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Dell Inc. (NASDAQ:DELL)

FQ2 2007 Earnings Conference Call

August 17, 2006 5:00 pm ET

Executives

Michael Dell - Chairman

Kevin Rollins - CEO

Jim Schneider - CFO

Lynn Tyson - VP, IR

Analysts

Richard Gardner - Citigroup

Toni Sacconaghi - Sanford Bernstein

Laura Conigliaro - Goldman Sachs

Harry Blount - Lehman Brothers

Richard Farmer - Merrill Lynch

Ben Reitzes - UBS

Rob Semple - Credit Suisse

Chris Whitmore - Deutsche Bank

Andrew Neff - Bear Stearns

Bill Fearnley - FTN Midwest Securities

Louis Ciocia - Cowen & Company

Brian Alexander - Raymond James

Presentation

Operator

Good afternoon and welcome to the Dell Inc. second quarter fiscal year 2007 conference call. (Operator Instructions) I would like to turn the call over to Ms. Lynn Tyson, Vice President of Investor Relations and Global Corporate Communications. Ms. Tyson, you may begin.

Lynn Tyson

Thank you. With me today our Chairman, Michael Dell, who is joining us from China; CEO, Kevin Rollins; and CFO, Jim Schneider. Jim will review the second quarter results, and then Kevin will follow with his perspective on the market and our strategy. We will then take Q&A, and then Michael will wrap up with some closing thoughts.

As the operator said, our earnings presentation is available on our website. I encourage you to read this deck for additional financial and operational information. As a reminder, we will host our analyst meeting in New York City beginning with an evening reception on September 12. The formal meeting, which will be broadcast live on Dell.com, is the morning of September 13. Invitations have been sent out via email. The space is limited, so please register soon.

Finally, I would 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 our current expectations. Actual results 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 statements contained in our press release and on our website. I would now like to turn the call over to Jim.

Jim Schneider

Thanks, Lynn. For the second quarter we generated $14.1 billion in revenue, an increase of 5% year-over-year. Units were up 6%, and we gained over 1 point of share sequentially, achieving a record 19.3% worldwide. Operating income was $605 million, or 4.3% of revenue, which includes $119 million of stock-based compensation.

We're not pleased with our performance. Kevin will have more to say about our strategy in a moment, but I want to give you some insights into Q2. We priced too aggressive in the face of slowing industry demand in commercial markets worldwide and slower overall demand in Western Europe. In addition, component costs came down less than we anticipated, resulting in operating income which was lower than our May expectations on roughly similar revenue.

As a result, EPS for the quarter finished at $0.22. Cash flow from operations was almost $700 million, and we ended the quarter with $10.8 billion in cash and investments. Our cash conversion cycle was a negative 40 days. Last quarter we spent $1 billion to repurchase 43 million shares of our stock.

Turning to products, we continued to unveil new products in client, enterprise, and server solutions that position us to exit this year with the most robust product line in our history.

In the enterprise, we began shipping our new ninth generation PowerEdge servers with Intel's latest Xeon 5100 Series processors late in the quarter. These systems deliver 152% performance increase over the previous generation, and can lower power consumption by up to 25%. In addition, we previously announced we will be using AMD Opteron in our PowerEdge multiprocessor servers. Today, we announced the addition of AMD for our two-socket servers, with both shipping later this year.

Blade units were up 36% year-over-year. And we began shipping our new PowerEdge 1955 Blade server, which incorporate an innovative chassis design that optimizes performance in cooling and rack-dense environments.

In storage, revenue was up 36% year-over-year. We had our first full quarter shipping our new Dell/EMC CX mid-range storage system. And we launched two new Dell Network Attached Storage Servers designed on our 9G platform. As a result, total enterprise revenue, which includes servers, storage and the associated services and software and peripherals, grew a healthy 11%.

In enhanced services, revenues grew 21% year-over-year. In the quarter we announced Platinum Plus, our highest ever level of support for customers' enterprise data centers. This new service includes performance and system uptime tracking features for managing data centers, with initial customers reporting a 30% reduction in resolution time.

In software and peripherals, revenue grew 10%. Within this segment total imaging revenue was up 5% year-over-year, with total consumables growth of 46%. Total laser revenue was up 34% year-over-year, and we launched our third generation of laser printers, including six new color and multi-function and mono lasers. The flagship product is a new 3110cn. This printer is three times faster than its predecessor and delivers enterprise-level color laser performance at less than half the hardware price of a comparable competitor model, with superior cost per page.

With this refresh we also announced our new Open Managed printer software, which gives IT administrators a comprehensive suite of management tools from a single console at no additional cost.

In mobility, revenue was up 8% year-over-year on 22% unit growth. We're a leader in embedded wireless broadband, and we finished a major upgrade of our notebook portfolio, including the 3lb Latitude D420. The increased security, conductivity and durability features of these notebooks reflect extensive input received from customers.

Our mainstream Inspiron e1505 recently received the Best Buy award from Consumer Reports, citing multimedia features at a competitive price. Additionally, the e1505, along with the XPS M1210, were both selected as Top 10 Back-to-School Systems by Laptop Magazine. These new systems, including our new Dual Core notebooks, are seeing great acceptance and we will enhance this lineup in the third quarter with Intel's new energy-efficient Merom processor.

