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Dell Inc. (NASDAQ:DELL)

F2Q10 Earnings Call

August 27, 2009 5:00 pm ET

Executives

Robert Williams – Director of Investor Relations

Michael S. Dell – Chairman and Chief Executive Officer

Brian T. Gladden – Chief Financial Officer

Analysts

Benjamin Reitzes - Barclays Capital

Brian Alexander - Raymond James

Maynard Um - UBS

Toni Sacconaghi - Sanford Bernstein

David Bailey - Goldman Sachs

Richard Gardner - Citigroup

Kathryn Huberty - Morgan Stanley

Bill Shope - Credit Suisse

Keith Bachman - Bank of Montreal

Shannon Cross - Cross Research

Bill Fearnley - FTN Equity Capital Markets

Mark Moskowitz - J.P. Morgan

David Wong - Wells Fargo Securities LLC

Jayson Noland - Robert W. Baird & Co., Inc.

Chris Whitmore - Deutsche Bank Securities

Richard Kugele - Needham & Company

Robert Cihra - Caris and Company

Operator

Good afternoon and welcome to the Dell Inc. second quarter fiscal year 2010 earnings conference call. I’d like to inform all participants this call is being recorded at the request of Dell. This broadcast is the copyrighted property of Dell Inc. Any rebroadcast of this information in whole or in part without the prior written permission of Dell Inc. is prohibited. As a reminder, Dell is also simulcasting this presentation with slides at www.dell.com/investor. (Operator Instructions)

I’d like to turn the call over to Rob Williams, Director of Investor Relations. Mr. Williams, you may begin.

Robert Williams

Thanks [Kristen]. With me today are Chairman and CEO, Michael Dell and CFO, Brian Gladden. Brian will review our second quarter results then Michael will follow with his perspective. When we get to Q&A please limit your questions to one with one follow up.

Our Investor Relations activities for the balance of this year include the Citigroup Technology Conference in New York in early September. We have a group investor meeting with Michael and Brian and one of them later in the month and two events in December including the CSFB Technology Conference and the Raymond James IT Supply Chain Conference.

I’d like to remind you that all growth comparisons made on this call are year-over-year unless otherwise stated and 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 and events could differ materially from these projected in the forward-looking statements because of the number of risks and uncertainties, which are discussed in our annual and quarterly SEC filings and in the cautionary statement contained in our press release and on our website. We assume no obligation to update our forward-looking statements.

I’d now like to turn it over to Brian.

Brian T. Gladden

Thanks, Rob. We’re generally pleased with the results of our second quarter. We believe that they demonstrate continued strong execution and broad progress on key initiatives we’ve shared over the last few quarters. Specifically, our cost reduction programs have never been more crucial than during this weaker demand environment.

Our results are driven by accelerating COGS improvements including better manufacturing efficiencies, continued OpEx controls and disciplined commercial execution. We also should highlight very strong working capital results for the quarter.

Michael will talk about relatively solid aggregate first half performance and I’d just like to reiterate that we’re still in a very tough environment with weak demand continuing, and we have a lot of work to do to continue to transform the company.

So let’s get right into the P&L and key performance metrics that you’ll find on Pages 6 and 7 of the posted web deck. Revenue was down 22% to $12.8 billion on unit shipments that were down 14%. Sequentially, revenue was up 3% versus the first quarter with unit shipments up 10%. This sequential improvement is consistent with our view that our demand environment has stabilized and while still mixed globally and by segment, it is improving somewhat. Gross margins were 18.7%. Solid progress on our COGS initiatives, disciplined pricing particularly in July and a buy-out of a revenue sharing agreement with a vendor and growth in enterprise products more than offset the pressure we saw from component costs, dependent pricing and client mix dynamics. The vendor transaction was worth about 50 basis points in the rate.

Much of the COGS progress was related to manufacturing and logistics actions associated with our $4 billion cost savings initiative. I’ll cover these items in more detail in a moment.

OpEx was down 14% and was 13.5% of revenue. Organizational effectiveness expense or OE was $87 million or $0.04 after tax, with the majority of this expense related to OpEx. Excluding the impact of $73 million in costs related to OE in Q2, adjusted OpEx was down $347 million or 17% year-over-year.

Intangibles amortization was $40 million and primarily affected our COGS. Expense related to our broader performance based long term compensation plan, which is primarily equity, was $92 million, split roughly 15% in COGS and 85% in OpEx.

Financing and other income was negative $42 million, driven in part by lower investment yields and higher interest expense related to the $1.5 billion in debt issuances we’ve done this year.

Our tax rate for the second quarter was 25% and overall GAAP earnings per share were $0.24.

We had a strong cash quarter. Referring to Slide 8 and 9 in the web deck, we generated $1.1 billion in cash flow from operations. Our cash conversion cycle improved 7 days sequentially to a negative 35 days. As we’ve said, we continue to see opportunities to sustain and even improve our cash conversion cycle. For the quarter receivables increased 8 days as a result of an increased mix of public and consumer retail related to back-to-school, though the quality of our receivables in the quarter and aging improved.

