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Dell Inc. (NASDAQ:DELL)

F4Q10 Earnings Call

February 18, 2010 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

Toni Sacconaghi - Sanford Bernstein

Benjamin Reitzes - Barclays Capital

David Bailey - Goldman Sachs

Richard Gardner - Citigroup

Kathryn Huberty - Morgan Stanley

Bill Shope - Credit Suisse

Maynard Um - UBS

Brian Alexander – Raymond James

Shannon Cross – Cross Research

Mark Moskowitz - J.P. Morgan

Keith Bachman - Bank of Montreal

Stephen Fox – CLSA

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

Operator

Welcome to the Dell Inc. fourth quarter fiscal year 2010 earnings call. (Operator Instructions) I would like to turn the call over to Rob Williams, Director of Investor Relations. Mr. Williams, you may begin.

Robert Williams

Thank you. With me today are Chairman and CEO, Michael Dell and CFO, Brian Gladden. Brian will review our fourth quarter results then Michael will follow with his perspective on the demand environment. We posted our web deck on Dell.com and we released a VLog with Brian on Dell Shares. I encourage you to view these as there is additional perspective.

You have told us you want more visibility into our enterprise solutions strategy. As a result, for Q1 we will be attending the Goldman Sachs Technology Conference on February 24th with Brian and Peter Altabef, President of Dell Services. The following week, Brad Anderson, who runs our Enterprise Product Group, will be with us at the Morgan Stanley Tech Conference and we will be attending the Financial Times Investing in a Sustainable Future conference on March 24th. Also, mark your calendars for our Analyst Meeting on June 23-24 in Austin.

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

Please note that today’s call will be referring to non-GAAP financial measures. These measures are reconciled to the most directly comparable GAAP measures in the slide presentation posted on the Investor Relations portion of our website at Dell.com. Additionally, please refer to our 8-K filed today that contains a full reconciliation of all financial measures. We encourage you to review the reconciliation of non-GAAP gross margin, operating expenses, operating income, net income and earnings per share to their most directly comparable GAAP financial measures.

When we get to Q&A please limit your questions to one with one follow-up. Now I would like to turn it over to Brian.

Brian Gladden

Thanks, Rob. First, we saw solid growth return to the business in the quarter. We are encouraged by the underlying demand strength we are seeing across the business and particularly our commercial businesses where we saw double digit year-over-year growth in both unit shipments and revenue.

The market demand improvements we saw in our third quarter accelerated into our fourth quarter and we are cautiously optimistic with how our new fiscal year is starting up as well. We are also beginning to see some pretty fundamental shifts in the company’s capabilities and in our financial framework. We continue to invest to grow our enterprise business. We are seeing solid growth in servers, storage and services and with the addition of Perot Systems, our new Dell Services Business now represents 13% of our total company revenue. We have also made outstanding progress in improving our cost position over the past two years and we think we are well positioned to benefit from improving demand trends.

While our gross margins are very solid in the commercial business units we did see some weakness in our overall margin rates due to the strong seasonal growth of our consumer business which also suffered from relatively weak margins during the quarter. For the full year we delivered 18.2% gross margins on a non-GAAP basis and we made fundamental improvements in our COGS structure and our OpEx structure which we believe positions us well for the future.

We generated nearly $4 billion of operating cash flow which is twice the cash we delivered last year. As we look forward we are very confident our commercial businesses are poised for earnings growth as demand returns and that our strategy to expand into the higher margin and recurring revenue streams in businesses like servers, storage, software and service solutions is progressing well.

With that let’s move to the fourth quarter P&L and the key performance metrics which you will find on pages 6 and 7 of the posted web deck. Including our acquisition of Perot Systems, revenue in the fourth quarter was $14.9 billion, up 11% year-over-year and up 16% sequentially. Ex-Perot total revenue improved in large enterprise and SMB both year-over-year and sequentially. Also, without Perot our public business also experienced a normal seasonal sequential decline but it was still up year-over-year.

On a GAAP basis our gross margins were 16.6%. Our OpEx was 13.2% and our operating income was 3.4%. Earnings per share on a GAAP basis were $0.17 per share. For the remainder of this discussion I will be speaking to non-GAAP financial measures.

Beginning with gross margin the non-GAAP result was 17.4% driven primarily by the typically [pending] mix of consumer revenue in the quarter. Additionally as we discussed coming into the quarter we also saw component cost pressures, specifically DRAM across the business and we felt this most in our consumer business where we were locked into holiday retail deals in some cases with fixed pricing.

OpEx was 12.1% of revenue and SG&A was below 11%. Our total OpEx has improved as a percentage of revenue but it was up sequentially on an absolute basis as the revenue growth returned and correspondingly we increased sales compensation for our commercial sales force who executed well in the quarter. We also invested incremental OpEx dollars to fund key growth programs as we have discussed over the course of the last couple of quarters.

Operating income was $798 million or 5.4% of revenue and on the same basis was $3 billion and 5.6% of revenue for the fiscal year. Our financing and other expenses were $41 million in the quarter and our tax rate for the fourth quarter was 28.1% which was within the range we provided last quarter.