In the regions, results were led by strong growth in Asia Pacific and emerging markets in the Americas. In Asia Pacific, where customers continue to embrace the advantages of the direct model, we had 17% revenue growth and 27% unit growth, almost triple the rate of the industry, excluding Dell. This allowed us to move into the number 2 position in the region with over 11% share, up 1 percentage point year-over-year. China revenue growth was 31% year-over-year, with units growing 37%. We expect to move into the number 1 share position in servers with almost 26% share.

In India revenue grew 63% year-over-year, on 82% unit growth. For the quarter, we expect to gain about 2 share points overall and 4 points on notebooks.

In Japan where the overall market declined 2%, we grew units 15%. We're now in the number 2 position overall with 16% share, and we expect to be the number 1 in all business segments.

In Europe revenue was up 3% year-over-year on unit growth of 6%. We gained 50 basis points of share year-over-year in the total region, including the Middle East and Africa. Western Europe was a more focused example of our global profit performance this quarter. Industry unit growth has decelerated from 16% in calendar 2005 to 1% in Q2, with industry revenue contracting both sequentially and year-over-year.

We priced aggressively to grow the business with the resulting significant adverse impact to our results. Against this backdrop we grew faster than the broader market, and believe we took share in commercial accounts where the industry experienced the biggest slowdown. In the UK we gained over 1 percentage point year-over-year, extending our leading share position to 29.3%. In Germany our share grew almost 2 percentage points to 12.6%.

Turning to the Americas business unit, revenue was up 3% year-over-year, led by growth in the Americas International segment which was up 29%, and is on an almost $4 billion run rate. Within Americas International, Latin America revenue grew 45% year-over-year, with 52% growth in the home and small business segment. In Brazil we grew revenue 58%, and finished the quarter number 2 in overall share and number 1 in servers, where our share has grown 11 percentage points year-over-year to 41%.

In the U.S., which is a large and important market for Dell, we grew revenue 1% year-over-year and 3% sequentially, taking share in a soft market. According to industry analysts, we gained almost 2 points of share overall. In public we also took significant share, and announced a customer win with Commonwealth of Kentucky worth up to $100 million.

Before I make some comments about the third quarter and turn it over to Kevin, I want you to know that in August 2005 we received notice from the U.S. Securities and Exchange Commission that it was conducting an informal investigation of the Company. The notice stated that the investigation is not an indication that any violations of law have occurred. The SEC has requested information relating to revenue recognition and other accounting and financial reporting matters for certain past fiscal years. Dell has been cooperating.

In the course of responding to the request, we recently discovered information that raises potential issues relating to certain periods prior to fiscal 2006. While we do not believe that these issues have had or will have any material impact on our financial position or our reported results of operations for the relevant years, our audit committee, upon the recommendation of management, has initiated an independent investigation. We are committed to addressing any questions, concerns or issues the SEC or the audit committee may have.

Now with respect to the third quarter, I would like to discuss a few items we believe are relevant to focus on in order to gauge our progress. The addition of AMD on Dimension desktops and two-way PowerEdge servers will give us additional product breadth and cause visibility as we move through the third and fourth quarters. We're also excited about new processors from Intel, including the Xeon 5100, Core 2 Duo for desktops and Merom for notebooks.

We continue to take share worldwide, particularly in strategic regions in customer segments, and we intend to balance revenue growth with profitability. We're making solid improvements in our customer experience, but ongoing investments will put pressure on operating expenses.

Finally, we believe industry demand will decline modestly over the longer term. In addition, we expect to spend about $1 billion for share repurchase in this coming quarter.

Lastly, as I mentioned before, a majority of our cash is outside the United States. This is typical for companies like Dell who are generating increasing profits internationally. Since repatriating does have an economic impact, we will likely borrow in Q3 to augment our liquidity.

Now let me turn it over to Kevin for a more detailed discussion of our strategy.

Kevin Rollins

Thanks, Jim. I would like to touch on three points in my comments today: our view on worldwide industry growth and consolidation, our cost position and what we're doing to improve it, and our progress in the area of customer support and service. We are seeing early indicators of our actions and that they're working.

But before I go there, let me reflect on the quarter. We're clearly disappointed with our financial results. For the next quarter and the foreseeable future we will continue to balance our revenue growth and profit without giving up share. In our relationship account, we're more closely monitoring our list and bid pricing. In consumer we are simplifying our pricing and our promotion structures. We can do better, and we know that.

In the quarter we did make considerable gains, however, regarding share. We gained share worldwide and achieved an industry-leading record global share of 19.3%. We moved into the number 2 position, both in Japan and for the Asia Pacific region in total and we saw exceptionally strong unit growth in emerging markets like China, Brazil, and India where customers have a strong preference for standards-based technology and our direct model.

This is all happening in a time when the industry is slowing modestly, with worldwide unit growth down from 18% in the second quarter of 2005 to 9% in the second quarter of this year. Western Europe is following a similar pattern with even more deceleration.

Historically Dell has fared far better than our competitors in such periods of industry moderation and consolidation. Since 2000 we have gained almost 8 points of share worldwide and 15 points of share in the U.S., while competitors have undergone significant changes, including mergers, acquisitions, restructurings and share loss.

Next, improving our cost position is critical. We're on track to drive more than $3 billion of cost improvements this year. This includes lower component cost, structural material cost, product transformation and warranty cost, which are back end loaded into the year.