Payables increased 84 days, driven by structural improvements in our supply chain and our transition to contract manufacturing. We continue to believe that over time we can generate cash flow from operations in excess of net income, and that we can operate our cash conversion cycle at negative 30 days or better.

Turning to the balance sheet on Slide 10, we ended the quarter with $12.7 billion in cash and investments and after improvements in the capital markets in June we issued $1 billion in three and 10 year notes. We’ll continue to monitor the overall capital and financial markets for any future cash needs.

Referring to Slide 11, we’re pleased with our progress in Dell Financial Services. As you know we’ve been actively working this business over the past several quarters to reduce risk, improve returns and diversify our exposure, and we’re seeing the results of those efforts in the results of DFS. During the quarter we saw improvements in managed portfolio delinquency and loss rates, but we remain cautious. Additionally, we continue to take actions that will further reduce our business exposure to specific partners in Q3.

Our cost out initiatives played a critical role in our second quarter financial performance. Specifically, let me share with you some of the key details of our COGS initiatives. We continue to make progress in our product redesign cost reduction programs, which you can see on Slide 12. Although we’re pleased with these results, the good news is that we still have significant work and opportunity in this area.

In Supply Chain 2.0 our goal is to optimize our global supply chain to effectively serve our different customers around the world. Earlier this year we shifted to a segmented supply chain strategy that provides different ways of fulfilling customers orders and creating differentiated value aligned to their specific needs. We’ll continue to balance our configured order supply chain capabilities with significant utilization of contract manufacturing. Approximately 40% of our volume is now going to contract manufacturing as of the end of the second quarter, and this will continue to grow.

As mentioned earlier, our efforts in optimizing manufacturing and logistics contributed to the sequential uplift in gross margins during the quarter, as we held on to these benefits as opposed to passing them through to the customer base. As I’ve said before these realized savings may not be linear and we may choose to reinvest some or all these benefits in the business.

Our business units had mixed results in the quarter and some are seeing better market conditions than others. The business unit results can be found on Pages 13 through 16 of the web deck.

Large enterprise had a revenue decline of 32% and 3% decline sequentially to $3.3 billion.

Operating income as a percentage of revenue was down 20 basis points to 5.2%, driven by global demand weakness and aggressive pricing activities on the demand we do see in the market right now. Despite this we continue to invest in our enterprise product, service and sales capabilities to help customers drive down the total cost of ownership, and we’re well positioned to benefit from a return to more normal demand in this segment.

Public was the best performing commercial business this quarter, with revenue down 16% and up 20% sequentially to $3.8 billion. Seasonal growth in our education segment was a key contributor to the improvement. Operating profit dollars were up 16%, while operating income percent was up 280 basis points as we exercised pricing and OpEx discipline. We remain focused on tailoring vertical solutions for our unique customer base in public and balancing our geographic expansion by leveraging best practices.

Our small and medium business revenue was down 29% and 5% sequentially to $2.8 billion in the quarter, with IT demand strongest in Asia and weaker in EMEA, where it appears that much of the industry demand was at the lower end of the product portfolio.

Operating income percent was up 40 basis points as we managed to improve gross margins despite the weak demand. Our efforts in SMB are still centered on delivering high value offerings and expanding our relationships through increase coverage.

Our consumer business posted a 17% year-over-year increase in unit volume, had revenue of $2.9 billion, up 2% sequentially and 9% decline from last year. Operating income was $89 million including a $53 million benefit from the vendor transaction we talked about. Similar transactions could occur periodically and as we work to expand sources of revenue and margins in this business we will see this variability in margins. This is similar to the dynamics we saw last year in the third quarter, when we had other vendor transactions in the quarter.

I want to reiterate that our operating margin outlook for consumer, we continue to believe that the 1 to 2% is the right range to think about for this business in the current fiscal year. A few weeks ago we showed a mobile device prototype at an event in China. We are working with China Mobile and this effort is consistent with our plans to explore opportunities in small screen devices, as we’ve discussed. Just to make sure you have the appropriate context, our primary focus and our investment priorities remain focused on enterprise and solutions.

On a regional basis, America’s revenue was down 19%, EMEA was down 33% and APJ was down 21%. Our total revenue from BRIC countries was down 17% and made up about 10% of our total global revenue. In the BRIC, Brazil and China were better on a sequential basis while declines in Russia were the most pronounced year-over-year. Revenue outside the U.S. was 45% of our total mix in the quarter.

Moving briefly to product highlights, in the client space mobility units were down 1% and revenue was down 21%, due to the soft demand in commercial segments and average selling price declines in consumer and SMB. Desktop units were down 23% with revenue declining 33%.

For enterprise products and services, our server revenue was down 19% on a 23% decline in units, while sequentially revenue and units were up 9 and 12% respectively. Our worldwide X86 server share was up both year-over-year and sequentially by 60 and 200 basis points respectively, as we remain in the number two position worldwide and number one in the U.S.

Storage revenue was down 20%. Our EqualLogic revenue was up 42% with continued strength in margin performance. During the quarter we launched our new PS4000 virtualized Storage Array with performance and capacity for branch office and smaller SAN deployments.