Earnings per share on a non-GAAP basis were $0.28 per share. Expense related to our broad performance based long-term compensation plan which is primarily equity was $107 million in the quarter split roughly 18% in COGS and 82% in OpEx. We had another strong operating cash quarter. Referring to slide 8 in the web deck we generated $1.3 billion in cash flow from operations which largely a function of our strong sequential growth and negative cash conversion cycle. There was lots of great work and strong execution here by the teams across the business.

Our working capital performance continues to be world-class. Our cash conversion cycle remained at negative 36 days as we absorbed the impact of our acquisition of Perot in this measure. You will remember on our December 16th call we said Perot would likely impact cash conversion cycle by 2-3 days. So we are pleased to hold our cash conversion cycle flat given that dynamic.

Both receivables and payables decreased two days to 38 days and 82 days respectively while inventory remained flat at eight days. Our days to pay are now up 15 days from last year while receivables are down four days from their peak two quarters ago. Overall for the year our cash conversion cycle improved by 11 days which we are very pleased with. Going forward we expect our cash conversion cycle to remain in the mid 30’s through the next fiscal year.

Turning to the balance sheet on slide 10, on November 3rd we used $4 billion to close the Perot transaction and we ended the quarter with $11.8 billion in cash and investments. Finally, as part of our ongoing efforts to optimize our capital structure and manage our cash liquidity we will continue to monitor the credit markets for possible favorable entry points.

Referring to slide 11, Dell Financial Services generated $1.1 billion in new originations during the quarter. The increase in fourth quarter originations and penetration rates primarily reflect the seasonality of the U.S. consumer business. Losses in our managed portfolio were up slightly at 8.2% and we remain cautious about the credit environment in fiscal year 2011.

However, we are seeing stabilization in consumer and SMB delinquency and losses. Funding costs for financial assets are improving and we have launched new conduits that will be held on the balance sheet. As a reminder, in our upcoming first quarter of fiscal year 2011 we will be consolidating our two non-consolidated fixed conduits in accordance with the recent U.S. GAAP changes.

Now let’s turn to our operating business results for the quarter and the full year. I remind you that fourth quarter results now include a full quarter of Perot Systems. The business unit results can be found on pages 14-17 of the web deck.

First let’s review our commercial businesses which include large enterprise, public and SMB businesses. For the full year these businesses were hit the hardest by the slowdown in the economy. Collectively we shipped nearly 5 million fewer units in these businesses this year than we did a year ago. Revenue in these three businesses fell 15% year-over-year yet total aggregate revenue per unit on the products shipped is flat and in some cases is increasing and the combined gross margins for these businesses actually improved from the prior year.

This improved performance comes partially from focused efforts on shifting our product mix to higher margin storage services and this is particularly true of our EqualLogic business which grew from less than $200 million in run rate revenue two years ago to more than half a billion run rate in business today.

Additionally during this challenging cycle these businesses reduced their OpEx by 13% from a year ago. So with solid margins and good OpEx leverage we expect to see improving profitability from the commercial businesses as demand returns. This dynamic is evident for the large enterprise business in the fourth quarter. In the fourth quarter we saw an unusually strong pickup in demand. Large enterprise revenue grew 23% sequentially to $4.2 billion with units improving 14% versus the third quarter.

The business delivered operating income of $281 million which is 6.7% of revenue or 160 basis point improvement over the previous quarter. The revenue upside in large enterprise represents two quarters of sequential growth and the third quarter in a row of improving growth rates. We are optimistic about improved demand environment for this business but we do believe we did see some year-end budget related activity in the fourth quarter and it will be difficult to repeat going into the first half of the year.

In public we see a story similar to LE. Demand for the year was much more stable with revenue only down 6% for the year. Hereto gross margins remained stable and operating income was up 8% for the full year. In fact, this year’s operating income of $1.4 billion is the best profitability performance in the history of our public business. Public’s fourth quarter includes the impact of Perot whose customers are primarily in the public segment.

For the fourth quarter revenue was $3.8 billion, up 3% sequentially and up 16% year-over-year. As I mentioned before without Perot public experienced a normal seasonal sequential decline but it was still up year-over-year. Operating income for public was $333 million and the rate was 8.7% of revenue.

The small and medium business revenue was $3.3 billion, up 13% sequentially and up 10% year-over-year representing two successive quarters of sequential growth. Storage, servers and client products all experience double digit sequential growth. Operating income was $282 million, up 18% year-over-year and flat sequentially.

Turning to our consumer business Q4 revenue was $3.5 billion, up 25% sequentially and up 11% year-over-year. Consumer has done a phenomenal job building a nearly $6 billion retail business with 56,000 stores and broad global distribution over the last two years. In addition, we now have the strongest and most exciting product portfolio in our history including Alienware, Adamo XPS, Studio and mainstream Inspiron Desktops and Notebooks.

Operating income for the quarter was a disappointing $9 million or 2/10 of a percent of revenue. For the full year consumer generated $107 million in operating income or 9/10 of a percent of revenue. Consumer margins were disappointing in the quarter due to aggressive market pricing dynamics and the fact that we also experienced component cost pressure early in the fourth quarter when we were committed to orders for the holiday with some locked in pricing.

I would like to reemphasize our strategic commitment to the consumer business. Just for context, for the full year consumer shipped over two million more units than last year, up almost 20%. This unit volume helps to drive scale with our supply base and with our cash conversion cycle contributes a lot of cash to the company.