Today we took a step forward in this effort with the addition of AMD desktop processors for consumers, which will be available in September. We announced Opteron 2-socket servers for the enterprise, which we will introduce later this year.

Finally, given the importance of the customer experience we have taken bold steps, and we are seeing a turnaround because of the improvements we have seen. We have decided to go beyond our initial investment of $100 million, and now expect to spend $115 million this year on improving service and support.

We are seeing clear signs of a successful turnaround. For example, consumer hold times have been reduced by 50%. Call transfers have been reduced by 33%, and satisfaction rates are up 20% this year. Our likely to repurchase data registered its highest results for the past six quarters, with a 6.5% increase for business customers, and a 5% gain for consumers.

In DellConnect, our new remote diagnostic tool designed to significantly improve resolution of technical issues, has now been used by over 1 million customers, with a 94% satisfaction rate -- unheard of in our industry. More importantly, our customers are acknowledging our progress. Dell's scores in the annual University of Michigan American Consumer Satisfaction Index improved 2.5 points year-over-year, our highest score since 2004. Results of the Investors Business Daily U.S. Home Computer Purchase Outlook Index showed Dell was the preferred brand for 50% of likely computer buyers in the July poll versus 41% in the June poll. That is against 12% for our nearest competitor. Among likely notebook PC buyers, Dell was the number 1 choice for 60% of respondents, which is highest score for Dell in nearly three years.

Overall, we are seeing encouraging trends. Our gains in share around the world in key markets; our turnaround in customer experience; and, our moves to broaden our product line improve our cost position. For our shareholders, we are committed to driving industry-leading, profitable growth over the long term. Profits to fuel cash and cash returns. For Dell, the current environment, we believe, plays to our strengths. We would now like to turn it over to the operator for questions, and then Michael will have a few comments.

Question-and-Answer Session

Operator

(Operator Instructions) Our next question comes from Richard Gardner - Citigroup.

Richard Gardner - Citigroup

Thank you very much. You made mention of pricing too aggressively in the quarter in a decelerating demand environment. You also made mention several times of balancing revenue growth and profitability. I'm just wondering if that means that pricing and margins are going to rebound in the third quarter and beyond? Or I was hoping you could give us a little more detail on exactly what you're doing with pricing here on a go-forward basis.

Kevin Rollins

I will talk a little bit about the pricing strategies. Real clear on this, we don't think we did a good job of that in the Q2 timeframe. We were overly aggressive in a slowing marketplace, and in a situation where component prices didn't come down as we had thought, so we had margin squeeze. In the future we're going to be a bit more circumspect on our pricing strategy, more careful.

However, we're not backing off and moving into a margin harvesting and loss of share situation. We're going to continue to gain share, but we're going to do it, I think, a bit more thoughtfully and more carefully. And we're doing that through more circumspect review of list pricing, bid pricing and on the consumer side, as I mentioned, doing that with better promotional control and review of our advertising expenditures on pricing.

Richard Gardner - Citigroup

Just one other follow-up: could you confirm that there was no impact from a precipitous or sharp decrease in Intel co-marketing dollars on the gross margin in the quarter? Was this all related to pricing and component cost, or was there some other costs, like warranty or loss of co-marketing dollars, that also contributed to the sharp drop in gross margin in the quarter?

Kevin Rollins

We would probably not communicate anything on that. It is proprietary. We do believe that component prices did not come down as we had anticipated, but we wouldn't comment on any of our agreements with suppliers.

Richard Gardner - Citigroup

Thank you.

Operator

Our next question comes from Tony Sacconaghi - Sanford Bernstein.

Tony Sacconaghi - Sanford Bernstein

Thank you. I have two questions please. Kevin, in the current quarter it does appear as though Dell lost share. It grew units at 6%; the market, by your own admission, grew at 9%. So you lost share despite very aggressive pricing. So going forward, how do we think about pricing? You said you don't want to lose share, yet you priced very aggressively this quarter and you lost share.

Do you expect the component environment to change dramatically next quarter, and that is going to explain the difference in terms of your ability to retain share despite less aggressive pricing, or how do we think about that?

Kevin Rollins

Tony, I don't think we did lose share. I think if you use your 9% number, and you compare that to what was going on -- those are IDC numbers -- we actually grew faster than that according to IDC, in their calendar quarter. So if you look really at their share estimations as well as Gartner's, we basically held share in the U.S. We gained share, according to Gartner, quarter-over-quarter by almost 2 points. We clearly gained share in Europe and Asian, and moved into the number 2 position in Asia Pacific.

Jim Schneider

This is the same conversation we have it seems like almost every quarter where you've got this mix between the calendar quarter and our fiscal quarter. A quarter or so ago, I think it was the opposite. We had reported a lot higher revenue, unit growth than the market growth. It depends on what month and how the seasonality is for us. This time you are backing out one calendar quarter, and you're adding in our July, and it changes. It is really hard to do that.

We only have market data for the calendar period that has been presented. We're showing to have taken share. You can't extrapolate that and say, you only have 6, so July must have been bad, because this happens all the time.

Tony Sacconaghi - Sanford Bernstein

Just to follow-up on that, I think the market share gains were something like 10 basis points from Gartner, and certainly less than 50 basis points somewhere else –

Kevin Rollins

That is in the U.S.