Enhanced services revenue declined 11% to $1.2 billion, while our deferred revenue balance grew 2% to $5.8 billion in the quarter. Although we continue to move towards more standalone services, a significant portion of our portfolio is made up of support services, which tend to correlate with hardware unit growth causing the year-over-year decline.

Software and peripherals revenue declined 15% in the quarter, driven by overall client unit declines as well as softness in displays and imaging.

Turning to the outlook, much of what we said at the July analysts meeting continues to hold true. From a priority standpoint, we’ll prioritize those initiatives and opportunities that drive a balance of liquidity, profitability and growth. We have a strong bias towards delivering cash returns. By disciplined execution on working capital and our ongoing cost initiatives, we’ll continue to fuel our results here. The second quarter saw better demand sequentially, particularly in the U.S. and parts of Asia where we are seeing some signs of stabilization, albeit lower levels of demand. We do believe it’s too early to say we’ve hit an inflection point, particularly given our mix of commercial accounts in large enterprise and SMB, where we continue to see significant year-over-year demand declines.

For our third quarter we expect to see some seasonal demand improvements from our federal government and consumer businesses, but it’s also important to note that the first part of the third quarter is generally a period of slower demand for our large commercial customers in the U.S. and Europe.

From a trending standpoint we do expect overall revenue for the second half of the fiscal year to be stronger than the first half, assuming that the current demand trends continue. We believe that a refresh cycle in commercial accounts will be a calendar 2010 story. We remain confident that the significant majority of commercial customers are deferring purchases and will accelerate IT spending to take advantage of technology driven productivity improvements. This acceleration remains predicated on an improving economy and related improvements in customer profits and government tax receipts.

While pleased with our gross margin performance and the ability to offset component and pricing pressures we saw in the second quarter, we continue to see headwinds in component costs, where we have line of sight to see increases in panels and memory in the current quarter.

Finally, we also expect to continue to absorb organizational effectiveness expenses this year as we continue to realign our business and improve our competitiveness.

With that, I’ll turn it over to Michael.

Michael S. Dell

Thank you, Brian. We’re pleased with our progress in an uneven demand environment globally. We also want to reiterate our commitment to optimizing operating income and cash flow growth over time.

The first half of this year saw our revenues down 23%, but up sequentially in the second quarter with order rates improving in July and that’s extended into August, that particular strength in our enterprise products and services, with our EqualLogic storage and our 11G server platform.

Excluding $272 million in OE expense, we delivered first half EPS of $0.52. Cash flow from operations was $1.8 billion and we built a solid cash position. Our results demonstrate the power of separating our commercial businesses. Our public business for example had strong sequential growth in almost every product group and customer vertical.

Now, when we look ahead, we see a pretty powerful new product cycle. When you think about the new Halo Processor family from Intel, Windows 7 to replace effectively in many customers Windows XP which is soon to be an eight-year-old operating system, Office 2010 which comes in the first half of next year which we think is a very significant addition to the client portfolio and tremendous progress in both client and server virtualization, all of these add up to what we see is a powerful new product cycle going into calendar 2010.

And from our EqualLogic offering to our 11G racks and blades to our data center solutions, we are well positioned to integrate and deliver the best value for enterprise customers. As we explained in July at our analysts meeting, the large majority of the current and future data center and server and storage opportunities are going to be based on simpler, more open solutions, the very kind that Dell can provide. With our position, our installed base, our tremendous access to customers of all sizes and our growing capabilities, this is where we’re focused, where we’re winning and where we expect to continue to win.

Continued progress on our $4 billion cost reduction program and progress on expanding our business across the globe and ongoing investments in enterprise products and solutions, taken together, we believe we can deliver solid operating income and cash flow to growth over time.

So now let me open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Benjamin Reitzes - Barclays Capital.

Benjamin Reitzes - Barclays Capital

Wanted to ask what happened since the analyst’s day on gross margins? It sounded like they were going to be in the mid-17s and excluding the gain around 18.2, so 70 basis points or so of better than expected progress towards the end of the quarter. I was just wondering if you could talk about what happened and the sustainability of things that surprised you there.

Brian T. Gladden

Yes, Ben, you know first thing I’d say is you know we’re committed to transparency. We at the time saw pretty clear pressure after about eight weeks into the quarter. We talked about component costs. We talked about what we were seeing in pricing. We had already at that point when we talked to you initiated actions to try and offset that. We said that during the meeting, and I would just say we’re pleased with the execution of the teams. We worked with tightened pricing. We accelerated some of our COGS actions. We managed discretionary costs. We worked through managing the mix. You know I think those are some nice accomplishments to get gross margins back where they should be. You know going forward I would just say as I said in the comments that we still see some challenges around component costs and I think pricing is going to continue to be challenging, and you know we’re working hard to offset those and improve profitability.

I think as we’ve said we’ve managed gross margins within a range. There are clearly some things that we’re going to do over time to try and get gross margins up, as we invest in the enterprise and the solutions that Michael talked about. That may cause us to invest in OpEx and you know change the dynamics a bit, but for the short term we’re focused on trying to maintain gross margins.