Additionally we are taking actions to improve our consumer business profitability. In the fourth quarter we consolidated our consumer and small business organizations under a single leadership team including the product development teams. With this combination we see opportunities to reduce costs in G&A and product development and in customer support while maintaining the focus and energy we need here on customers. We will still need to continue to run these businesses separately and report them separately as well.

We are also embarking on a broad effort to simplify our client product offerings which will provide the next level of cost out in the products. We still believe our 1-2% operating income target is achievable in the near-term and we can get margins higher than that over time.

Now let me quickly discuss Perot. We are very pleased with the launch of our new Dell Services Business. Our performance there was very much in line with expectations and signings in the fourth quarter have improved significantly. More importantly customers on both sides of the Dell and Perot relationship have embraced the acquisition and the integration is tracking well from a customer retention, financial metric and growth perspective. Our sales teams are targeting new opportunities and are very excited about taking new capabilities to a broader set of customers.

From a go to market synergy perspective there are approximately and specifically 200 growth synergy opportunities we are working on which range in size from very small server monitoring engagements to data center outsourcing engagements. The biggest challenge in the near-term comes from narrowing our focus to a targeted few opportunities where we can deliver high customer value. We have already seen some significant wins where customers who were either all Dell or all Perot have given us opportunities to bid on a broader set of products and services that we couldn’t do before and this is just going to continue.

On a regional basis revenue in the Americas was up 12% sequentially and up 11% year-over-year. In EMEA revenue was up 24% sequentially and down 3% year-over-year. In ABJ revenue was up 16% sequentially and up 38% year-over-year. Our total revenue from BRIC countries was up 13% sequentially but up 72% year-over-year with China and Brazil both experiencing very strong double digit sequential growth, around 70-80% growth year-over-year as well. The BRIC made up 11% of our total revenue in the quarter and revenue from outside of the U.S. was 48% of our total mix.

Moving briefly to product highlights, in the client space our mobility units were up 12% sequentially and revenue was up 11% due to increased demand in all segments while year-over-year revenue improved 16%. Mobility average selling prices declined by 1% sequentially. Desktop units were up 10% sequentially and revenue improved 14% sequentially and was down 3% year-over-year.

Turning to enterprise products and services, our server revenue was up 17% sequentially on a unit increase of 10% while revenue and units were up 26% and 17% year-over-year respectively. The trough in server revenue was the first quarter of this past year. We have now had three consecutive quarters of server growth.

Our data center solutions business where we sell servers into very large cloud computing infrastructure customers was up over 250% year-over-year and up 75% sequentially. Server revenue in large enterprise was up 47% year-over-year.

Our storage revenue while down 15% on a year-over-year basis was up 18% sequentially driven by strong growth in our Dell EMC and EqualLogic storage arrays. EqualLogic revenue was up 44% year-over-year. We continue to mix our storage revenue to higher margin offerings and storage is now a solid driver of Dell’s operating income and contribution margins both of which are expanding year-over-year.

Dell Services now includes Perot systems. Total revenue was $1.9 billion including approximately $600 million from Perot. Our deferred revenue balance is now $6.1 billion, up 6.4% versus prior year. As I said, services now represent 13% of Dell’s consolidated revenue versus 9% a year ago. Software and peripherals revenue grew 3% sequentially and was flat year-over-year driven by intentional decisions to prioritize LCD panels for system applications.

As I review our progress on our $4 billion cost target I want to quickly summarize some of the progress we have made in transforming the business. Over the past two years we have spent over $750 million in severance and facility actions costs to sell, close and consolidate our facility and manufacturing footprint and reduce our G&A spend. Prior to our closing of the Austin TMC facility we operated 11 manufacturing facilities versus only six today and have reduced our internal manufacturing capability by about 60%.

This massive operational effort has taken a bulk of two years to realize and today nearly 53% of our products flow through our contract manufacturers. The capability is in place to move this percent significantly higher. Our headcount ex-Perot has come down from a peak of 92,000 in fiscal year 2008 to about 72,000 today, a 22% reduction in three years. With Perot we added back 24,000. In total we have reduced our OpEx by $1.5 billion from our fiscal year 2008 baseline with a lot more opportunity here.

On the COGS side nearly 90% of our consumer platforms and more than 65% of our business client platforms have gone through our cost optimization framework. In fiscal year 2009 we saved over $600 million and in fiscal year 2010 we saved an additional $1.8 billion related to our design to value, plain sheet procurement and supply chain efforts. Both the OpEx and COGS reduction efforts have led to successfully improving gross and operating margins in our commercial businesses for the full year.

In consumer our cost reduction efforts were partially offset by inflationary component cost pressure in the back half of the year. It is clear to us we must continue to drive more costs out.

As you sum up these results you can see we have reduced total costs by $3.9 billion and we are already ramping the next phase of our ongoing cost initiatives. This journey does not end. This has been really tough work during the most difficult economic environment in the history of the company particularly in our core commercial business. While it is a good start we still know there is a lot more to do to make our business more competitive. Ongoing competitive pressure and economic realities never top and we can’t either.

