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Executives

Rob Williams - VP, IR

Michael Dell - Chairman and CEO

Brian Gladden - SVP and CFO

Steve Felice - President, Consumer, Small and Medium Business

Analysts

Katy Huberty - Morgan Stanley

Toni Sacconaghi - Sanford Bernstein

Richard Gardner - Citigroup

Brian Alexander - Raymond James

Maynard Um - UBS

Steven Fox - CLSA

Ben Reitzes - Barclays Capital

Keith Bachman - Bank of Montreal

Aaron Rakers - Stifel Nicolaus

Mark Moskowitz - JPMorgan

Brian Marshall - Gleacher & Company

Jayson Noland - Robert Baird

Abhey Lamba - ISI Group

Amit Daryanani - RBC Capital Markets

Chris Whitmore - Deutsche Bank

Dell, Inc. (DELL) F3Q2011 (Qtr End 10/29/2010) Earnings Call November 18, 2010 5:00 PM ET

Operator

Good afternoon and welcome to the Dell Inc. third 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 www.dell.com/investor. Later we will conduct a question-and-answer session. (Operator Instructions)

I'd like to turn the call over to Rob Williams, Vice President Investor Relations. Mr. Williams, you may begin.

Rob Williams

Thank you. With me today are Michael Dell, Brian Gladden, and Steve Felice, Head of our Consumer, Small and Medium Business. Brian and Steve will review our third quarter results then Michael will follow with his comments.

We have posted a web deck on dell.com and we released a VLog on Dell shares. I encourage you to review these materials for additional perspective. In Q4 we will be attending the Credit Suisse Technology Conference on November 30, Barclays Capital Conference on December 9 and the Raymond James Conference on December 14, as well as CES in January.

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 dell.com and in our 8-K filed today. I encourage you to review these documents. Please also 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. I'd like to start by saying, that we had a good third quarter with solid revenue and profitability growth and good cash flow. Highlights for the quarter include improvement in our gross margins, continued expansion in emerging markets and sustain strength in our global commercial customers demand, as they continue to see value in our products, services and solutions. These accomplishments validate our strategy and demonstrate we're making progress towards our long-term value creation framework.

Revenue for the quarter grew 19% year-over-year, driven by our enterprise solutions and services business and a strong commercial client refresh. We believe we're making strategic progress in improving our consumer business, but we do still have work to do there. And Steve Felice is here today to provide an update on both consumer and SMB later in the call.

Execution on pricing and cost initiatives and the favorable component environment led to the highest operating income we've seen in nearly five years. The profitability in our commercial businesses was driven by improved product margins in our enterprise solutions and services and client hardware businesses.

Let's take a closer look at the third quarter P&L and key performance metrics, which are provided for your reference on pages five and six in the web deck.

Revenue in the third quarter was $15.4 billion, up 19% year-over-year. Enterprise solutions and services grew 31% to $4.3 billion in revenue. Our client product business grew 18% to $8.5 billion, driven by commercial client hardware revenue growth of 23%. Sequentially, consolidated revenue was down 1%, primarily due to a softer than anticipated consumer demand environment.

On a GAAP basis, operating income was $1 billion or 6.7% of revenue, earnings per share was $0.42, which was up 147% year-over-year and up 50% sequentially. Interest and other benefited from the receipt of the $72 million merger termination fee. For the rest of this call, I'll refer to non-GAAP financial measures.

Operating income grew 58% to $1.17 billion or 7.6% of revenue. All of our commercial segments showed improved operating leverage in the quarter. The commercial segment as a whole delivered 10% operating income, representing a 230 basis point increase from the previous quarter. We delivered 20% gross margins, driven by better supply chain execution, pricing discipline and broad component across the clients, which affected all of our lines of business, from client hardware to services to software and peripherals.

As these component cost declines work themselves through the industry supply chain, we do expect the industry pricing environment to more fully reflect these changes. We continue to manage operating expenses well, while we're making important strategic investments in the company. OpEx at $1.9 billion or 12.4% of revenue was up slightly, primarily driven by increased expense related to our performance based compensation. As we told you in June, our variable compensation plans are directly tied to revenue growth, operating income growth and cash flow.

Interest and other expenses were $20 million, with some favorability from the reevaluation of foreign currency denominated assets on the balance sheet. Our tax rate was 23.7%. Earnings per share increased 96% year-over-year to $0.45 per share. We generated $913 million in cash flow from operations and $866 million in free cash flow. For the trailing 12 months, cash flow from operations was $3.8 billion.

This quarter, we purchased the portfolio of financing receivables from CIT, which brings in-house the majority of receivables Dell was managing for CIT as part of our previously dissolved joint venture. There are more details on this transaction in the web deck on Page 10.

Our cash conversion cycle was a negative 32 days. While we saw a one day improvement in days of inventory, payables fell by five days, driven by our deliberate reduction of inventory levels and the linearity of our supply chain in the quarter, which we think will normalize in the fourth quarter. Days receivable was flat sequentially. We expect our cash conversion cycle to be in the mid-negative-30s.

We ended the quarter with $14 billion in cash investments and issued $1.5 billion of new debt. During the quarter, we repurchased shares worth $200 million.

Now, let's look at our lines of business and regional performance, which you could find details on pages 11 through 15 of our web deck. We had another strong enterprise solutions quarter, which is at the heart of where we're driving this strategy. Enterprise solutions and services now represent 33% of commercial revenue in our third quarter.