Benjamin Reitzes - Barclays Capital

So to be clear, was accelerating your cost savings and managing the mix at the end of the quarter and was there anything in services or were those the main things? And anything in any particular geo?

Brian T. Gladden

You know if you look inside the business what you saw was real strength in the enterprise portfolio and the high margin elements of it. And that was a significant contributor to the margins in the quarter.

Michael S. Dell

Yes, mix in the last month of the quarter was significantly better.

Brian T. Gladden

And I think what we’re also seeing as we start to win more enterprise business, you know it is typically in the industry more you know last month’s in nature and we certainly saw a fair bit of that in July.

Operator

Your next question comes from Brian Alexander - Raymond James.

Brian Alexander - Raymond James

Just in terms of the upgrade cycle comments, I’m just curious why you think PCs will be a huge priority for CIOs next year given we’re coming out of a period where spending on almost any technology has been deferred and there are arguably more important investments for companies to make. And then just following on, how strong do you think that refresh opportunity will be in the commercial sector, specifically what percentage of the PC install base do you think will turn over next year and into 2011 for the industry?

Michael S. Dell

I think the data center virtualization is going to continue to be a high priority. What I would tell you is that when you look at the age of the install base, we know that after a certain period of time the cost just becomes pretty onerous and the percentage of these machines out there that are based on Windows XP, which again is an eight-year-old operating system in another month or two, you know also what many of you may not have done and I would encourage you to do is go to dell.com, buy a modern PC, put Windows 7 on it, put Office 2010 on it, you will love your PC again. And as more and more people do that, I’m here to tell you there’s going to be a refresh cycle next year. It’s not all going to come in the first month or the second month, but over the course of the year there will be a big refresh cycle.

Brian Alexander - Raymond James

Can you be a little bit more specific, Michael, in terms of what percentage of the install base do you think will get turned over next year versus kind of your normal expectation for a replacement cycle?

Michael S. Dell

I don’t think we really know. You know we do know that we have a large install base and we have pervasive customer relationships, and certainly we’ve built the product lines to go serve that up. I would also tell you that you know we’re gaining share in servers and storage. And you know building the solution portfolio to win and in the data center. So I wouldn’t focus only on the client comment.

Operator

Your next question comes from Maynard Um – UBS.

Maynard Um – UBS

Can you just talk about the process for these PC refreshes in 2010? Because it sounds like it’s going to be a fairly you know so you may get some enterprises kind of refreshing in large orders. Do you anticipate new RFPs that are going to be put out? Have you seen any of those RFPs yet or when do you anticipate those will be there? And just in terms of the competition for those RFPs, should we anticipate that the ASPs and margins might be a little bit lower, given the increase in competition?

Michael S. Dell

You know what we’ve seen so far is there have been a number of large RFPs, and we’ve actually won quite a few, but they’ve been delayed in deployment because of the kind of state of the economy and budgets. You know we’re certainly expecting as the economy is kind of stabilizing and giving some signs of improvement, that where those wins have occurred will start to go from kind of won to actually being deployed. What the process looks like next year I don’t think we really have any way of knowing at this stage. As Brian said it will depend on kind of larger economic factors. But we do know that after a certain period of time, people will replace their machines and there’s a large install base. The average life has extended and whenever you get an alignment of technology as powerful as this, and an old install base, you know we have every reason to believe that there will be a strong refresh.

Maynard Um – UBS

If I could just follow up on that, just on these RFPs that you’ve won, is there any sense of what percentage of the install bases within those RFPs are being refreshed or upgraded?

Michael S. Dell

No. I don’t have any data like that. But you know I could tell you anecdotally that you know we have customers that have you know install bases of four and five year old machines. And you know they’ve planned to deploy new machines and for budget reasons haven’t done it yet. So we’re convinced those will occur, but they’re delayed.

Operator

Your next question comes from Toni Sacconaghi - Sanford Bernstein.

Toni Sacconaghi - Sanford Bernstein

I wanted to ask you about operating expense. It was down about 17% year-over-year. Revenues were down 22% so I realize it’s difficult to keep cutting OpEx at the rate that revenue is falling. But on a sequential basis it was essentially flat, despite the fact that it seems like you took a lot of organizational effectiveness expense last quarter, I think about $180 million, and another $73 million this quarter. Is that organizational expense not principally workforce reduction? If we work backwards from that math, that would kind of imply 4,500 people have come out over the last two quarters, yet we saw OpEx actually marginally go up when you make the one time adjustment sequentially. So I guess the questions are one, can you explain what this organizational effectiveness charges are? You’ve stated that you expect them to continue and accordingly should we expect operating dollars in the second half to be materially lower than they were in the first half of this fiscal year?

Michael S. Dell

Do you mean OpEx for the second half, Toni?

Toni Sacconaghi - Sanford Bernstein

Correct.