Jim Schneider

Probably further on, because I know we will have some of the same questions on growth and margins as well, I just want to interject further on to what Kevin said. I think if you look at the markets -- I will give you an example like the large corporates in the United States, and public, and markets that are big for us and very important, to us, we actually took a reasonable amount of share without really any growth. So those markets that we view as the most attractive markets in this last quarter had very little growth. I think that has been part of it.

In some of those markets, if you take the end of last quarter, we said that we would price aggressively, but selectively. I think we were more conservative in terms of how we approached some of the consumer markets, for instance, which are less important to us profitability-wise, and we were a little bit more aggressive in places like Europe where we would like to continue to increase our share presence.

In some of those markets there was very little growth, and that is where we were pricing a little bit more aggressively to enhance our position there. Some of that just give us the elasticity because the markets were weak and we suffered profitability-wise. But if you look at most of the share data where you will see some of declines it is really more in U.S. consumer, and some of that is intentional by us.

Tony Sacconaghi - Sanford Bernstein

Now just switching topics, if I may. One of the most startling numbers in your press release was your change in headcount, which is up about 14,000 people over the last year. That is 22%. Your revenues grew 5% year-over-year. Can you talk about how this dramatic increase in headcount jives with your notion of accelerating your cost initiative?

Secondly, can you comment about what all these people are actually doing, and where they appear on the income statement from a cost perspective?

Kevin Rollins

Sure. If you look at the year-on-year versus it quarter-on-quarter, we have been making continued strides in moving from outsourcers into in-house. So you are seeing that going out into our numbers now. If they are a outsource number it would not have been in headcount. It is now moving into Dell. That is a conscious effort which shows in headcount numbers.

Secondly, we are hiring more, as we talked about in spending the $100 million to correct this service and support issue, which has now turned around. The money has proven to be well spent and so we're going to accelerate it. I think though you go forward and look now on quarter-on-quarter numbers, you're going to see that headcount number come back in line.

But we are not shy about adding the heads to make sure our CE, or our customer experience, got fixed and got fixed fast. We are very happy with looking at the reports now that it is improving.

Jim Schneider

I just want to clarify this, because we have always reported our headcount. We have talked about this in some prior periods. We have always reported our headcount on who is Dell badged. We have always had overflow capacity, using some temps and outsourcers. I think over the last couple of years and we grew more, particularly in the transactional space, we used more of those people. So they have always been in the P&L, but you don't see the headcount.

As we are working to improve our customer experience we have actually converted more of those heads to Dell badged. so you're seeing some additional cost as we put more emphasis on resolution and customer satisfaction, you're seeing more cost, but you're also seeing a lot more heads because we're converting people to Dell badged.

Tony Sacconaghi - Sanford Bernstein

If you could maybe just clarify, and then I will get off. It is just I think you had said customer service you would be looking at 2,000 people. Again, there has been 14,000 people added over the last year. Can you help us understand if there were big pockets of outsourcing, specifically what they were? Was bringing some form of IT outsourcing in-house adding 6,000 or 7,000 people? But I think the numbers you talked about for customer service are much smaller than the 14,000 net adds. So I'm just trying to get a better example of where some of the big pockets of addition have been.

Kevin Rollins

The 2,000 was really net hires that we made. But part of the 14,000 was conversion of temps and outsourcers into Dell badged. We also, Tony, have grown revenues, at least this quarter, of 5%. Some of it is just growth and investment in overall service and support areas, and in the general headcount.

Like I said, I don't think you're going to see after this settles out a year the headcount growth that will be as dramatic as it has been year-on-year. You'll be better served by watching quarter-on-quarter. We're very cognizant of the headcount. We know that drives OpEx. But we're going to make the necessary investments for CE, and start to managing our headcount much more closely to revenue on a quarter-on-quarter basis.

Tony Sacconaghi - Sanford Bernstein

Thank you.

Operator

Our next question comes from Laura Conigliaro - Goldman Sachs.

Laura Conigliaro - Goldman Sachs

A question first on the component side. You talked about component pricing not being as aggressive as you expected. Maybe you can give us more detail about that? Because certainly, first of all, it seemed from Hewlett-Packard's comments that they actually cited pretty aggressive component pricing, as well as from the market itself where we saw component pricing dropping in certain very key important components for PCs. Then in your slides you refer to the fact that you are thinking about lower component costs, basically back end loaded into the year.

Apart from AMD, where I presume you have a lower component cost element there, can you talk to us about where you would expect lower component cost? To what extent that makes a commentary about your view of normal seasonality, or maybe there not being normal seasonality?

Kevin Rollins

I will make a quick comment, and I will turn it over to Michael to say a few things on this too. The CPU, or processing area, is a big one. So we believe that offering a multiple of product lines, choice for consumers and for our corporate server customers, along with technology, will be a big issue. It will be very important for us. With the other commodities there are puts and takes here and there that we think will be positive. And let me turn over to Michael who could maybe comment on those.

Michael Dell

Yes, the processors as was mentioned is a significant one. I think we have been systematically adding products in a way that is going to provide significant benefit there in our cost. We are also undergoing a full re-examination of all of our procurement and supply chain practices to look for new opportunities. The process that we've had for the last several years has generally worked quite well. Although we've reached a share point and a critical mass where we are seeing some new things, I am not quite ready to talk about it yet, but we are exploring all sorts of ways to accelerate new releases in cost improvement.

