Dell CEO Discusses F2Q2011 Results - Earnings Call Transcript

 |  About: Dell Inc. (DELL)
by: SA Transcripts


Good afternoon, and welcome to the Dell Inc. second quarter fiscal year 2011 earnings conference call. I’d like to inform all participants that this call is being recorded at the request of Dell. The broadcast is the copyrighted property of Dell Inc. Any rebroadcast of this information in whole or part without the prior written permission of Dell Inc. is prohibited. As a reminder, Dell is also simulcasting this presentation with slides at Later we will conduct a question-and-answer session. (Operator instructions) I’d like to turn the call over to Rob Williams, Head of Investor Relations. Mr. Williams, you may begin.

Rob Williams

Thank you. With me today are Michael Dell, Brian Gladden, and Steve Schuckenbrock, Head of our Large Enterprise Business. Brian and Steve will review our second quarter results, then Michael will follow with some brief comments.

We’ve posted a web deck on and we released a VLog on Dell shares. I encourage you to review these materials for additional perspective. Some of our upcoming investor relations activities include the Citi Technology Conference on September 8 and the Deutsche Bank Cs on September the 15th.

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

Please note that on today’s call we will be referring to non-GAAP financial measures, including non-GAAP gross margin, operating expenses, operating income, net income and earnings per share. Historical non-GAAP financial measures are reconciled to the most directly comparable GAAP measures in the slide presentation posted on the Investor Relations portion of our website at and our 8-K filed today, which we encourage you to review. Please note that unless otherwise mentioned, all growth percentages refer to year-over-year progress.

Now I’ll turn it over to Brian.

Brian Gladden

Thanks, Rob. We had another solid quarter when you look at our revenue growth, operating income growth, and our strong cash flow generation. The key to our results continues to be strong global commercial demand, especially in servers and networking storage and services. These revenues were up 43% to $4.3 billion, with strength across the board and also aided by the integration of Perot.

We had another strong quarter in emerging countries with 52% growth in the BRIC countries. While we had solid performance at the operating income line, we continue to see challenging dynamics in our supply chain costs, which pressured our gross margins and consumer profitability. We continue to have confidence that we will improve gross margins in the second half, as we see a better cost component environment and we execute operational improvements in our Consumer business.

Given our enterprise focus, today we have asked Steve Schuckenbrock to share his view on the progress in our Large Enterprise Business as well as the overall trends in enterprise solutions. But first, let’s look at the second quarter P&L and key performance metrics, which are provided on pages five and six of the web deck.

Revenue in the second quarter was $15.5 billion, up 22% year-over-year and 4% sequentially. This is slightly above our typical historical seasonality as we saw better demand in all the commercial businesses and a typical second quarter. On a GAAP basis, operating income was $745 million or 4.8% of revenue and EPS was $0.28, which is up 17% year-over-year. On the rest of this call, I’ll refer to non-GAAP financial measures.

Operating income grew 9% to $872 million or 5.6% of revenue. Consistent with our views from the first quarter call and the analyst meeting, we saw improved client product demand from commercial customers and sequential commodity component inflation. These dynamics resulted in a sequential gross margin decline of about 40 basis points. Given this margin pressure, we managed OpEx to 11.6% of revenue, while still making key investments in enterprise solutions R&D and sales related resources.

Our financing and other expenses were $49 million, which is down modestly versus the prior quarter. We continue to expect F&O to trend in the plus $50 million range. Our tax rate was 23.6%, reflects some discrete items along with increased profits and lower tax jurisdictions. For the year, we expect our tax rate to be in the 25% to 26% range, which is slightly lower than our previous outlook.

Net income was up 9% to $629 million, while EPS increased 10% year-over-year to $0.32 per share. We generated $1.3 billion in cash flow from operations. In addition, we delivered $1.4 billion in free cash flow in the quarter and $4.4 billion of free cash flow for the last four quarters. Our working capital performance continues to be solid. Days receivable were up three days along with a one day increase in inventory, offset by a four-day improvement in days payable, with our overall cash conversion cycle flat at negative 36 days. We expect our cash conversion cycle to remain in the negative mid-30s throughout the year.

We ended the quarter with $13.1 billion in cash and investments. During the quarter, we again repurchased shares with $200 million and expect to maintain a modest buyback program for the rest of the year. As part of our ongoing efforts to optimize our capital structure and manage our US liquidity, we are also monitoring the credit markets for potentially favorable entry points.

Turning to our Global business unit performance, our combined commercial businesses grew revenue 28% to $12.7 billion with op-inc up 22%. Strong demand trends continue within commercial. Steve will talk more to the Large Enterprise Business along with our overall Enterprise results in a moment.

Our Public business revenue was up 21% to $4.6 billion, benefiting from the Perot integration year-over-year. We saw strength in the healthcare space with initiatives like our medical archiving solution, while state and local government revenue was relatively flat. Operating income was down 4% to $369 million, but remained at a healthy 8% of revenue. Server and networking revenue was up 12% in the quarter.