Michael S. Dell

Yes, you know I would say as you know as we look at these organizational effectiveness activities, they do span both OpEx and COGS. We have made some changes in our manufacturing footprint as part of the transition and incurred some costs there. And that has contributed to our benefits on the COGS line as well. And there were also some facilities related costs that show up in those numbers, so that’s kind of one perspective around OE. I think as you look at OpEx and you look sequentially, you know there are things that we’re investing in. And I think as we talked about the strategy and gain more confidence in our ability to invest in solutions and building out capability organically, we’re doing some of that. I think you’ll see that going forward and as I said we would hope over time that has an impact as well on gross margins, and you’ll see gross margins expand. So we’ll continue to make those trade-offs. There are costs continuing to come out of OpEx, but we are selectively as we see some stabilization in demand we are selectively making some OpEx investments in the business as well.

Toni Sacconaghi - Sanford Bernstein

If I could just follow up, for the organizational effectiveness charges that you took in Q1 and Q2, what percentage benefit did you get? So did you get 50% of the benefit from those charges in Q2? Did you get 25? You know I often realize that once you take workforce charges you don’t get any benefits for a little while, so what percentage of the roughly $250 million that you spent on operating organizational effectiveness charges have you received benefits from through the end of Q2? And I don’t think you answered the question on whether you expect OpEx in dollar terms to be lower in the second half or not.

Michael S. Dell

You know in general we think about these organizational effectiveness programs, I mean we tend to look for in aggregate a one year sort of payback. And when you get into the details of you know where these programs are and you know in some cases when they’re in Europe you have to deal with Workers Councils and you have a bit longer process, your payback isn’t nearly that immediate. So as we look at the second half of the year and some of the actions that we took even in the first part of the year that have involved our European operations, you’ll see some of those benefits kick in then. So I mean it varies. But again in general in aggregate we’re looking for kind of a one year payback on these kinds of programs.

And in terms of second half, you know again we’ll continue to see costs coming out of OpEx. The question is you know how much are we going to make organic investments in the business to offset that given our confidence in where we see demand going. So we’ll continue to make those trade-offs. You know it’s hard to say at this point, Toni.

Operator

Your next question comes from David Bailey - Goldman Sachs.

David Bailey - Goldman Sachs

Can you give us a little bit more detail on the improvements that you saw in demand, particularly in July and August, either by product area or geography?

Michael S. Dell

Well you know U.S. and Asia minus Japan were up sequentially in revenues, you know 11% in Americas and 11% in Asia minus Japan. China was up 9%. The total was 3. BRIC was up 16% so you know emerging and U.S. was quite strong. And you know challenges in EMEA. EMEA down 13%, Japan down 24 although sequentially Japan always has a down second quarter. And as we’ve talked about the mix into some of the enterprise products was very healthy.

David Bailey - Goldman Sachs

But that was for the full quarter, but you made a comment that July was I think the strongest month of the quarter and that continued into August. Are those areas that continue to be the strength or did you see something different?

Michael S. Dell

Yes, I think the strong areas continue to be strong. You know U.S. and Asia you know had strong Julys.

David Bailey - Goldman Sachs

And any comment on back-to-school so far?

Michael S. Dell

Back-to-school looks pretty good.

Operator

Your next question comes from Richard Gardner – Citigroup.

Richard Gardner – Citigroup

I just wanted to follow up on all the discussion regarding the corporate upgrade cycle next year and ask you, Michael and Brian, whether your confidence in a refresh next year is based on actual conversations that you’re having with your customers and you know what you see in terms of RSP activity or whether it’s more based on you know just the aging of the installed base that you see out there.

Michael S. Dell

Yes, you know when we survey our field teams and talk to you know CIOs out there, this is what we hear. And you know I think it’s not 2010 and it hasn’t started yet. And certainly there are risks here. You know customers may look at Windows 7 and say well maybe I’ll wait or it has a problem or not good enough. Everything we see right now tells us it’s actually quite positive and we also think there’s an overlooked piece of this that most people haven’t paid attention to and that’s Office 2010. And you know for those of you who are into this sort of thing you might go check it out.

Richard Gardner – Citigroup

And just as a follow up, I was wondering, Michael, if you have a view on what percentage of the installed base is capable of running Windows 7 or Windows Vista at this point, based on your own customer installed base? And also I think historically a lot of large corporates have upgraded their PC and their operating system infrastructure separately and as long as the PCs were good enough for the new OS in many cases they would put the new OS on the existing hardware base. So I’d be interested to get your thoughts on what percentage of the hardware base is ready for Windows 7?

Michael S. Dell

Well, it’s always a subject of debate in terms of you know do you put the new OS on the old hardware. I think that the difference now is the size of the installed base of old hardware has never been greater. And again you’re talking about you know a change from an eight-year-old operating system, so it’s a significant you know change over in terms of capability and you know we just see a lot of old machines out there that are going to be replaced. Certainly some people will put Windows 7 on the installed base. You know generally the larger customers don’t like to touch a machine once they’ve put it out there. It’s just more expensive for them to just leave it in place and do a rolling upgrade.