Laura Conigliaro - Goldman Sachs

Can I follow up please? Again, can we go back to where were components not as aggressive as you expected? Which components? Again, which components do you think are going to tighten up in the back half of the year, or going to get even more aggressive in line with your lower component comment?

Kevin Rollins

Laura I don't think we can share that with you because that is proprietary information in terms of deals we cut and places we're negotiating. As Michael mentioned, there is new methodologies. I'm afraid we're going to have to beg off on that. I think we have told you about some key ones.

But you have got other issues surrounding flat panels, big categories of storage, big categories of memory. Those are all areas that you would imagine we would focus on doing it with new methodology.

Laura Conigliaro - Goldman Sachs

You have told us in the past roughly the percentage that you saw component costs down. Can you give us a sense of that?

I guess the one other follow-up question, which is to the extent that you expect component costs to come down more in the second half of the year, what kind of comment is that, or what kind of message should we be taking from that about how you think demand is going to be in the second half of the year? Because typically they go hand in hand.

Kevin Rollins

I think to some extent they do. We do see that there has been a slowdown, as we have talked about, from 18% last year to 9%. So we are seeing a factual slowdown in the unit growth worldwide. We talked about Europe being slower. So we would anticipate there will be a continued moderation of growth. It is not going to be precipitous, but it will moderate for all of these macroeconomic reasons you and we see every single day.

But in terms of each of the components, it really is based on some proprietary arrangements we have, capacity that is being built into the industry already and then shifts in what that capacity is used for. Again, I'm afraid we're not going to be able to share with you all of the things we are doing and knowing there, other than to let you know that we're very focused on component costs, as well as general, what we call structure materials, materials we put into every system, as key enablers in the back half of the year.

Jim Schneider

Partly to your question, we have tended to talk about what a basket of costs looks to us quarter to quarter, and we've talked about costs reductions moderating in the prior quarters. In this past Q2 it was lower than it had been in the prior couple of quarters. I think we are expecting it to improve. It would still be at a moderate level. I would say from cost reduction standpoint, it was certainly not what we anticipated.

Kevin Rollins

Laura, I think the point of all of that is we don't think that we have been doing a good enough job there in terms of getting the component costs, so the history and the data we have given you is not good enough.

Laura Conigliaro - Goldman Sachs

But is my assumption about the second half correct? That is, if you are anticipating lower component costs that that goes hand in hand with your view that you think we won't get a rebound in second half demand?

Kevin Rollins

No, I don't think we said that there is not going to be a reasonable -- there's always a bit of an uptick in the past half of the year -- but we just don't think it is going to be maybe as big as it has been. But that is about all we can tell you.

Laura Conigliaro - Goldman Sachs

Thank you.

Operator

Our next question comes from Harry Blount - Lehman Brothers.

Harry Blount - Lehman Brothers

I want to come back to the comment on balancing growth and profitability. Should we take that to mean that we should start to see profitability bottom out with this quarter, and effectively start improving from here on out?

Secondly, relating to the balancing on the pricing side of the equation, I think this is maybe the fourth or fifth quarter where we have heard about you guys not quite executing as crisply on pricing relative to marketplace and elasticity as you would have liked.

I guess the question then is, why should we believe that the actions you are taking now are going to be any better than the actions you have taken in prior quarters?

Kevin Rollins

A couple of thoughts to that, and you're right, we haven't done a very good job on having forecast visibility. A lot of that I believe has been because our visibility on components and cost hasn't been very good. As Michael alluded to, we have got to do a better job of understanding cost in order to predict price, profitability and then elasticity. That is what we are working on now.

On the pricing side we alluded to a number of things that we found in the quarter where we felt we had missteps in overly aggressively pricing, and therefore leaving margin on the table when we could have probably not had the margin squeeze that we had. Those we're going to correct. They are methodological within the Company, both in the corporate sector, as well as moving off of the pricing only strategy in the consumer business in the U.S., which has not been very effective. We are seeing signs of improvement there. But those are the initiatives that we are going to undertake to try to develop better visibility.

Harry Blount - Lehman Brothers

What about on the profitability side of the equation, at what point do we start seeing margin stabilizing, or even start improving on a normalized basis?

Kevin Rollins

We're not giving guidance, and that would be in the form of guidance, so I will have to pass on that.

Harry Blount - Lehman Brothers

Thank you.

Operator

Our next question comes from Richard Farmer - Merrill Lynch.

Richard Farmer - Merrill Lynch

Jim and Kevin, first on the SEC informal investigation, I think you said August 2005. Is that date accurate? If it is, why did you wait a year before disclosing it? What is different today versus a year ago? But more importantly, what are the issues that are being looked at in your revenue recognition, either by the SEC or by the internal group that you have had look at it?

Secondly, on the AMD ramp, before you had decided to support the AMD platform, one of the reasons you had given for not doing it was the cost of supporting a second platform. Now that you are ramping on AMD, how much incremental cost is that causing you to incur? And how much does that explain some of the margin performance that we saw in the quarter?

