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Dell (NASDAQ:DELL), which is in the middle of a takeover battle between Carl Ichan and founder Michael Dell, reported its Q1 FY14 results on Thursday. It saw a 2% y-o-y decline in revenues to $14.07 billion as it continues to diversify into end-to-end solutions in order to reduce its dependence on PC sales. Net income also declined by 79% y-o-y to $130 million as weak PC demand and higher investment in research and marketing eroded profits. It reported GAAP earnings per share of 7 cents, down 81% y-o-y, and non-GAAP EPS of 21 cents, down 51%.

The shift in Dell’s focus to end-to-end scalable solutions is evident as its enterprise solutions, services and software revenue increased by 12% y-o-y to $5.5 billion. Despite this increase, end-user computing division revenues, linked to PC sales, declined by 9% to $8.9 billion which indicates a challenging business environment in the personal computing industry.

Server and Networking Division Drive Top-Line Growth

The server and networking division is Dell’s second largest division and makes up ~10% of its total value. For Q1 FY14, Dell reported a 14% y-o-y increase in revenues to $2.67 billion. One of the primary reasons for this growth was strong demand in Dell’s hyper-scale data center servers. The company continues to power 75% of the top social media sites worldwide. Dell’s 12th generation servers, which have higher computing power and caters to social media platforms, were sold at higher price points, which resulted in an increase in average selling price (ASP) for the server division. However, we expect the ASP to decline to ~$200,000 by the end of our forecast period as competition intensifies and companies such as IBM ans HP look to increase their market shares.

Service Division Adds to Profitability

The services division contributes only ~15% to Dell’s revenue but makes up 30% of its estimated value. In Q1 FY14, revenue from the services division increased by 2% y-o-y to $2.1 billion. Dell is targeting $5 billion in sales in the coming years, and it plans to achieve this by targeting key areas such as network security, cloud storage, systems management, business analytics, virtualization and thin client systems. Additionally, Dell’s security and systems management division reported an 11% y-o-y increase in revenues to $612 million in Q1, and Dell expects this will be a billion dollar business in the next few years.

We expect services to be the key growth driver for Dell as it has a higher growth rate and profit margin compared to the computer hardware business. In Q1 FY14, the operating profit margin for the services division increased by 140 bps y-o-y to 17.6%. Considering the improvement in operating margin, we expect Dell to maintain its gross margin at 34% until the end of our forecast period. Moreover, as Dell continues to expand its portfolio in the services domain, we expect revenues to increase to $11.5 billion by the end of our forecast period.

PC and Mobile Devices Business Continues to Suffer

Weak PC demand across the world continued to plague computer manufacturers as PC shipments declined by 13.9%. Dell also felt the heat and saw its PC business revenue decline by 2% y-o-y to $3.27 billion in the quarter. However, its PC division did better than the industry as the company shifted its focus from the lower-end to the mid and high-end PC market.

However, Dell’s mobility business, which includes tablets and mobile phones, underperformed the global Smart Mobile Device (SMD) segment. While globally SMDs shipped increased by 37% y-o-y in Q1, Dell’s mobility revenues declined by 16% y-o-y to $ 3.6 billion as incumbents like Apple and Google continued to dominate the segment.

The PC and mobile division together with the hardware peripheral division forms the end user computing (EUC) division of Dell. The EUC division reported a 9% y-o-y decline in revenue to $8.9 billion. We expect revenues from this vertical will continue to suffer due to intense competition from incumbents and pricing pressure on Dell.

We are in the processing of updating our model for Dell and have a $12.83 Trefis price estimate, which is ~7% below the current market price.

Disclosure: No positions.

Source: Dell's Earnings Reflect The Continued Challenging Business Environment