Brian T. Gladden

Hey, Rich, I’d just jump in there to just kind of remind everyone that we’ve always believed that you know the cycle would be predicated on an improvement in the economy and kind of related improvements in customer profits, etc. If you look at you know the commercial accounts, you know probably across the globe, you’ve still got some commercial businesses that are down you know 20 to 30% literally across the globe and that’s just not [audio impairment], that’s across many companies that we look at. And people are pretty convinced that budgets are locked for the back half of this year. That will be a little bit better because they didn’t spend as much in the first half. Yes, so I mean we’re going to continue to remind you guys that we believe this is a 2010 event. We’re excited about it, but this is something that will begin gradually and build through the year and we’ll just have to see how things break in terms of you know the improvements in underlying economic conditions and corporate profitability.

Operator

Your next question comes from Kathryn Huberty - Morgan Stanley.

Kathryn Huberty - Morgan Stanley

Six weeks ago you sounded more concerned about gross margins dropping with the higher competitive cost environment than you do today. Is it fair to extrapolate that it’s the strength in server and storage sales that you saw in July and that should continue into the next couple of quarters that gives you you know more confidence and less volatility on the gross margin line?

Michael S. Dell

Well I think we’ve also raised prices and I think we’ve also done some work on COGS. So I think it’s a combination really of all three that are helping to offset that pressure we see.

Operator

Your next question comes from Bill Shope - Credit Suisse.

Bill Shope - Credit Suisse

Yes, I have another question as well on gross margins. Just to be clear, outside of the issues you mentioned in the release and so far on this call, were there any noticeable late quarter improvements in the component pricing environment, whether it’s through price breaks on traditional components or through volume incentives from Microsoft or Intel that provided the benefits to margins after the analysts day?

Michael S. Dell

So, Bill, to clarify, you’re asking if there were vendor based incentives that benefited gross margins?

Bill Shope - Credit Suisse

Well looking at all the components, right, so traditional components including panels, memory and as well as the prices you pay through Intel and Microsoft, I’m just wondering, I understand the overall basket you know was headed in the wrong direction at the analysts day. I’m wondering if there was any change in that direction at the tail end of the quarter, whether one time in nature or whether something that you’re going to continue to see offset some of the pressure in coming quarters?

Michael S. Dell

Nothing surprising. I mean we generally have you know a lot of volume based deals where we have rebates that are tied to specific commitments, but I would tell you nothing in the quarter that surprised. One you know deal that we talked about that we called out relative to consumer business would be the only thing that I would call out. Everything else was generally typical.

Bill Shope - Credit Suisse

And then ex that vendor buyout, would you characterize the current gross margins as within a sustainable range in the near term?

Michael S. Dell

Yes, I think if you take that buyout out you know it’s probably in the range. Sure.

Operator

Your next question comes from Keith Bachman - Bank of Montreal.

Keith Bachman - Bank of Montreal

Brian, I wanted to ask you about the services line item if I could. It was down sequentially. I know it’s highly correlated to units, but units were generally up across the board. What conclusions should we draw about the revenue run rate of services as we look out the next couple quarters? And related to that, is there anything we should be thinking about in terms of mix that would impact services profitability going out the next couple of quarters as well?

Brian T. Gladden

Well I think you know services revenue at sold we’ve got 11% year-over-year. I think on a sequential basis you know pretty close to what we saw with units. We did. The deferred services balance actually grew in the quarter on a sequential basis.

Michael S. Dell

To its highest ever level.

Brian T. Gladden

Yes, $5.8 billion. So I mean obviously that’s something that we look at in terms of upsell, in terms of the tax rates and you know really a good sign in terms of our progress of building the services business. So you know that’s I think encouraging for the future and as we continue to build that deferred services balance, you know that’s obviously a positive for us going forward. In terms of mix that we would expect anything different, I don’t think so. I mean I think we continue to grow you know some of the higher ended enhanced services as well, faster than the core business, and that will help. Those will be higher margin. We feel pretty good about the services progress.

Operator

Your next question comes from Shannon Cross - Cross Research.

Shannon Cross - Cross Research

Wanted to talk a little bit about what’s going on in sort of the notebook ASP range. Can you, Michael and Brian, can you talk a little bit about you know the mix shift that you’re seeing to lower ASP notebooks and netbooks? How much of it you sort of attribute to the weak economy versus you know a more permanent shift down in ASPs? And then if you can talk a little bit about how you’re thinking about market share. I know you’re balancing profits versus market share but is there a level of market share that you don’t want to slip below and that you’ll sort of fight to maintain?

Michael S. Dell

Yes, I think there is with the economic pressure some trading down. You know we also have seen that customers you know will get enticed by the price point or the size of a 10” or 11” platform and then you know decide that the screen is not big enough. They can’t see enough of the things they want to do and they want to go back to a bigger screen. You know we’re going to be disciplined in managing around operating profit and cash flow here. We’re not driving for market share. We’re driving for profit.

Shannon Cross - Cross Research

But there’s no level that you’re sort of watching? You just sort of take it quarter-by-quarter?

Michael S. Dell

We’re focused on profit share, we’re not focused on market share.

Operator

Your next question comes from Bill Fearnley - FTN Equity Capital Markets.

