margin going forward, because of the competitive environment.

Brian Gladden

Last quarter, we talked about where we were in terms of price position, and expected to get more aggressive as we sort of headed into the quarter. The settlement allows us to do that. I think it is a bit of recognizing we need to keep this business in price position, we need to scale it appropriately to ensure we have the right cost position, and making some of that tradeoff.

I would say that on a gross margin basis, clearly it was dilutive, excluding the benefit of the settlement in the quarter. And we look at these accounts that we were engaged with, where we actually were able to win business, and see them as long term opportunities for the company, and see revenue growth as well as margin coming really outside the quarter.

And I think that’s the way we thought about it. This is a bit of an investment in the business to ensure we’re in the appropriate price position to grow and maintain our cost position. No question.

Operator

Our next question will come from the line of Aaron Rakers with Stifel, Nicolaus.

Aaron Rakers - Stifel, Nicolaus

I just want to build on that. Brian, I think at the analyst day event back in June, you talked about some scenarios on the PC business or end compute division, and stress testing that. But comfort level in maintaining a plus-5% op margin in that business, can you just update where you stand? Do you still think that’s an obtainable target, and if so, is that a function of some of the cost savings that you’re trying to drive out of the model, or something more?

Brian Gladden

That is not something that we would intend to provide updates on a quarter basis. As you know, we don’t really even track the business that way, and we’ve given you visibility and transparency to those results on some regular basis. I guess what I would suggest is as we head into the first quarter results and begin to report the business on a product based segment basis, you’ll get a lot more visibility to that.

I think that business, for us, continues to be an important element of the portfolio. We think we can drive solid profitability and strong cash flow from the client business, and as you know, it pulls to lots of other elements of the portfolio, and that’s an important part of our business model.

Operator

Our next question will come from the line of Jayson Noland with Robert W. Baird.

Jayson Noland - Robert W. Baird

Brian, just to clarify, you referenced April 2014. I think that was an XP end-of-life statement. What percentage of the installed base for Dell today is XP?

Brian Gladden

I think that’s really tough to get at, but the data that we’ve seen would suggest there’s still somewhere in the range of 40% of the corporate installed base for PCs that is XP or Vista that needs to be upgraded. So that’s, I think, pretty consistent with the data that we see for our installed base, and for what we hear from our corporate customers.

Operator

Our next question will come from the line of Brian Marshall with ISI Group.

Brian Marshall - ISI Group

Your server networking business obviously up almost 20% year over year, doing well, and you highlighted hyperscale data centers as one of the key drivers of that. But one of the world’s largest consumer internet companies has recently talked about building a third data center in Sweden based on 100% non-OEM servers. So I guess the question is, how do you feel like you’re going to be positioned going forward if we do see more of this [unintelligible] market start to merge with some of the biggest service providers out there?

Brian Gladden

It’s not a new dynamic. I mean, this is something that we’ve seen for the last few years. It is relatively isolated to a few number of large scale customers who can make the economics work, and given that, we’re still seeing strong growth in that business, and significant opportunities to continue to grow the hyperscale business. So I don’t think it’s a new dynamic. I think it’s one that we’ve seen, and the differentiation that we’ve shown in the 12G products actually is showing very well, and then helped us to continue to gain share in servers.

Tom Sweet

The other thing I would add is that there is a push on certain hyperscale people to provide their own boxes, but the benefit that we drive is around the engineering and logistics and some of the other service capabilities that come along with our suite of solutions.

Operator

Our next question will come from the line of Amit Daryanani with RBC Capital Markets.

Amit Daryanani - RBC Capital Markets

Just a question on the services side. It looks like revenues were down about 3% year over year. Could you maybe just talk about what was driving that, and also, to the extent you can talk about services revenues that were client-centric, how did that perform versus the non-client-centric services revenues?

Brian Gladden

The services business in general I would say, from our standpoint, the apps and BPO space is a place that we’ve been continuing to really exit legacy contracts and focus and improve business profitability. That’s continued, and you see that in the results in the quarter. We’ve seen good growth in the security element of infrastructure cloud and security, and that’s really the Secure Works business driving 17% growth in the quarter.

Support and deployment, I would say, again, that is obviously going to feel the impact of the unit declines that we’re seeing on the client business. To keep that business flat, obviously, it’s taken some good work from the teams around the tax rates, around pricing, and I think we continue to see very favorable performance, especially on the enterprise type services side.

So clearly in a flat number there, we would have seen the client side of support and deployment down, and we saw significantly better enterprise growth as we implement a lot of the support capabilities around some of the acquired enterprise hardware capabilities in the business.

So that’s really how it’s playing out. I would say we feel pretty good about the progress in the apps/BPO infrastructure side of the business, in terms of improving profitability. And I think we’ll continue to see progress with that as we move into the early part of the year.

Tom Sweet

I’d also point out that the deferred services revenue balance on the balance sheet grew 3%, and further evidence of that long term annuity that’s building on the balance sheet given the good work that the teams have done around attach rate.

Operator

Our final question will come from the line of Brian White of Topeka.

Brian White - Topeka Capital Markets

I’m wondering if you could talk a little bit about the trends you saw in Europe in the quarter, and what you see looking forward.

Brian Gladden

You know, Europe has, I would say, over the last couple of quarters, been relatively stable at a relatively low level. So you look at the declines we saw in the fourth quarter, pretty similar to what we saw in the second and third quarter in Europe. So, stabilized at a relatively low level, still some good progress around the enterprise side of our business in Europe, and saw some good growth there. Clearly better in Eastern Europe than Western Europe, but I think we’re sort of bracing for a similar environment in Europe as we move forward. Don’t see anything that’s going to make that a whole lot different as we move into fiscal year ’14.

Operator

This concludes today’s conference call. We appreciate your participation.

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