As I have described before we have consolidated our product development activities and global operations function under Jeff Clark. As part of our efforts around client reinvention he is focused on taking us to the next level of lean manufacturing, improving our logistics, supply chain and reducing complexity. We will limit the number of configuration choices where appropriate and move more of our products to a low touch, fixed configuration [ocean] ship model. Over the year these changes will further cost optimize our model and lower G&A and support costs.

Turning to the outlook, we are moving into the next phase of our transformation. We will be taking less severance and facilities expense going forward but we will stay focused on cost initiatives and growth. You have seen us be more acquisitive and this is part of the plan we laid out at our analyst meeting to increase the mix of higher margin and recurring revenue streams. We are re-tooling our sales team to be more solution oriented and we will continue to make investments to develop IP and deploy resources against improving the value and connections we provide our customers.

You will see us allocating new OpEx dollars to important growth programs. We will continue to invest OpEx in periods of revenue growth and are committed to scaling this investment to our revenue. We remain intent on driving improvements in our core business that will particularly affect our consumer business and structurally change our sales manufacturing and delivery of products.

We will continue to balance liquidity, profitability and growth as our framework to drive long-term value creation. As you see we generated very strong cash flow this quarter and for the full year. For the first quarter specifically the overall PC and server industry is typically down 10% in units sequentially. We expect to do better than industry norms but still believe our revenue will be down sequentially in the quarter.

As I mentioned earlier we anticipate continued tightness in supply. Suppliers have been reluctant to add additional capacity until the demand environment among commercial customers and broadly is as robust as it has been over the last few quarters. For instance, panel pricing bottomed in January and market prices have begun to increase again in conjunction with strong demand for TVs in Asia and anticipated PC demand and memory pricing, particularly for DDR3 could be up again in the first quarter.

We delivered greater than 18% gross margins for the full year. There will be seasonal volatility and we saw some of that in the fourth quarter. As we move into the first quarter you should anticipate a revenue mix working back towards a more balanced dynamic. Our tax rate came in between 28-29% consistent with the guidance we gave you last quarter. Given the continued globalization of our business we would expect this tax rate to decline modestly. We will continue to examine our tax structure as the business changes including the effects of acquisitions.

Again our long-term value creation framework is focused on delivering 5-7% top line growth and returning our operating margins to 7% plus on a GAAP basis over time. Cash flow growth is our true focus and we expect to deliver through a combination of growing revenue, expanding our gross margins modestly and continuing to manage and optimize our cost structure with a constant focus on great working capital efficiency. We are confident in our ability to deliver the right technology to commercial customers and to participate in a meaningful commercial upgrade cycle. Our commercial businesses are well managed and we are positioned for further operating leverage as demand returns in the coming quarters.

With that I will turn it over to Michael.

Michael Dell

Thank you Brian. This past year demand started off quite slow and gradually improved as the year progressed. Towards the latter part of the year as the economy was stabilizing we saw broad increases in demand across all of our businesses and that has continued. The drivers include strong return on investment especially for server and storage solutions, an aging installed base and Windows 7.

We are seeing a continuation of the favorable demand trend this year. We are focused on and seeing significant strength with our enterprise solutions. Our 11G servers, Dell EMC and EqualLogic storage and the expanded Dell Services capabilities enhanced with the acquisition of Perot Systems.

On the client side we are seeing the beginning of a refresh driven by Windows 7 and increased mobility. The age of the installed base is significant and customers see the refresh as a productivity enabler. We think the refresh takes time and stretches well into 2011.

IT is the engine of productivity for our customers and we are well positioned with solutions that deliver total cost of ownership leadership and an expanding recurring revenue and profit and capital stream for our shareholders.

This year we are very focused on and you are going to see us invest in delivering best value solutions that are simultaneously open, capable and affordable and create significant value in the key IT architectural transitions. You will also see us further reducing our product complexity, simplifying our supply chain and providing our customers with choices and value while improving profitability in the process and significantly enhancing our online capability with Dell.com and related online properties to improve customer experience, build loyalty and raise margins.

You will also see us continue to make inorganic investments adding new capability as we have done with Perot Systems and Services and last week with KACE Networks and Systems Management. All of these investments are part of a consistent strategy aimed at delivering technology solutions that enable people everywhere to grow and thrive.

With that let’s open it up to the operator for questions.

Question and Answer Session

Operator

(Operator Instructions) The first question comes from the line of Toni Sacconaghi - Sanford Bernstein.

Toni Sacconaghi - Sanford Bernstein

I am still struggling with the significant deterioration in gross and operating margin on a sequential basis. I know you are contributing a lot to consumer in that mix but the fact is despite the fact all four of your business units had meaningful sequential revenue growth three of the four actually had a decline sequentially in operating margin percentage. So you are actually getting negative leverage in the quarter. Can you help us beyond consumer understand what was happening? I know you talk about component prices but it actually looks like your ASPs were slightly up sequentially so you were able to offset some of that by passing it on to customers.

Michael Dell

I think when you look at the gross margins in total mathematically from a consumer mix standpoint there is at least 30-40 basis points of quarter-over-quarter pressure there. The consumer margins separately in terms of their own gross margins were also challenged. Those were the two things we isolated. I think when you look at even gross margins within the commercial business we saw strength and improvement there so the teams did a nice job really offsetting component price increases in the commercial side of the business.