Bill Fearnley - FTN Equity Capital Markets

Michael and Brian, I wanted to ask you guys what’s the latest on the upsell part of the direct sales model? How is it working versus your expectations and is it a factor in the gross margins performance this quarter? Do you have any additional color on the attach of additional PC features, service attach, S&P attach would be helpful in the upsell model.

Michael S. Dell

Well services attach has had a lot of success. And you see that in the deferred services balance. You know generally attach rates have been good on other items and we continue to build out the portfolio of other things. You know our pro support type attach rate has kind of gone from the low 30s to the mid-30s, and actually a little north of the mid-30s. And we built some you know industry leading features now into the pro support offering, particularly for the enterprise products, and that seems to be resonating. You know we were up kind of mid double-digits on blades this quarter which seems to be pretty different from the industry.

Bill Fearnley - FTN Equity Capital Markets

And what about add-ons though to the PCs themselves, you know how are you seeing the customer take on upgrades for memory, upgrades to hard disk drive size, you know better graphics? How are you seeing that upsell of those components versus historically? Is it more cash-and-carry or how’s the upsell working for the components themselves on the custom built PCs?

Michael S. Dell

I haven’t really seen any big changes there. You know on the enterprise side the memory footprints have expanded considerably as virtualization has become a bigger part of the demand.

Brian T. Gladden

And in our S&P business for the quarter actually performed better than the overall hardware business.

Operator

Your next question comes from Mark Moskowitz - J.P. Morgan.

Mark Moskowitz - J.P. Morgan

I have a question and then a follow up. Just trying to understand more about the sustainability within the public sector, could you give us a little more color, Brian or Michael, about the drivers there? Is this including China and the stimulus activity over there? Was this just U.S. federal government? And then also was the government piece a big driver of the DSO spike at the end of the quarter?

Michael S. Dell

You know it’s typical in the second quarter. We generally have a pretty strong, seasonal, education driven sector, you know strong growth in the quarter. We enjoyed that quite a bit. That came as expected. I think it’s important to understand and you know that put us in the context of an opportunity. We’re still pretty focused you know in terms of the majority of our business is very much domestic U.S. business, so it’s a real opportunity for us to continue to expand that model and do that globally. Most of it was driven by the U.S. and I would say that again education. It’s typically driven, you know education in Q2 and then the federal budget timeframe forces a strong demand in the third quarter. And then it drops off in the fourth.

So I think in terms of sustainability we would expect pretty strong third quarter and then fourth quarter decline.

Mark Moskowitz - J.P. Morgan

This is the follow up. You did a nice job in terms of expanding your retail outlet footprint in terms of going to 40,000 versus 30,000 in the prior quarter. Can you guys just comment a little on the quality of the sales velocity you’re seeing with these expanded stores? Is it starting to take a little longer before you see kind of a same store sale improvement?

Michael S. Dell

It’s pretty good. I think we’re in a little over 43,000 you know retail locations, you know up a little over 22% from the first quarter. And you know we’re seeing good traction inside those retail outlets.

Brian T. Gladden

And I think for the first time we’re getting to the point where internally we’re measuring same-store sales with these partners. We actually went through the process over the last quarter of changing out some of the poorer performers there for the first time. So I think we’ve got a robust process to make sure we’re getting you know what we need from each of these outlets.

Michael S. Dell

Picking up particularly strong in China.

Operator

Your next question comes from David Wong - Wells Fargo Securities LLC.

David Wong - Wells Fargo Securities LLC

Can you give us some feel for the percentage of your notebook sales that are currently netbooks? And also what your plans are to introduce CULV machines?

Michael S. Dell

In terms of netbooks, we’ll have to check on that for you, David. You know the penetration in the commercial accounts which is the majority of our business is really you know almost non-existent. It’s in the teens in consumer so then you kind of say well what is that overall? Well the teens of you know 25% of your units is a small number.

Brian T. Gladden

It would be less than 5%.

Michael S. Dell

So it’s a small number.

Brian T. Gladden

Yes, again we’re focused on profit share not unit share. If we wanted unit share we’d go sell a whole bunch of netbooks but we wouldn’t have the operating income we have.

David Wong - Wells Fargo Securities LLC

And CULV? Do you plan to roll out CULV machines in the second half of this year?

Michael S. Dell

We’ve already introduced our first CULV. In fact we were first to market with the Inspiron 11z. Go check it out.

Operator

Your next question comes from Jayson Noland - Robert W. Baird & Co., Inc.

Jayson Noland - Robert W. Baird & Co., Inc.

Michael, a question on client virtualization you mentioned earlier in the prepared remarks. Maybe if you could talk about your expectations around timing of PC virtualization and then the likely financial impact.

Michael S. Dell

Well you know we’ve had a great practice around server virtualization and some activity around client virtualization has started. I think it got a little bit slowed down with the economic issues and you know there are certain kind of applications and environments where client virtualization works really well, but it’s not every customer and every environment. You know the offerings are coming together and I think in line with this refresh and all the new technology elements that there’ll be some good opportunities there. But I wouldn’t view client virtualization as pervasive yet as the idea of server virtualization.