Our Small and Medium Business had a very strong quarter. Revenue was up 25% to $3.5 billion and operating income grew 32% to $323 million or 9.1% of revenue. Our server, storage and client businesses all delivered double-digit growth in the quarter as a result of improving demand and solid execution across the business.

Our Consumer business revenue was flat at $2.9 billion and generated a $21 million operating income loss. As we discussed at our recent analyst day meetings, we are confident we can improve our Consumer business operating margins to the 2% level in the near-term. We have been repositioning the business, which involves targeting our efforts to the right geographies, products and customer sub-segments.

We have a solid product portfolio lining up for the holidays and we are making progress in simplifying our product portfolio on increasing our ocean shipments and in growing our fast track capability. And we do have line of sight to additional G&A savings that will help the business.

Regionally, we saw revenue growth across all regions. APJ delivered 38% growth while the Americas and EMEA were up 17% and 24% respectively.

I wanted to briefly cover some other key product highlights before I turn it over to Steve to talk about Enterprise. The corporate refresh cycle is continuing. And we’ve seen commercial client revenue growth of 14% and 25% over the past two quarters. In our second quarter, total revenue in mobility and desktops were 21% and 17% respectively. Mobility units were up 21%, while desktop units were up 12%.

We saw particular strength in Large Enterprise and Small and Medium Business here. Software and peripherals remains an important business for us, growing revenues at 6%, driven by strong performance from displays and electronics and peripherals. Servers and networking, storage, and services accounted for 34% of commercial revenue in the second quarter, up from 30% a year ago.

Now let me turn it over to Steve Schuckenbrock to discuss some of the successes we are seeing in enterprise solutions and the Large Enterprise segment.

Steve Schuckenbrock

Thanks, Brian. On our June analyst meeting, we mentioned a number of initiatives to drive growth in our enterprise solutions business, including investments in sales and solutions resources. We are investing in training and the acquisition of key assets to fill gaps and address customer needs. I’ll talk more about all of these in just a moment. However, I’d like to start with Large Enterprise.

We had a good quarter, as we saw broad based demand across verticals and double-digit growth in all geographies. Large Enterprise grew revenues 38% to $4.5 billion, which represents the fourth consecutive quarter of sequential growth and brings us closer to the pre-recession demand levels in fiscal 2009. Operating income dollars were up 68% to $288 million or 6.3% of revenue. Operating income was driven by increased scale and strong enterprise solutions growth. While we encountered some pressure from the commodity costs and an increase in client revenues, overall the performance was good.

From a business line perspective, we saw a number of positive trends. Server growth led all categories except services with a revenue increase of 54% driven by customers taking advantage of positive ROI projects along with another strong quarter in our data center solutions business. Storage was up 14%, and we had a significantly improved profitability, as customers continued to adopt our EqualLogic solutions.

As Brian mentioned, we are seeing continued evidence of the corporate refresh cycle, as notebook and desktop revenue were up 51% and 35% respectively. For the significantly aged installed base and a relatively low Windows 7 migration, we expect these general trends to continue well into the next few quarters.

Now let me turn to a few highlights on Dell’s overall enterprise solutions. Let me state that Dell has not been this integrated and aligned around how to drive solutions ever in its history. It is exciting to see this comprehensive approach in thousands of employees in the company that support and execute on solutions every day. And it is also important that our customers recognize us as one team, and that’s happening. We had another strong enterprise solutions quarter.

Our combined commercial server, networking, storage and services revenue grew 43% to $4.3 billion. In services, we continue to make solid progress with respect to the integration. Commercial Dell services grew 68% to $1.8 billion, driven by the integration of Perot. We are on track for our cost synergies and sales targets, and industry demand conditions are improving as customers gain greater visibility into their businesses.

The outsourcing pipeline is expanding, which should position us well for the second half of the year. In addition, we benefited from a stronger discretionary environment during the first half, as project revenue grew double digits during the quarter. In servers, revenue grew 35% fueled by the strength in blades with a growth of 35% as well as our data center solutions business. Dell now powers 21 of the top 25 most heavily trafficked websites in the world.

As a whole, our storage was up 13% to $624 million. More importantly, our storage product mix continues to drive improved operating margins. EqualLogic and PowerVault led revenue growth up 63% and 14% respectively. We continue to see adoption of EqualLogic across a wide array of customers, small, medium and large. And EqualLogic scales very well through all of those needs.

Let me turn to acquisitions and alliances. During the quarter, we announced the acquisition of Scalent and Ocarina. Scalent is a company that provides technology used in the scale advanced infrastructure manager, a key building block for Dell’s virtual, integrated solutions. Ocarina is a leader in online storage optimization solutions, including compression and de-duplication, and brings significant value as network utilization and storage utilization are dramatically increased.

With the addition of key IT and technology from companies like Ocarina and Exanet, we will continue to enhance our product offerings, as we seek to provide customers greater choice and value in storage and data management solutions. In addition, we continue to be pleased with the progress of our case integration and have seen strong growth in the early stages. We are really excited about this growing set of assets and capabilities and will continue to make targeted additions in areas such as storage, software and services.