You do see some incremental OpEx going into the business as we see in some cases sales compensation that goes with the growth. In some cases we have made R&D and strategic investments that have taken up the OpEx. I think those are smart investments and we are trying to do that in a way that is consistent with the growth we are seeing in the marketplace. I do think on the commercial side of the business you will see some good leverage as we move forward with this growth.

Brian Gladden

The operating income was up sequentially in the commercial businesses.

Toni Sacconaghi - Sanford Bernstein

I guess the question is when do we, as you mentioned the gross margins were up percentage wise in the commercial business but still in two of the three the operating margins were down despite a pretty significant sequential improvement in volume. So as we look out to 2011 how should investors think about gross margin and operating margins given the cost cutting? If I take what you are saying qualitatively which is you are going to continue to work on the cost side hopefully the mix will kind of more normalize, you are going to get some volume leverage, the natural inference is to believe you should have higher if not materially higher growth in operating margins in 2011. Is that a reasonable expectation? What caveat should we put against that?

Michael Dell

I think you have to break it into pieces. If you look at we had I would say pretty strong operating income rates within the SMB business and within the public business in the quarter and in the public throughout the year. I think there is room for us to gain leverage and improve the operating income levels in the LE business as we get some leverage there and I would expect that to look more like the public business from a profitability standpoint. Then we have talked about consumer. I think as we look at that at 9/10 of a percent of operating income for the year we think that should be at least double that and obviously we need to improve beyond that over a period of time. Gross margins I think you have to look at over a longer period of time it has been relatively stable. That would be our intent as we mix the business up to higher margin enterprise products and more services and things like that I think you will see that move up but there will be some volatility there.

Operator

The next question comes from the line of Benjamin Reitzes - Barclays Capital.

Benjamin Reitzes - Barclays Capital

I guess I wanted to delve a little deeper into constraints. You talked about there were constraints in the quarter but also last quarter you had constraints. I was wondering how much revenue benefited in the quarter from constraints last quarter and whether there was anything that was maybe better than expected due to that. To that end, also what impact did constraints have in the current quarter and how much demand is pent up into upcoming quarters?

Michael Dell

I think it is fair to say as we entered the quarter we saw better demand than what we expected coming into the quarter. We did see component prices be challenged and we had positioned ourselves in terms of supply to support some growth in the quarter but it is fair to say we were chasing parts in the quarter.

Brian Gladden

We were chasing the demand and I think we are feeling like we are starting to get out in front of it but I will tell you the demand has continued to be strong.

Benjamin Reitzes - Barclays Capital

In particular on the component side you mentioned DRAM as particularly tight and should continue to be, panels getting tighter. Any comments on anything else including drives and anything else that has been particularly tough that you have had to do anything either at normal or anything that is also contributing to the cost?

Michael Dell

I think the bigger discussions have been around industry capacity. So we have sat down with the leading companies in the supply chain and said okay here is what we think we are going to need in the next six quarters, ten quarters and let’s talk about capacity investments because I think a number of these folks didn’t have the capacity and as we look at our business and expected demand there is some investments that are needed. We are starting to see those go in. We were able to get pretty good response on the upside request that we had because we didn’t anticipate demand would be a strong as it was. So that is a pretty good characterization of it.

Operator

The next question comes from the line of David Bailey - Goldman Sachs.

David Bailey - Goldman Sachs

To follow-up on the gross margin a little bit could you comment on the impact on gross margin from Perot in the quarter? Would gross margin have actually been lower without Perot?

Brian Gladden

The impact of Perot was basically zero. It came in at fundamentally basically the same gross margin rate as our core business.

David Bailey - Goldman Sachs

To follow-up on that you said that gross margin the last couple of years gross margin has been flat or slightly down quarter-over-quarter going into the April quarter but it sounds like you are saying it should be different this year. Is that accurate?

Brian Gladden

No. Gross margins typically go up in the first quarter because you don’t have the consumer effect and we would expect that will occur again in this first quarter.

Michael Dell

I think we were saying we were looking at industry seasonality typically down 10 and I think we said we would expect to do better than that. That is more of a revenue comment.

Operator

The next question comes from the line of Richard Gardner – Citigroup.

Richard Gardner - Citigroup

I wanted to ask what makes you think the strength in LE in the fourth fiscal quarter was budget flush and is not sustainable as we go into the first half of calendar 2010? I think Michael you mentioned demand has continued to be strong and there was also another comment that you are optimistic about what you have seen so far in the April quarter. So what is it exactly that makes you believe there may be a pause here as we go into the first half of the year?

Michael Dell

I think we were surprised at how rapidly that business came back in the latter part of last year and I think we have been pleasantly surprised at how strong it has stayed and you sort of take this on a week by week basis but there is a lot of refresh and a lot of spending we are seeing and it is fair to say the signs are quite encouraging in the day to day orders that we see from that business.

I would say there was clearly some end of year effect in that business as customers had confidence that their budget wasn’t going to change as they got to the end of the year they said hey what do we want to spend that on? It was infrastructure. It was servers and storage and we captured quite a bit of that. But I think the budgets are in place for this year and they have a lot of client refresh in them. They have a lot of server virtualization. They have a lot of storage virtualization and we are well positioned to go capture that and I think customers are spending with a lot more conviction at this point in the year than they were certainly this time last year.