Jayson Noland - Robert W. Baird & Co., Inc.

And is it less attractive from a financial standpoint, even if it’s just more tactical?

Michael S. Dell

Well I mean of course the way we’ve structured this is we intend to earn more when we virtualize the client than when we don’t virtualize the client. And of course that’s all about offering the whole solution for us. The solution stack kind of starts with the storage and server and then goes to the devices. The device is the least important part of the profit picture.

Operator

Your next question comes from Chris Whitmore - Deutsche Bank Securities.

Chris Whitmore - Deutsche Bank Securities

I had one more gross margin question. First can you confirm that you expect gross margins to be about flat sequentially, in the low 18s? And what’s the component price assumption to get you there in terms of specific components? Can you provide some color?

Brian T. Gladden

Yes, I’m not going to give you any specific guidance around gross margin rates. I think what I said is we’ve been pretty effective even over a period of multiple years at managing within a range. And I think you can look at that range and you know we’ll be within that. I think that’s what we would say.

The dynamics we see around component pricing, I think you know we’ve called out LCDs and memory as the key problem areas. I think everything else would be more around typical sort of deflationary trends. So you know we expect as I said to see continued pressure on those two key components in the third quarter and probably get a little bit better into the fourth.

Chris Whitmore - Deutsche Bank Securities

A follow up question on the storage business, EqualLogic continues to go quite nicely. That implies the EMC business is declining materially. Can you comment on the health of that relationship and the health of that product line?

Michael S. Dell

Well look, you know the Dell EMC partnership is still an important part of our business and we continue to build and work that relationship. You know the EqualLogic platform is a big one for us. Certainly we’re attracted by having our own IP and the profit that that brings. But these products are somewhat different. You know when a customer is a fiber channel customer, we tend to focus them on the EMC platform. And you know obviously EqualLogic is ISCSI platform today. We’re investing further to extend that into broader areas. But you know I think you can expect to see you know Dell EMC continue for quite some time. And you know we’re working with them on how we create the kind of products that we need, that fit with our enterprise offering, because they’ve got a solid position. We’ve built a great alliance together.

Operator

Your next question comes from Richard Kugele - Needham & Company.

Richard Kugele - Needham & Company

Since you brought up your mobile solution in China, I just wanted to follow up on that. You know in particular what it is that you see is attractive to that market, what can Dell bring to the table? And you know if it winds up being solely an Asian solution for you or if you think you can broaden it to other regions. And then within that context obviously your Cupertino competitor is talking about a tablet again. That market has never really taken off. It’s always been a relatively small percentage of total units. And so if you have any perspective on whether you think the tablet market is worth materially chasing or not.

Michael S. Dell

You know the way I think about this is that first of all you know our primary focus is on the enterprise and the server and storage and solutions area that we’ve talked about. Within our consumer business we have a carrier-centric strategy where we work with the major carriers around the world and you’ve probably seen you know commercials and relationships with companies like AT&T, Verizon, Vodafone, China Mobile, etc. And you know within that carrier strategy you know we’ll go and build products that those great carrier partners want to see and the prototype demonstration that was referred to earlier is one of those products.

Richard Kugele - Needham & Company

Any thoughts on the tablet in that sense?

Michael S. Dell

No thanks.

Operator

Your last question comes from Robert Cihra - Caris and Company.

Robert Cihra - Caris and Company

Just had a question on your consumer margins, I guess if you ex out items it looks like consumer operating margin was still just over 1%, which was better. Are you still targeting sort of a 1 to 2% operating margin in consumer and sort of more specifically if you or if I let’s say assume that your consumer direct is certainly over that, what does that really mean for your retail margins that are now are in kind of as a target? I mean is that something you’re almost targeting as just over breakeven or is it that retail can be 2% and consumer direct maybe even more than that?

Brian T. Gladden

I think Rob it depends on the timeframe. As we talk about the consumer business this year, you know we think given the investments we’re making in growing the business and gaining share yes 1 to 2% is what we’ve talked about. That’s pretty consistent with the messaging we’ve had all year. Over time, as we, you know, not only grow that direct business which is a very profitable business for us, but improving the margins in the retail business we think it can be better than 1 to 2% and you know significantly better than that. So we’ve got a plan. We’re working through that plan and I think we’re on track towards the kind of profitability we would expect with that business.

Operator

We’ll now turn the call over to Rob Williams for closing remarks.

Robert Williams

Thanks a lot. I hope you’ve heard this afternoon that we continue to work on the core business in what is still a pretty challenging demand environment, particularly as we roll through the back half of the year with challenged commercial businesses around the globe. But at the same time there’s a big focus on our enterprise products and solutions portfolio and we believe that that will help us drive our operating income and cash flow growth over the long term. And so thanks for joining us and we look forward to talking to you again soon.

Operator

This concludes today’s conference call. We appreciate your participation. You may now disconnect.

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Source: Dell Inc. F2Q 2010 (Qtr End 07/31/09) Earnings Call Transcript
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