We are also very pleased about our plans to acquire 3PAR, which we announced earlier this week. This acquisition brings together 3PAR’s architecturally advantaged technology for the club, with Dell’s ability to deploy, scale and grow it. And 3PAR fits perfectly with Dell’s commitment to open capable and affordable solutions that deliver value and lower total cost of ownership. You might say that 3PAR represents in the fiber channel space, but EqualLogic in the iSCSI space.

Now let me turn this back over to Brian.

Brian Gladden

Thanks, Steve. Let’s turn to our outlook for the remainder of the year. Overall, we are pleased with our year-to-date revenue and operating income results along with a very strong cash flow generation. Our priorities remain to increase operating income through the back half of the year through aggressive enterprise solutions growth as we continue to make targeted investments and prudently manage our costs.

As we’ve said for the past three quarters, we are seeing a broad corporate client refresh, and we believe this solid demand will extend through the next several quarters. We are well positioned to benefit from this growth, as our commercial businesses make up 81% of our revenue. For our third quarter, we expect the typical seasonal improvements from our federal government and commercial businesses. Overall, we expect to see a pickup in the low-single digits in the third quarter.

Component pricing is improving, and we expect to see a return to modest cost reductions in the third and fourth quarters. Currency volatility is also a concern, though our hedge programs do provide stability for us. As you see in our second quarter results, we continue to manage OpEx in a disciplined way, with lower spending in G&A and in our client business.

We also are seeing some of the impacts from the consolidation of our Consumer and S&B businesses. Despite the impressive OpEx performance for the quarter, we do expect OpEx to trend upward and expect gross margins to increase, as we will manage operating income in those dynamics while we make the right enterprise and sales investments for the company.

Finally, with the solid commercial demand and improving commodity price environment we are seeing, we expect revenue growth for the year to be in the 14% to 19% range. We also are confident that our operating income growth will be in the 18% to 23% growth range.

With that, I will turn it over to Michael.

Michael Dell

Thanks, Brian. Our progress in the first half shows that we are executing to a clear and consistent strategy. Demand trends continue to be favorable with our stronger weighting towards commercial. In the client business, we are seeing the corporate refresh cycle continue, as both notebooks and desktops demonstrate a strong revenue and unit growth.

According to IDC, approximately 65% of enterprises have already begun or will begin their migration to Windows 7 within the next six months and 89% of companies have definitive plans to begin their migration to Windows 7 within the 24-month period. I’m also very encouraged by the progress in our enterprise business. Customers are increasingly choosing Dell servers, which grew 35% in Q2. Today, two of every five in the United States and one out of every three servers sold worldwide are Dell. We feel great about the progress we are making also with blades and carb revenues.

In storage, EqualLogic continues to gain momentum and experience wider adoption, delivering over $1 billion in revenue since the acquisition and about $800 million this year. And we are continuing to build our enterprise portfolio with our planned addition of 3PAR. Overall, we feel good about this demand environment and the evolution of our enterprise business and the expansion of our IT portfolio in the data center.

Now, I will turn it back over to Rob.

Rob Williams

Thanks, Michael. Just a quick reminder to please limit your questions to one with one follow-up. Casey, can we have the first question?

Question-and-Answer Session


(Operator instructions) And we do have a question from Brian Alexander with Raymond James.

Brian Alexander – Raymond James

Okay, thanks. Can you guys comment how much of the sequential decline in gross margin was related to the Consumer business? And related to that, I think your Consumer business lost more money this quarter than any quarter since you began reporting it separately. So could you explain in more detail the profit performance there in Consumer and what surprised you in the quarter? Brian, I think you mentioned supply chain cost pressures. So what specifically gives you confidence that this business will generate 1% to 2% operating margins in the near-term? Is it component cost becoming more favorable of the specific initiatives to drive profitability? Which ones are important and which ones you accelerate? Thanks.

Brian Gladden

Yes, Brian. Component costs clearly were the biggest pressure on gross margins during the quarter. That affected the entire business commercial as well as Consumer. Consumer margins within the Consumer business, I would say, weren’t necessarily down. And frankly, as we laid out at the analyst meeting, we’ve got some pretty dramatic and significant actions underway to improve profitability in the business, especially in the retail business. And I would tell you that we’ve seen some progress there though, as you mentioned and the P&L shows, it’s not quite evident yet.

I would say for Consumer, we did see some demand weakening during the quarter, during the latter parts of the quarter. But I would also remind you that the Consumer business – the consumer industry has been very strong for more than two years, and we’ve grown faster than the market during that period of time. I also remind you that Consumer is 19% of the business. So we will continue to watch that demand. But we would say we are still committed to driving to a 2% operating income target as we look out over the next couple quarters.

Brian Alexander – Raymond James

Okay. Thanks.


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

Keith Bachman – Bank of Montreal

Hi. Thank you. Steve, I want to ask you about Large Enterprise. And the dollars were up, but the operating margin performance slipped a little bit. And I just want to see if you could bifurcate, you mentioned component costs as well as mix. Could you just give us a little more color and how you think that trend unfolds as we look out over the next quarter? So – thank you.