Richard Gardner - Citigroup

So to be clear there was nothing about the linearity in the quarter that made you think things were trending down a little bit in January or the customers were re-trenching a little bit as they evaluated their 2010 budgets?

Michael Dell

No. I wouldn’t say that.

Operator

The next question comes from the line of Kathryn Huberty - Morgan Stanley.

Kathryn Huberty - Morgan Stanley

My question is on the consumer margins. With 90% of the consumer platform cost optimized, volumes up double digits, your competitors talking about both better margins and ASP trends in this business, I want to better understand what the structural limitations are to hitting a better margin profile even with some of the DRAM issues you saw in the quarter? If the answer is component costs are really the biggest limitation are you doing anything in terms of locking in better pricing as you go through this year so you can address that issue?

Brian Gladden

First I would say we are disappointed with the margins. We have done a lot on costs. From a product redesign standpoint we have done a lot of the efforts there. There is still work we have to do in the supply chain and that is a lot of the efforts you hear we talk about client reinvention and continuing to get costs out and overhead out of manufacturing. Those are important steps for us to continue to take costs out of the products. I think the reality is it is challenging and I think there is more work to do there. As we look at some of the structural things we are trying to do here we have some plans in place I think will continue to make us more competitive in consumer. We like the growth. We have seen very strong unit growth. That has been important to us from a scale standpoint but the reality is we are disappointed in the profitability so more work to do there.

Kathryn Huberty - Morgan Stanley

When would you expect the new actions to be reflected in the margin profile of the business?

Brian Gladden

I think you will continue to see efforts around cost out over the next several quarters including continued efforts to consolidate manufacturing, continued efforts to simplify the product line and that stuff will rollout really over the next several months.

Operator

The next question comes from the line of Bill Shope - Credit Suisse.

Bill Shope - Credit Suisse

I hate to ask another margin question but I want to make sure I understand the strategy here. Presumably you could have seeded some revenue outside this quarter to preserve gross margins as you did for all of last year. Should we view the gross margin performance as a sign or at least a partial sign you are shifting your focus at least back towards market share preservation now that the economy is recovering and you are potentially entering a potential refresh?

Brian Gladden

Again you have to really break it into a couple of pieces. I think on the commercial side of the business margin rates were good and solid. I think we saw very good demand. I think the challenge, as we said, was really on the consumer side and one of the specific issues as we said was some of the component pricing earlier in the quarter and some of the retail deals we had there that were locked into pricing. So again focus around margins really has to be a consumer discussion and that is what we will go work on.

Bill Shope - Credit Suisse

Shifting topic a bit can you give us some more color on how your acquisition strategy may evolve over time particularly as we go through this year. Where are the primary areas of focus and where do you have holes to fill? Are you still looking more towards relatively smaller targets at least in fiscal 2011?

Michael Dell

I think you will see certainly more small things than medium sized things but we are quite focused in the data center and in the whole solutions area. I think if you look at the history of recent transactions it gives you a reasonably good roadmap for the kinds of things to look for. I wouldn’t expect a lot of larger transactions.

We are finding lots of opportunities and I think if one looks at what we have done with EqualLogic we think there are many candidate companies that fit a similar profile where our customer access and distribution can dramatically expand the opportunity. KACE Networks being I think the latest example of this and a solution really and solution really is software that fits very much with the capabilities that we uniquely have to go execute on.

Operator

The next question comes from the line of Maynard Um – UBS.

Maynard Um - UBS

Can you give us the amortization of intangibles and other one-time items between the product and services COGS just so we can get to pro forma segment gross margin? If there are any kind of one-time reversals or air freight that had a gross margin impact. Secondly, I want to talk about Perot and the opportunity there. You originally talked about the opportunity being international. It sounds like you are also seeing some benefits here in the U.S. from a synergy perspective. Can you just talk about the international strategy for Perot, whether that has changed? I am wondering are there people on the ground you have today internationally where you can leverage the Perot platform or do you think you have to make some upfront investment or acquisition before we start to see the revenue start to ramp there?

Michael Dell

I will address the services question. One of the things we are seeing is an increased win rate in a number of parts of the business as our solutions capability both real and perceived have substantially increased here. In terms of building that internationally we do have some footprint and capability that could be leveraged but there is a lot to do here both organically and inorganically to extend the platform. Some of these services can be delivered in a remote fashion. Some can be delivered as SKUS that are attached to products which is a great engine for us and is where you see this deferred services balance continue to grow and that is quite healthy margins for us.

We have also integrated our own IT organization into Dell Services and that gives us a global platform and capability we are going to extend rapidly out to customers. So as we look at Brazil, China, India, there are significant opportunities to take those Dell Services capabilities and extend them globally.

Brian Gladden

I think your question was really around the amortization of intangibles. In the quarter we had a total of $86 million. $40 million of that was really the existing Dell and then there was $46 million related to Perot. That is the breakdown. In terms of incremental cost related to expedite and things like that it would have been generally immaterial.

Maynard Um - UBS

But of the $86 million could you give us the split within COGS versus SG&A so we can get to segment gross margin pro forma gross margins?

Robert Williams

If you go to the reconciliations that are at the end of the press release and are also included in the tables associated with the web deck it is all in there in that walk from GAAP to non-GAAP. So I believe it is $71 million related to COGS and $15 million related to OpEx.