Kevin Rollins

On the investigation, you put it in the right context. An informal investigation really starts out as a letter from the SEC just requesting some information from you. At the time we got it, it seemed like we responded to the information. There was really no reason to disclose it at that time. And in fact, what I understand, there is hundreds if not more of such “investigations” started each year by the SEC and the vast majority are not disclosed because you really have a dialog process on some issue they want information on.

This has gone on in a deliberate process for about a year, which we put in the press release. In the course of researching some matters related to a request from them very recently here, we uncovered a couple of issues going back prior to fiscal 2006 that we felt warranted an additional look. We decided rather than just management doing it, we would have a investigation done by our audit committee.

But in any event, as this goes on and more people get involved internally, it is really a matter of we're not trying to necessarily keep this a secret from people, but the longer something like this goes on, we felt like we should disclose it publicly. Again, I don't believe that the issues that are under investigation right now should cause any material change to our financial position or results of operations for the years under question.

Richard Farmer - Merrill Lynch

If I could just follow-up on that, just qualitatively what are the issues? Is it something to do with services, recognition, or can you just help us understand topically what you're looking at, understanding that you don't expect it to be material when you finish the process.

Kevin Rollins

I really can't comment on that since it is under investigation. At the appropriate point we will let you know more.

Michael Dell

On the AMD part of your question, there are some start-up costs involved. We have been pretty thoughtful about this in terms of our architecture and different platforms that we're introducing, and believe that those will be paid back very, very quickly, given the major nature of this thing. So some start-up costs, but absolutely the right thing to do.

Richard Farmer - Merrill Lynch

But you wouldn't characterize those start-up costs as being one of the major drivers in what caused you to have the significant change in your margins in the quarter?

Michael Dell

No, there is some OpEx associated with that, but it is certainly not a margin driver in the second quarter.

Kevin Rollins

It is really not margin, it is one of operating expense.

Richard Farmer - Merrill Lynch

I should say on the operating EBIT line, is the change in your EBIT margins significantly driven by that or is that really not an issue from your point of view?

Michael Dell

No.

Kevin Rollins

No, it's not. But you would imagine, we didn't develop these yesterday.

Jim Schneider

It certainly contributes.

Richard Farmer - Merrill Lynch

Thank you.

Operator

Our next question comes from Ben Reitzes - UBS.

Ben Reitzes - UBS

Good afternoon. I've got a question and a few follow-ups here. I want to understand why you need to borrow next quarter? What is going on with the cash flow? From what I understand, you have a Malaysian entity which has lower taxes. You get your notebooks through there, as well as probably some of your APAC business as well.

Is there a major change now in your model in that a lot of profits and revenue are coming through Asia, and with notebooks, you actually now need to borrow to fund your business? Can you explain what is going on there? I'm confused.

Jim Schneider

It all has to do with tax, which we have pretty clearly disclosed in our financial statements that profits that are earned offshore, we consider permanently reinvested offshore. To repatriate those profits you would pay a U.S. tax on that, net of a foreign tax credit. We could repatriate profits that would have some tax costs to us. We had a one-time window a couple of years ago, but that actually reached back further when we were smaller internationally. We were only able to repatriate so much cash at that time.

Since then we've generated a lot of foreign cash. Think about it in the last couple of years. In a year we bought $4 billion of stock back. We didn't generate $4 billion in U.S. income. So what we did was we ate into all the U.S. income that generated cash, and we are left with foreign-sourced income. If you want to use it for share repurchase you can, but then you would have to pay a U.S. tax on it, so we prefer to borrow some money.

Part of it is also, it is not just a share repurchase, we're doing more funding with DFS and then intra quarter we can have issues on cash. We can end by the end of next quarter not being in a borrowing situation. But we need to have some liquidity. We talked about this even a quarter ago. There isn't anything really new about this disclosure.

Kevin Rollins

It is not that unique from what other companies do as well, Ben.

Ben Reitzes - UBS

I'm just saying that you had a major shift where APAC maybe beat expectations, Europe didn't. And it seems like the profits of the Company are obviously have a much different mix than what we thought they would be a few quarters ago. I'm just wondering if the capital structure and the pace of repurchases and the capital structure of Dell is changing as a result of these market dynamics that we have seen. Your comments about borrowing seem to be a wake-up call. You guys don't seem to be concerned.

Kevin Rollins

We actually said that last quarter, that we were. There is actually nothing new. This is just an update to what we said last quarter.

Ben Reitzes - UBS

All right. Then with regard to the battery recall, can you talk about your efforts there to diffuse that situation? We have gotten an email here internally about having to turn in our laptops, potentially. It seems like companies are taking it more seriously than the average recall. Could you talk about if there's any costs associated with it that might impact, and if you think it will be no big deal? I know financially you're getting reimbursed, so really I'm talking just in terms of demand and how you manage that issue.

Kevin Rollins

I don't think we know exactly how the demand will actually play out. What we do believe though is to recall the batteries was the right thing to do. We recalled a lot larger quantity than the specific incidents would normally require, because we are dedicated to customer service and support. We don't want our customers to believe that we will not do the right thing all the time no matter what the impact.

We're getting fairly positive results for that though from the media, from industry analysts and frankly, from customers, that are having a lot of trust in us doing the right thing. For corporations, we're working with each of the companies that we sell to on a plan for how they will change their batteries out. Some will do it in a centralized fashion. Some we will distribute to multiple locations. But that plan, as you might imagine, takes a little bit of time for us to work out with each one of them.