Steve Schuckenbrock

Yes. Thanks for the question. Yes. Clearly, we are quite happy with the year-on-year progress on op-inc and improvements of 110 basis points. And if you look on a Q-on-Q basis, I think we saw an accelerated client refresh underway with our customers. And Michael referenced that in his comments as well. When you combine that and the margin rate associated with the client business relative to the rest of our business, it has certainly put some pressure on the gross margin line. We have very specific plans in place, especially now that we have the E1 to E2 transition in the laptop under our belts for how we can get the client margins back up. And we feel very confident on our ability to execute that in the coming quarters.


Our next question will come from Richard Gardner with Citigroup.

Richard Gardner – Citigroup

Good, thanks. I was just hoping to flush out the component pricing and availability environment as we go into the third quarter. I think, Brian, you mentioned modest component price declines, but it seems like the declines here lately have been pretty dramatic. So just wanted to clarify your thoughts on that. And also talk about whether you did strategic buys during the July quarter and whether there is an issue where we might be – you might have some components that were bought at higher prices. Thank you.

Brian Gladden

Yes, Richard. We saw – as we were together in June, that was sort of the very early end – very early start of seeing some of these declines. We did do some strategic buys. As you see, our inventory balance in the quarter, we’ve put some more strategic inventory on the books. And I think we are starting to see more dramatic declines. I do have some concern in some cases that there will be some capacity that comes out, and those prices will stabilize in the short-term or in the medium-term.

So we continue to watch it. I think we did not see a lot of benefit in the P&L over the second quarter of declines and all of the second half of the quarter. We do expect to see some of that as we move into the third. And we’ll watch it. I mean, I think it’s – as you know, I mean, it’s across the board memory, LCDs, hard disks. We’re seeing prices come down. But I think it remains to be seen how that plays out beyond the September timeframe.


Our next question will come from Toni Sacconaghi with Sanford Bernstein.

Toni Sacconaghi – Sanford Bernstein

Just one follow-up. First, on the – in terms of your looking forward beyond this quarter, your fiscal Q4 hasn’t really exhibited any normal seasonality over the last five or six years. Can you help us understand how you are thinking about that? If we assume even flat for Q4, you’re going to be close to the high end of your revenue guidance range, probably somewhere around 18%. So, A, how do we think of seasonality for Q4, what is kind of normal and we can calibrate against that? And then secondly, why shouldn’t we be looking at the high end of your revenue guidance at this point? Is there anything you are anxious about? And I have a follow-up, please.

Brian Gladden

Yes, Toni. I think – it's a very good question. I think there is, as I called out in my comments and in the answer to the question, I think there is some – we are watching the consumer demand. And as you look at our historical fourth quarter performance, it would typically be driven by a pretty dramatic increase in the Consumer business around the holidays. I think that’s the biggest question we have right now as we look at the second half of the year, how that might play out. So I would hesitate to call that. I would suggest that if we saw typical seasonality, we would see a sequential pickup driven by Consumer, and your conclusion is probably right. But again, a little bit of hesitancy just given what we have just recently seen with consumer demand. So we will continue to watch it.


Our next question will come from Steven Fox with CLSA.

Steven Fox – CLSA

Hi, good afternoon. Can you just expand a little bit on what you’re seeing from a public sector standpoint? There are obviously still some concern about state and local and national government spending. Have you ever seen anything to discourage or encourage spending heading into the new budget season?

Brian Gladden

Well, we just sort of experienced the year-end of the state and local budgets. And generally, on a year-over-year basis, they were relatively flat. But that was about what we expected. We continue to see going into the third quarter, which obviously is the big federal budget period for us, we expect to see a relatively good federal business. And as we look at the pipeline today and the order rates that we’ve seen, so far we haven’t seen anything that isn’t consistent with that at this point.

Steven Fox – CLSA



Our next question will from Maynard Um with UBS.

Maynard Um – UBS

Hi, thank you. Can you just – given kind of the concern of the Consumer, can you just talk about back-to-school? It seems we’re off to a little bit of a slow start. I’m wondering if that’s in line with your expectations. How should we think about back-to-school maybe over the next few weeks? And then, are inventory levels at levels where it could impact selling for the holiday season, meaning, inventory levels at the retail channel? Thanks.

Brian Gladden

I think what we are seeing is consistent with what you are hearing from others in terms of back-to-school being a little bit weaker than we would have expected. And I think as we are heading towards the end of that period, it’s mostly done. And I think – as we think about inventory in the system, as you know, our business model generally is pretty light on that in terms of our model serving the customers. So I mean, it’s not necessarily an issue for us. We would have – as you know, our inventory balance is up and there are investments we’ve made in strategic inventory.

As we move to ODM and as we’ve talked about, we are putting more material into the system, into the supply chain, and some of that is on the water in terms of a transportation model that allows to get some cost out and be competitive. So there would be more inventory in the system for us than there otherwise typically historically would. But I don’t see it having any impact in terms of our margin behavior or how we price in the marketplace. It’s not that significant.