Operator

The next question comes from the line of Brian Alexander – Raymond James.

Brian Alexander – Raymond James

Back to the balancing of [inaudible] and profitability in the commercial space given the focus on profitability and the corresponding market share losses you have seen in the commercial client space you have talked a lot about consumer on the call but at what point do you think you will be in a position to win back market share in the commercial space?

Michael Dell

Well I think if I look at the business sequentially comparing our business to key competitors, certainly our revenue growth was well ahead of competitors sequentially. We were 16% sequentially growth and double digit on units. Our competitors were single digits on revenue. One was double digit on units and another was single digits on units. So we outgrew certainly on revenue. We are also playing this a little bit differently on the average selling price side. We are not participating in some of the less than profitable units.

Robert Williams

This is where it gets to be a little bit of a challenge when the unit numbers continue to be brought up over and over again. I am not implying that you do that at all, but we are really focused on driving revenue share growth in the IT spend and I think while one quarter doesn’t make a trend we have some encouraging signs here and we need to watch this for a few quarters and see that it lines up and starts to repeat itself over time.

If you look at the commercial businesses there was some pretty healthy growth there on a sequential basis and even when you back out the effect of Perot we had some pretty strong growth. Again one quarter doesn’t make a trend but I think we are pointed in the right direction there.

Operator

The next question comes from the line of Shannon Cross – Cross Research.

Shannon Cross – Cross Research

Can you provide some more color just on where you are specifically investing in your enterprise business? Are there areas where you are hiring sales people? Have you changed comp plans? Any color you can give us on where you are investing and clearly we need to think about how you are doing that with revenue growth and then balancing the profitability. So more details would be helpful.

Michael Dell

I think you can think about servers, storage, solutions. If you look in the quarter we had high teens sequential growth in servers and storage. 26% year-over-year growth in servers. 44% growth in revenues in EqualLogic. We are investing a lot in that whole kind of solutions layer in the infrastructure and efficient enterprise and certainly shifting the capabilities of the sales force. A bit part of this past year was building those capabilities inside the sales organization to really go focus on the data center and solutions.

Brian Gladden

I would say this past summer as we started to see some demand come back to the business we made some decisions to free up additional investment that really started in the third quarter into the fourth quarter and is accelerating really around those specific areas and funded programs where we though they fit well with the commitment around solutions and high margin recurring revenue opportunities.

Michael Dell

All of the areas I mentioned and Brian just mentioned are areas where we are hiring and will hire to go invest in growth.

Shannon Cross – Cross Research

Are there any puts and takes we should focus on for cash flow in the next quarter just anything that would be different on a year-over-year basis or anything we should focus on?

Brian Gladden

I can’t think of anything unusual as we go into the first quarter. The consumer dynamic is one that we faced in the fourth quarter that should be a little bit simpler in the first quarter but other than that I can’t think of anything.

Operator

The next question comes from the line of Mark Moskowitz - J.P. Morgan.

Mark Moskowitz - J.P. Morgan

I may have missed this and I apologize but in terms of gross margins can you give us the puts and takes in terms of the sequential degradation in services including software gross margin? How much of that was related to one-time items versus consumer versus commercial? I am kind of surprised consumer would have that much of an impact on the services gross margins given the product gross margins were not that bad.

Brian Gladden

The way we have explained it, it is really isolated to a consumer dynamic. If you look at walking from a third quarter 18+ gross margin really 30-40 basis points is driven by just incremental consumer mix and the rest of it really is weaker margins within consumer given some of the retail transactions we talked about. We have isolated it to that. Services when you think about Perot really came into the portfolio and consolidated with a very similar gross margin rate. 18% or so.

Mark Moskowitz - J.P. Morgan

I wonder if you could help us understand as far as how investors should think about your leverage in your commercial business going forward just given the Nehalem refresh. It seems to be driving a richer content of sale out there for a lot of folks and almost kind of a mini gold rush if you will in terms of a server refresh and getting a lot of other IT investments or stages. How should we think about the upward pressure there? Does that start to offset some of the other challenges in consumer or is that more a wait and see type thing?

Michael Dell

I think if you look at the Nehalem phase I was really strong. You look at our business we had 26% year-over-year growth. I think if you go to Nehalem EX the ROIs just get higher and this becomes extremely compelling. You have the opportunity for a faster refresh cycle because as customers look at the Nehalem EX they say I can virtualize more machines. It is even more compelling to go and replace.

We also created this data center custom solutions business. It has been growing very, very fast. You are going to see some more announcements from us next month as we kind of take those capabilities to a broader set of customers and I think it is fair to say we have been winning the lion’s share of the opportunities with the largest web-driven firms in the world. What is interesting to see here is that there is a continual shift to X86. Of course all of this we are working really hard to tie storage into it with our EqualLogic platform with our Dell EMC platform and we have other storage platforms plus processing type platforms and you will continue to see us build those out over time.

Operator

The next question comes from the line of Keith Bachman - Bank of Montreal.

Keith Bachman - Bank of Montreal

Operating expenses on a dollar basis, how will that trend for the next couple of quarters particularly if revenues are down sequentially in the April quarter?