But we are dedicated to taking these batteries off the market as fast as possible, and have acquired enough of capacity and replacements that we can do that in a timely fashion.

Ben Reitzes - UBS

Can you confirm also, was Alienware about $50 million in the quarter in terms of revenue contribution?

Jim Schneider

No, I don't have the exact amount. Actually, Ben we just started to consolidate it during this quarter. It is relatively small.

Ben Reitzes - UBS

Thank you.

Operator

Our next question comes from Rob Semple - Credit Suisse.

Rob Semple - Credit Suisse

I can understand not wanting to cede any share, and potentially waiting to harvest some of the profitability and margin down the road. But at what point is the incremental market share that you're going after just not worth it? It would seem that it has at least been highly dilutive to date. Does it really make sense to try to grow in this environment? Your core market being PCs and servers, at least from a revenue perspective, isn't really doing a whole lot in terms of growth. I'm just trying to figure if it really is worth it to go after that incremental share?

Kevin Rollins

I guess the question is what do you mean by incremental share? I think we are pretty clear saying we wanted to hold or gain share. But we're not suggesting we're going after 3X the market growth rate.

Rob Semple - Credit Suisse

I guess in terms of your core market, U.S. corporate, how would you characterize that market in terms of underlying demand in the quarter? Was it worse than expected, and what is your outlook going forward?

Kevin Rollins

I think that the market was, again, healthy. If you look at the growth rates as discussed by IDC, but they have been slowing. It has been slowing in the U.S. as well. I think that you're seeing a modest decline in the growth rate that is going on. You have seen pockets of growth. Notebooks grew 22% for us this quarter. That has been a very hot market for us and moving. Desktops are declining, are a slower market for us. You're in the midst of an overall slowing, some good things and some slower things.

Operator

Our next question comes from Chris Whitmore - Deutsche Bank.

Chris Whitmore - Deutsche Bank

Thanks, good afternoon. In an answer to a previous question you indicated you left some money on the table by being too aggressive on pricing. Is there any way to get a feel for the magnitude of that money that you left on the table? At what point or under what timeframe do you expect to get that back?

Kevin Rollins

I think this comes through changing some of the pricing structures that we have had, and it will come back slowly as we make those moves into the marketplace. We're not in the position of forecast guidance margin improvements at this point in time. But we think that these will be positive moves, and that we can do better in terms of the margin realizations, but still capture some reasonable market share, and stay with the market growth rate.

Chris Whitmore - Deutsche Bank

You talked about a cost savings number of about $3 billion for the year. How much of that has been realized? What is to come in the back half of the fiscal year? Related to the overall cost-savings initiative, why not restructuring? Have you look at restructuring? Does restructuring make sense?

Kevin Rollins

We don't think restructuring makes sense, because we think that the investments we need to make, both in our infrastructure and also in our customer experience were postponed too long. Now is the time to make those appropriate investments. We're building the Company long-term. This will be the year when we will be doing that. So while we drive cost improvements, we also are putting investments back into the Company in places like infrastructure, places like customer service and support that will be important for the next five years.

Operator

Our next question comes from Andrew Neff - Bear Stearns.

Andrew Neff - Bear Stearns

Just two things if I could. One, if you can talk about the storage side of the business, that sort of stood out in terms of growth. Was there anything in particular driving that? Secondly, related to storage, were there any sort of selling arrangements with EMC to direct business to you that EMC would have taken otherwise?

Kevin Rollins

I don't think as a main strategy there is that kind of an approach at all, Andy. We have a very good relationship with EMC. And whenever we work together it is because we think working together will win the business. That is how those decisions are made of whether or not we take revenue, they take revenue. It is how do you win it? What does the customer wants us to do?

We had a good quarter in overall midrange storage with our Clarion business. That continues to grow nicely, as does the software associated with VMware. This was the first quarter we were really able to bring that full new CX product line into the business as there was a transition in the Q1, Q2 timeframe. So we are very happy with the product line we have now and believe that is just going to continue to be very a positive story for us as customers continue to need more and more storage.

Andrew Neff - Bear Stearns

Were there any implications in terms of operating income? Did that track the revenue growth on that side of the business, or can you give us any sense about that relative to the other businesses?

Kevin Rollins

It is a profitable business for us. The Clarion midrange storage is good, but we haven't been breaking out profitability on it.

Operator

Our next question comes from Bill Fearnley - FTN Midwest Securities.

Bill Fearnley - FTN Midwest Securities

Two questions on the expense side here. How should we be thinking about the operating expense trend going forward? The reason I ask that is because a number of your initiatives you're starting here, are we seeing a negative effect on the OpEx line because of start-up costs for some of these initiatives, which will dissipate over time? Or do you think this is something that is going to be elevated for the near term as you start up multiple initiatives? And then I have a follow-up. Thanks.

Kevin Rollins

If you actually look at OpEx right now as a percent of revenue, it is higher than it has been in some periods in the past. I'm talking about this quarter. I think some of the investments that we're making will put some pressure on operating expense. Then we hope that over time these investments will pay off, and we will actually be able to take it back down to levels that maybe are closer to what you saw in the past. Again, I think in the near-term though, you won't see that.

Operator

Our next question comes from Louis Ciocia - Cowen & Co.