Our next question will come from Katy Huberty with Morgan Stanley.

Katy Huberty – Morgan Stanley

Brian, just to tie together some of the prior questions, how much of a stretch is it to expect that you could get back towards an 18% gross margin in the back half of the year, just given the direction of component costs and cyclical and seasonal strength you are seeing in the higher margin segments right now?

Brian Gladden

I think there is – there is a bunch of competing elements that drive the margin rate, as we think about it. There is very strong demand in the enterprise side of business. That’s a good – that helps obviously. If component prices stabilize at lower levels, which we’re seeing now, I mean, we should make progress in terms of gross margin improvements. I think what we showed in the quarter is that even with pressure on the gross margins, managing the cost level, OpEx in the business, we are trying to drive operating income and operating income dollar commitments. And that’s sort of the way we’re thinking about it, Katy. I hate to size the gross margin improvement given the uncertainty around component prices right now.


Our next question will come from Scott Craig from Bank of America.

Scott Craig – Bank of America

Thanks. Good afternoon. Michael, just help us out a little bit in the storage area. You’ve obviously made a couple big moves there with EqualLogic and now with 3PAR, but you also have a big EMC business re-selling. So how do you foresee the relationship there playing out? And are you interested in adding some more, let’s call it, competing lines with EMC over the longer term? Thanks.

Michael Dell

Sure. If you look at the changes in the storage business, I think one of the most remarkable ones is the increase in gross margin dollars in this business. And certainly, that comes from having more and more of our own IP. We had great success with EqualLogic. The EMC relationship continues. And as we pointed out earlier this week, about 80% of the Dell-

EMC relationship fits into the lower end CLARiiON CX-120 product, the AX product, the NAS products and data domain, which are really products that we today do not have similar offerings for. And so there is a strong relationship there that I think will continue for some time. Certainly, there will be places where we choose to partner and places where we choose to compete. But we also see with this proposed 3PAR acquisition a great opportunity to grow the high end of our storage portfolio and continue to make this rapidly growing part of Dell’s overall business.


Our next question will come from Jason Maynard with Wells Fargo.

Jason Maynard – Wells Fargo

Hi. I just wanted to follow up on kind of the back-to-school comment on maybe a little hesitancy around sort of the Q4 Consumer. And just to get your take on the impact that you think either the iPad is having on that sort of outlook and the potential for a lot of Android-based tablets coming into the market. It looks like the tablet category, in general, is going to taking a bigger share. So how does that sort of weigh into your positioning and your thoughts on kind of into the year?

Brian Gladden

Mike, do you want to take that one on the tablet?

Michael Dell

Yes. I think it’s a question, how many tablets do you think will be sold. If the PC market is 380 million units and the tablet market is – take a guess – that – I'm not sure if it is at a huge percentage this year. Certainly there is a lot of excitement around Android and we will participate in that. Lots of those working on tablets and touch-type solutions. I think next year you will see a lot more of them.


Our next question will come from Jayson Noland from Robert Baird.

Jayson Noland – Robert Baird

Great. Thank you. Steve, a question for you regarding integration with an M&A. I guess, is there a risk of marginalizing some of these unique assets or maybe a risk of overwhelming your sales force?

Steve Schuckenbrock

I think the best thing we can do is point to our past and look to a little bit at EqualLogic, which has become a significant multiple of what it was when we bought it. Brian, I’ll defer to you in terms of the numbers. The thing that we are doing relative to this with Dave Johnson’s leadership is really putting a world-class team up against every one of these acquisitions and ensuring that every aspect of integration needs to be contemplated as getting done. And it gets the highest possible priority in the business.

From a sales force standpoint, I can tell you that on a fact that our intention to acquire 3PAR actually resonates exceptionally well with our sales force. One is that as you’ve seen with our server numbers, more and more we’re raising the heart of the data center. And number two is that the value proposition from 3PAR has an awful lot of analog to the value proposition with our EqualLogic in manageability, in thin provisioning, in terms of all of those type characteristics. The ease of installation and management of that platform is phenomenal. And so the value proposition will resonate well.

Our challenge is to scale. And so we will clearly be scaling our specialist capability in the storage space to reference that not only our intended acquisition of 3PAR, but the continued growth of our EMC business and the midrange that Michael referenced and the significant – continuing the significant growth we have seen around PowerVault and EqualLogic. So I’m quite confident. And when you look at the software acquisitions we have made with Ocarina, with Scalent, and with Exanet, those would beautifully impact that strategy. So we happen to have a couple thousand of our sales force in town this week for training, and I can tell you that the energy and enthusiasm couldn’t be any better.


Our next question will come from Ben Reitzes with Barclays Capital.

Ben Reitzes – Barclays Capital

Yes. Thanks a lot. Michael, question for you. Can you talk about what you thought of the Intel-McAfee deal? Does it impact who you may buy in the future and your strategy? Are you excited about that deal? Does that add value to you? And what do you think it means about consolidation in the space? Thanks.