Brian Gladden

I think we are going to try and manage some of those investments for the long-term. We will make an attempt to scale it on a quarter on quarter sequential decline we think it will be relatively modest in the first quarter. So we will continue to manage that tightly and as fast as we see the growth coming. I would expect it to be slightly up going into the first quarter as we invest. Then as we see growth in front of us we will continue to make the important investments for the future.

Keith Bachman - Bank of Montreal

On SMB again going back to the operating margin it was down about 100 basis points and yet as I look at it mix seemed to be richer in SMB with servers and storage outperforming the other parts of the business. I want to try and understand profit margins in SMB and why those profit margins were down sequentially.

Brian Gladden

I think underneath the covers a bit there is some sequential regional mix that impacts the margins of the SMB business as you look across the globe. I think that is one of the dynamics. I think there is also some sales comp from an OpEx standpoint in the quarter that may impact the OpInc in the quarter. We are pleased with the profitability of the business. Very strong gross margins and good operating income and it is good to see the growth back.

Robert Williams

To add to that I think even as you look at some of the sequential changes in operating margins across the global business units you have to think about that same comment we made about you are going to see some of that volatility from time to time just because of the mix of the business and some of the things we are going to try and accomplish. We are really trying to manage that across the broad businesses and portfolios. You are going to see that from time to time in these businesses just like Public. Public was down this quarter. The quarter when their business was seasonally down and they still have that OpEx they are carrying through the slowest quarter of the year.

Keith Bachman - Bank of Montreal

To follow that, last quarter public was actually up sequentially in profit margin. Last year the public was actually up sequentially in profit margin.

Robert Williams

You are talking…

Keith Bachman - Bank of Montreal

4Q09 to 1Q10.

Robert Williams

Again we are managing it as a portfolio so it is really hard to kind of say look at those sequential patterns and the historical patterns and say that is exactly what is going to happen. There are different factors that are kind of working into the whole portfolio play there.

Brian Gladden

For the public business with relatively good demand last year relative to the rest of our business we managed that OpEx to basically flattish and operating income expanded 120 basis points during the year. We are pleased with how the public business performed last year.

Operator

The next question comes from the line of Stephen Fox – CLSA.

Stephen Fox – CLSA

A question on the pipeline. I was wondering if you could differentiate a little bit between what you are expecting for the next couple of quarters in large enterprise versus SMB. Lastly when you consider the public pipeline is there any negative implications from maybe municipal and federal deficits slowing down growth there.

Michael Dell

I would say relative to last year the large enterprise pipeline is certainly a lot stronger. Both of the pipelines feel pretty good and I think we are feeling good about our enterprise services opportunities in those. In terms of public, you are right to point those out. There are some states that are in a state of distress, if you will. I think the interesting question here is if you look at the history of mankind public organizations generally do not reduce their spending.

If they do reduce their spending it would be the first time it has ever happened. That would be interesting to actually see what happens. I think the other thing we are finding is that many of these organizations have not adopted what I would call commercial best practices. If you think about for example Universities that have a decentralized IT structure and now the provost of the University is saying how am I going to meet this budget challenge. Hey we know how to do that. It is called server virtualization. So actually I think some of the budget pressures in these public organizations may create opportunities for IT. We find that the public organizations tend to be some of the ones that have least taken advantage of the newest technologies. So all of the things we talked about earlier in terms of high ROI with server virtualization you actually don’t find nearly as many of those in public organizations as we would all like to see.

I think the budget pressures may create more opportunities there but you are right to highlight those potential risks.

Operator

The next question comes from the line of Jayson Noland - Robert W. Baird & Co., Inc.

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

On the cash conversion cycle, I guess as we move more towards build to inventory and away from build to order would we expect to see a negative impact to CCC that hasn’t shown up yet?

Brian Gladden

No. I think we have a pretty solid plan to manage through that and try and maintain current levels of cash conversion cycle. We said in the talking points that mid 30’s is sort of what we are targeting and that is what we will push for. I don’t see any reason why that is not achievable.

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

On storage, up 18% sequentially. Pretty impressive. Could you talk about any more details around operating profit contribution? I assume it has been very good given EqualLogic and then the relationship with EMC as the Dell EMC platform becomes a smaller portion of the mix there.

Michael Dell

The mix has been improving. I think within the EMC relationship we have been moving it more towards the real value add products and less of the pass through products. That is definitely putting some pressure on the top line but it is improving the margins there and I think putting us in the kinds of business we really want to be in. But the operating margins and the margin dollars in storage are definitely improving and we have a significant platform there.

I think we have added about 15,000 new EqualLogic customers since the acquisition and we are adding about 2,000 per quarter. So this is a platform that is very, very strong. We are integrating a lot of new partners. For example if you look closely you will see a lot of work going on with Brocade and many others as this kind of becomes a real platform. I also think as we talk to customers there is a lot of momentum around 10 gig Ethernet at the data center. As we bring 10 gig to the server, 10 gig to the storage there is enormous opportunities that kind of create the efficient data center structure here with our core kind of crown jewels right at the center of it.

Robert Williams

Thanks to everyone for participating today. We look forward to meeting with you on the road and here in Austin over the course of the quarter. Take care.

Operator

This concludes today’s conference call. We appreciate your participation. You may disconnect at this time.

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Source: Dell Inc. F4Q10 (Qtr End 01/29/10) Earnings Call Transcript
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