Louis Ciocia - Cowen & Co

Thank you. I wanted to ask a question, one of the things that always made Dell very unique was your build to order capabilities in your desktops. As the market continues to shift to notebooks, and the Taiwanese are making roughly 75% of the worldwide notebooks, how can you regain the high ground as this secular shift occurs? And I have one follow-up.

Kevin Rollins

We have been making notebooks for a long time. That has been part of our overall business. I will invite Michael to comment a little bit more on this one too. I think it is basically improving the design. We have recently launched a whole new line of corporate desktops, the best in the history of the Company, second to none. We have recently launched a number of XPS mobility and notebook products which are top-of-the-line and getting awards from PC World and a number of others in terms of their performance, their design, the features set.

I think really the issue has been one of cost, cost, cost. While that is still important, and we've got our direct model that still delivers great cost, features and benefits and styling is becoming more important in that space.

Michael Dell

Yes, we are the world leader in the notebook market. In the business market we have about the same share as the number 2 and number 3 companies combined in this market. Our competitor is ahead in the consumer space. The business market we think has much better long-term profitability characteristics.

But the supply chain that we have for notebooks with our operations in Malaysia, we believe delivers solid profitability. Granted, there has been some erosion as competitors have improved their models a bit, but we're still maintaining healthy profits in that business and got a number of strategies that we're investigating to look for breakthroughs to take that even further.

Louis Ciocia - Cowen & Co

Thank you. Just one quick follow-up. On the switch to AMD on the desktop, was it mainly trying to get your cost down or would you say it was more so because customers were requesting it?

Kevin Rollins

I would say it was a third reason too. As we announced with our server product line, I think one reasons that we have been possibly slowing down and not gaining the share we had in the server product line is we didn't have all the products that the customers wanted. Granted, the new Woodcrest processors that we are seeing from Intel are very good. They have a good roadmap. We're happy with the technology. But we have been out of the AMD technology market all along the growth of that business. So technology is a big one. Customers obviously are wanting that technology, so we listen to them now.

Then the third issue is the overall cost issue. It benefits us and our customers by having multiple suppliers, and so that is what we're doing.

Operator

Our final question comes from Brian Alexander - Raymond James.

Brian Alexander - Raymond James

Just a couple of questions. You talked about pricing too aggressively several times. I was wondering why do you think your competition seemed unaffected or did not notice the pricing actions you took during the quarter?

Kevin Rollins

I think part of the reason is we priced in situations where it didn't really affect the competitive environment, so we either did it badly or were too aggressive. I think that has something to do if it. But again, I think if you look at the overall share gains, we gained share worldwide, gained share big in Europe and big in Asia. So to some extent, the elasticity did occur.

Brian Alexander - Raymond James

I'm just trying to better understand how fixable the pricing issues are, as I think several of us are. How much of the changes that you're making to pricing are related to personnel changes versus philosophical changes in pricing strategy, or maybe changes in the systems and tools that you're use to monitor pricing on a real-time basis? Is this a case of poor decision-making or a lack of the appropriate tools to make good decisions?

Kevin Rollins

No, it is a little more complicated than that. Obviously, margins are driven by prices as well as costs. You have to have both of them to be able to have great visibility and forecasting skill.

The second thing is there are methodologies which work for a number of years, which have allowed us to have pretty good forecasting capability and price prediction, that we don't think work as well and so we're changing those methodologies. They're not philosophies so much as they are methodologies of how you determine the best way to get volume, create demand, and get share.

So we have made some major announcements, at least here in the U.S., on changing from our promotion priced-focused strategy to much more of an every day low-price strategy, and weaning ourselves off of promotions. That has very positive impact on customers and on our overall profitability. That is one methodology change. We have got others that are proprietary within our corporate business in our other segment that we will be implementing this quarter and in the future.

Brian Alexander - Raymond James

Just lastly, the share repurchase in the second quarter and the third quarter, $1 billion is the lowest we have seen in five quarters. Yet the stock price is lower now than it was then. Why not buy back more stock? How much of this is due to the repatriation issue versus maybe just a recalibration of share repurchases due to a lower level of expected cash flow?

Jim Schneider

I think if you go back historically, we have probably not purchased more than $1 billion in most quarters. In fact, it has been less than that. I think we had a few quarters where we spent more. Yes, there is some consideration of some of the cash and liquidity issues. Some were just even on the market issues. It is not to say that we could not spend more. We usually take this quarter by quarter, so it is still under consideration, Brian.

Operator

We will now turn the call over to Mr. Dell for closing remarks.

Michael Dell

Thank you everyone for joining us today. While we gained share in the key markets worldwide and achieved record market share of 19.3% this quarter, we're not satisfied with our performance, and we will do better. We're focused on dramatic improvements in customer service and support. We announced today that we are expanding our investments in this area, and we are seeing solid progress.

Lastly, we're focused on improving our cost position and product leadership. Our announcements today are another step in that direction, and increase our belief that we will exit this year with the most technically advanced pipeline in our history.

Kevin, Jim, and I are confident that we're making the right long-term decisions for our customers and our shareholders. We look forward to seeing all of you and talking more about this at our upcoming September analyst meeting. Thank you.

Operator

This concludes today's conference call. You may disconnect at this time.

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Source: Dell FQ2 2007 (Qtr End Aug 2 2007) Earnings Conference Call Transcript
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