Michael Dell

Hi, Ben. I think it might be a little too early to try to speculate on those questions. Certainly, McAfee is a company we work with closely and don’t really have any thoughts for you at this stage. I’d like to understand a little more and we will get back to you at the appropriate time.


Our next question will come from Chris Whitmore with Deutsche Bank.

Chris Whitmore – Deutsche Bank

Thanks very much. Wanted to get your views around the competitive environment. How do you expect competitors to respond to weaker consumer demand and dropping commodity prices? Do you expect pricing to get more aggressive as they move forward to trying to simulate units? What’s your view there?

Brian Gladden

Chris, I think it will vary by market. And I think as you look at what we’ve seen over the last six or eight months, we’ve seen firmer pricing and more – as you look at the individual products in the client world, prices have been generally pretty stable as compared to last year. As we look at component prices moving, clearly that could be a catalyst in terms of overall market pricing. But I think it will – we will have to see how it plays out in terms of how these component prices move, and that will be the bigger driver, I think.


Our next question will come from Lou Miscioscia from Collins Stewart.

Lou Miscioscia – Collins Stewart

Okay. Just to tailgate a little bit off that question, Brian, at the analyst meeting, you talked about I guess three headwinds if I got it right; components, FX and mix. Obviously we saw some of them play out. Is the main one now still components and where that’s going to go? You did mention on the call that you thought that you would recover some on the gross margin line. I guess most of us were modeling 17.7% or 17.8% gross margin. Do you think we are going to get there next quarter?

Brian Gladden

I think components – it depends on what you’re looking at, Lou. I mean, if you look year-over-year, components still continue to be a pretty dramatic headwind. I think if you look sequentially, we will probably see some relief and, as we said, some modest improvement in terms of component pricing. There is still pressure from an FX standpoint on the business. As you look at where the euro is versus hedges that we’ve had over the last couple quarters, and that’s something that the teams are very, very focused on in the marketplace to try and recover. I think with component prices moving down and to the extent that they can continue to moderate or soften a bit, that should be a catalyst that allows margin rates to move back up. We will manage that throughout the year, and as we showed in this quarter, I think we will look at the cost line as well in terms of trying to managing the operating income commitments.


Our next question will come from Abhey Lamba from ISI Group.

Abhey Lamba – ISI Group

Yes, thanks. Brian, on the Consumer segment, do you need consumer spending to get better and Q4 to be much better than you are currently kind of baking in your guidance, as you alluded to one of the other questions, to get to your 1% to 2% goal or do you have enough level on the cost side (inaudible) even if the demand does not come through? Thank you.

Brian Gladden

Well, I think we’re working multiple plans and obviously have efforts going across the business. Most of it focused on our mix of business where we play in the Consumer business. We have some new products launching in the second half of the year for the holiday season, which we think – we feel very, very good about. We have continued activities that help us improve the supply chain costs. Component costs should also help. So most of those would be really demand independent and would help us improve the profitability in that business, and we will continue to manage the OpEx as well. So I think we’re trying to build a plan that gets us there in sort of any environment, and we will continue to watch that demand environment.


Our next question will come from Aaron Rakers from Stifel Nicolaus.

Aaron Rakers – Stifel Nicolaus

Yes. Thanks for taking the question. I want to talk a little bit about the server side of the business. Looks like you guys had a pretty healthy revenue growth number. I think you also disclosed that you grew units by about roughly 15% year-over-year in the quarter. The question is that if I compare that to what the third party research firm had estimated at kind of a mid-30% growth rate, it seems like there is a little bit of a disconnect with those estimates relative to what you reported. So can you talk about that? Is that reflective of any slowing that you saw maybe in July? And then maybe on the heels of that, where do you think we stand currently in the server refresh cycle in total?

Brian Gladden

Just, Aaron, to clarify, the server business, for us, was up 35% year-over-year in the quarter. So that was – we think that was pretty strong performance. And I think the IDC data would say that we actually gain share in servers in the second quarter. And I’ll let Steve make a couple comments.

Steve Schuckenbrock

Yes. I would say that the – while the granular IDC data is not out yet. All indications are that we outgrew the market pretty well, and now we are pretty happy with what we’ve done at up 35%. That strength we’ve seen across all of our commercial businesses. All three businesses were up double digits in the server space. And that’s with a healthy DCS or our Data Center Solutions business. But I’d say, Data Center Solutions business was not as strong as it was in the first quarter. So you are seeing it on the back of our general purpose servers and on the strength of our overall product line.

Michael Dell

I think there is another trend that’s going on. Also, you talked about where we are in the cycle. I think certainly the virtualization wave is still well and bloom, and there is a lot of that activity. But we’re also seeing a continued migration of what I would call networking-related activities moving into the server domain. You see this in a couple of forms. One is the specialized networking companies moving on to an x86 platform that’s relevant because of Dell’s OEM business with those companies. At the same time, you see those companies creating a virtual version of their application, which is easily put into a large complex of Dell servers in the form of one of our large blades or other architectures. So we think the server space is going to continue to be on a rapid growth.


Our next question will come from Ananda Baruah from Brean Murray.

Ananda Baruah – Brean Murray

Hey, thanks for taking the question. I just wanted to get a clarification on the comments you made earlier about expectations for improving in the IT outsourcing business. Just wanted to get your thoughts on how you see that business I guess unfolding in the second half of the year maybe into next year and maybe a little texture on what you have actually seen change as we move through the first half of the year?

Brian Gladden

Well, I think the integration with Perot could not going better. I mean, the teams are very, very well aligned in the field. I think the customers have received this as a component of Dell’s business very, very well. We’ve closed a number of good deals. We’ve got a very healthy pipeline, as we look to the second half of the year. We’ve already – we are not trying to hurry these signings into the current quarter. We are taking the signings as they come, and in fact, as we start the third quarter, are already off to a very healthy start.

When I look at the outsourcing business overall, I think demand is pretty strong. I think Dell has the opportunity to capitalize maybe a little better than some of the others because there is a fair amount of white space for us in certain geographies, EMEA and APJ specifically and across our entire commercial business. And for Large Enterprise, I’m certainly seeing that with a pipeline that is now $1 billion between now and the end of the year.


Our next question will come from Amit Daryanani from RBC Capital Markets.

Amit Daryanani – RBC Capital Markets

Thanks for taking my question. Just a question, I guess, assuming component costs continue to ease up in the back half, would your perspective in that environment be to actually use those savings and pick up market share, or would you flow that through the bottom line? I'm trying to understand what are you more focused on in the back half? Is it market share, or is it more leverage on the bottom line?

Brian Gladden

We shared a view at the analyst meeting of our priorities and how we think about the company. And I would say that hasn’t changed. The incentives and the comp plans of the company are all aligned around growing operating income. And so it’s not about market share. It’s about profit share. And that’s what you would see that we are doing right now. And in the second half of the year, that would be true too.

Michael Dell

I think you will see our operating income faster than revenues for the entire year.


Our next question will come from Mark Moskowitz from JP Morgan.

Mark Moskowitz – JP Morgan

Thank you. Good afternoon. I just want to follow up on that if I could. I'm just trying to understand the flex that is in the model now versus, say, maybe five years ago. Are there certain components now in terms of ocean freight, more channel protection, marketing dollars being thrown to the channel partners that maybe limit the upside potential just given the switch in the build-to-orders, the build-to-forecast model going forward?

Brian Gladden

Well, I mean, I think if you were to look at the business versus five years ago, clearly there is less margin to work with on the client side of the business. That’s for sure. I do think in terms of opportunity, as you think about the volume leverage in the business, we continue to look for strong commercial demand driving the overall business. And as you look at the second half of the year, that’s the dynamic we would expect to see and you will see leverage of the P&L as a result of that. And I think that’s the overriding dynamic in the company.


Our next question will come from Bill Fearnley from Janney Montgomery.

Bill Fearnley – Janney Montgomery

Thanks. A question for Brian, if I could, on the up-sell. How is it working and how is it affecting your gross margin? And have you changed the sales incentive plan to reinforce or incent that behavior? And then any additional color on products or services that you are having specific success with on the up-sell would be helpful. Thanks.

Brian Gladden

I take that you mean services up-sell and I’ll comment and let Steve talk about it. I think – we've seen continued improvement in the attach rates on services in the business. And if you go back and look at it on a year-over-year basis, our attach rate in the quarter is 35%. A year ago, it was 30%. So we continue to have success in attaching services and up-selling across the business. And that’s an important driver of the P&L obviously for us.

Steve Schuckenbrock

Yes. I would just comment that the attach rate of account [ph] support is quite strong. And Brian just referenced the numbers on that. The other thing that I would focus you on is CFI, our ability to customize the software load that goes on to the hardware in our factories. That business has been terrific. I just, as an example, reviewed that piece of the business in APJ where it’s well over 50% on a year-on-year basis. And that drives terrific short-term margin and it really is a very sticky set of services for our customers.


Our next question will come from Nehal Chokshi from Technology Insights.

Nehal Chokshi – Technology Insights

Thanks, guys. Actually following up on that comment that you expect operating income to grow faster than revenue on a year-over-year basis, it would probably be a lot more comforting if you could say that on a sequential basis. Any color you can provide there?

Brian Gladden

Well, I mean, I can tell you – I mean, if you look at second quarter results, we did see 4% sequential revenue growth and 6% sequential operating income growth. And I think without getting into specifics on the second half of the year, our call for the total year stands and I think you would see nice leverage as well in the second half of the year as we’ve seen in the first half. I think if you look at the first half of the year, we did see leverage in the business, especially when you look – in the second quarter, for instance, if you adjust results from prior year for – last year, if you recall, we called out a one-time vendor of transaction, which represented about $69 million benefit for us. If you adjust for that from last year, I mean, we’ve seen in the first half of the year operating income growing at 24% while revenues growing at 21% year-to-date. So you are seeing leverage in – that's sort of the overall outlook we’ve called for the entire year is pretty consistent with that.


Our next question will come from Andy Hargreaves from Pacific Crest.

Andy Hargreaves – Pacific Crest

Hey. Just want to go back to storage, and I apologize if I’m missing something obvious. But EqualLogic is doing really well, but the total storage business at least on a trailing 12-month basis is down over the last couple of years. So can you just talk about the dynamic there? And are we expecting any cannibalization with the 3PAR acquisition?

Brian Gladden

No. Let me explain that. I mean, our – about a year ago, we really changed the focus in our storage business from being a pure reseller to being a real storage business that brings not only our own IP, but IP from our partner EMC through an OEM lens as opposed to just as a pure reseller. And so that’s impacted the revenue line. But what you are seeing is a significant increase in the overall margin execution in our business. And so what you’re seeing on a year-over-year basis from a growth standpoint is that SIM [ph] is getting out of the number entirely, but is still overlapping with the SIM.

Michael Dell

I’d just put in a little context. The gross margin dollars in storage are up on a year-over-year basis almost as much as the EqualLogic revenues were up.


Our next question will come from Rob Cihra from Caris & Company.

Rob Cihra – Caris & Company

Hi, thank you very much. I wonder if you can just save from a macro standpoint you have got four quarters now in a row of sequential growth in Large Enterprise. I guess I'm just curious – well, two things. One is, how much of that do you think is Windows 7 refresh versus just kind of macro GDP corporate profitability improvement? And then I guess taking that further, is that something that you think is peaking soon, or are we early in that if you could ballpark it? I mean, you said now in the release it’s well underway. But I don't know. I'm sure you won’t say, but if you had to pick an inning, which would you pick? Thanks.

Steve Schuckenbrock

I’m not sure I know how to pick the innings, but I can tell you that when we look at this business, we are in the early stages of the Windows 7 deployments in the commercial space. And in Large Enterprise, I think what we’ve seen is that came a little bit faster than we might have expected, but it’s terrific. It is terrific demand and we are capitalizing on that demand, I think, quite well. When you consider more broadly where are we in this overall environment and what are the key drivers of it, in the client space, it’s certainly been seven it’s the age of the assets. And the fact that replacing the assets with new technology saves company’s money as it reduces maintenance costs, reduces power and cooling costs, etc.

And as they are deploying Win 7 anyway, it gives them a great window to deploy the new technology. In the server space and in the storage space, we continue to see customers driving down the total cost of ownership in the infrastructure arena and are continuing to standardize on x86 servers. They are continuing to virtualize all of their infrastructure, and they are consolidating their storage footprints to better carrying of that storage and better utilization of that storage. And all of that is behind what’s driving the demand. I won’t predict any. But I can tell you that there is plenty of headroom for savings in companies and their IT infrastructure, and I think that is fueling us.


We will now take our final question from Shannon Cross with Cross Research.

Shannon Cross – Cross Research

Thank you very much. I have a question and a follow-up. The first question is just, if you can talk geographically, you had mentioned linearity during the quarter for consumer things weakened. But can you talk about China and some of the emerging markets, as well as your just sort of linearity, what did you see as the quarter progressed?

Brian Gladden

Yes, Shannon. I think – Europe, as we’ve said, I think, was up 24% for the quarter. And there was some pretty broad based strength in Europe. Germany was up 31%.

France was up 22%. UK was probably the weak spot at up 6%. And I think we would say Europe – I mean, there is the normal slowing that you would see in the back half of the second quarter. But I wouldn’t call it unusual. We didn’t see dramatic slowdowns in Europe. And I would call that relatively steady. If you look at Asia, it was driven by China. China was up for us over 50%. NE was up over 75%. Japan was probably the solid growing country at 5% growth. And then A&G [ph] for us was up over 30%. So – and I would say the same thing. We did not see a dramatic slowdown in APJ towards the end of the quarter. It was pretty steady throughout the quarter. And we’re expecting continued relatively strong demand there.

Shannon Cross – Cross Research

Okay, great. And then just my last question on the component side, I'm just curious if you think the declines in pricing for components are coming more from the lower demand, so basically the vendors are just ordering fewer components, or is it more that the manufacturers have actually increased capacity so that if we do a bounce back in terms of demand for PCs, will people be able to meet it, or are we going to be in another sort of shortage situation?

Brian Gladden

I think as we talked about the first half of the year, there is expected capacity in many of these commodity markets that is planned to come on in the second half of the year. I would tell you that what we are seeing now is more driven by short-term demand. And that’s sort of what’s driving the current commodity environment that we see. That capacity is still out there. I’m just not sure they are going to – it depends on what happens obviously with demand as to whether or not they will need that in the second half of the year. But I think it is there. So I wouldn’t be as concerned about that.

Shannon Cross – Cross Research

Okay. Thank you.

Rob Williams

Great. Well, thanks, everyone, for joining us today. We will speak again with you soon.


Ladies and gentlemen, this concludes today’s conference call. We appreciate your participation. You may now disconnect.

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