Service and storage grew 20% and 7% respectively. In servers, our new cloud products contributed to our growth, while demand for blades was up 49%. In storage, our EqualLogic business grew 66% and we continue to work with EMC to optimize this relationship and drive additional profitable storage growth. In our networking business, revenue was up 36% in the quarter.

Dell services revenue grew 55% to $1.9 billion, driven by the combination with Perot. The services business is detailed on pages 12 and 13 of our web deck. We're now a full year into the integration and ahead of our revenue and cost synergy targets.

We're seeing solid growth in the discretionary project and consulting and attach-based transactional services. Transactional and project services grew 5% and 14% respectively. Outsourcing was up 1% year-over-year and 3% sequentially.

We do have a strong outsourcing sales pipeline, but we continue to experience a longer outsourcing sales cycle that does appear to be an industry-wide dynamic. We continue to believe that the corporate refresh cycle was well underway, and client hardware revenues overall were up 18% with mobility and desktops up 16% and 21% respectively.

In commercial, client revenue was up 23%, while consumer growth was weaker at 8%. Software and peripherals grew revenues at 8%, driven by strong performance from displays and electronics and peripherals.

Geographically, we saw revenue growth across all regions with APJ up 29% and the Americas and EMEA up 18% and 15% respectively. Emerging countries continue to be a key driver. BRIC countries grew at 30% and now represent 13% of our consolidated revenue for the company.

Turning to a segment level performance on pages 16 through 20 in the web deck, in the three commercial segments combined, revenue grew 24% to $12.4 billion. Strong demand, pricing execution and a favorable cost environment led the strong double-digit gross margin dollar growth in every line of business. The commercial segment delivered $1.2 billion in operating income or 10% of revenue.

First, let me start with the large enterprise segment. Revenue was up 27% to $4.3 billion, led by an ongoing hardware refresh among our largest corporate accounts. Client revenue was up 38% and server growth was up 16%.

Operating income as a percentage of revenue improved nearly 300 basis points sequentially driven by product margin improvements in servers, storage, services and client hardware. Operating income was $400 million or 9.2% of revenue for the large enterprise business.

Our public business revenue was up 20% to $4.4 billion. We continue to see a tougher spending environment in Europe offset by overall stable demand in the U.S. Server revenue was up 18% with client hardware up 8%. Our state and local government business in U.S. represents approximately 9% of the public business and less than 3% of Dell revenue. This business was up 5% in the third quarter.

Overall, public operating income of $451 million or 10.2% of revenue was driven by the higher mix of enterprise solutions and services, tight cost controls and the improved component environment.

Now, I'll turn it over to Steve Felice to discuss our SMB business and provide some color on the changes that we're making in our consumer business.

Steve Felice

Thanks, Brian. As Brian has already mentioned, our commercial business really had a good quarter, fueled by our transformation to a solutions provider and strong execution in our client business. Our sales teams are executing on selling the value embedded in our offerings, particularly enterprise services and solution.

Our small and medium business had a very strong revenue and profit quarter. Our direct model gives us a unique advantage in the mid-market and we have earned a trusted advisor status with our customers.

Revenue of $3.7 billion was us 24%, the highest level in two years, driven by strong demand across all product lines. Servers and Client hardware were up 28% and 27% respectively. Storage was up 24%, and EqualLogic which continues to resonate with small and medium business customers was up 84%.

We delivered operating income of $391 million or 10.7% of revenue. High growth and improved profitability occurred in every region of the world.

We are particularly pleased to see EMEA continue a year of share gains and strong profitability. And while medium business has led us into the recovery, small businesses are beginning to see signs of strength. Our recently acquired KACE Appliance revenues are exceeding forecast and we are excited about our recent acquisition of Boomi that will allow us to provide an integration cloud to our customers, and new cloud offerings in the near future.

Revenue in our consumer business was $3 billion, and we delivered breakeven operating income. We continue to make great progress in matching our supply chain with retail buying seasons. Both our direct and retail businesses were profitable, offset by investments we chose to make in the business. We have been working all year to position the consumer business for sustained profitable growth.

First, we've streamlined our consumer brands to three; Inspiron, XPS and Alienware. In the past few weeks, we announced an exciting new line-up of great products including the Inspiron all-in-one, the Inspiron Duo, a unique convertible netbook, and three new XPS notebooks with industry-leading sound and video performance. All of this is enabling our strategy of moving back to a mix of higher-priced band offerings.

Second, our supply chain efforts are progressing well, and beginning to deliver some important results. We've cut delivery times by one week, improved product quality, lowered our manufacturing cost and enabled ocean shipping for a significant portion of our volume ahead of the holiday season. We should see positive results from these changes as we move into the fourth quarter.

Third, we have been maniacally focused on delivering a superior customer experience, a heritage of Dell. Our progress is excellent, with our most recent loyalty scores up significantly to new highs.

Finally, we have shifted our merchandizing and advertising to emphasize value with a segmented focus on key consumer buying groups. All of this will lead to sustained profitable growth.

Now let me turn it back over to Brian.

Brian Gladden

Thanks, Steve. Let's turn to our outlook for the fourth quarter. Our year-to-date results are very good, with revenue up 21%, gross margins at 18.3%, OpEx at 12% and our operating income improved to 6.3%.

Given the cost challenges of the first half of the year, and the muted demand for the consumer PC business, we feel pretty good about these solid results and the progress we've made towards improving our operating margins, consistent with our long term value creation framework.

We continue to aggressively expand our enterprise solutions and services capabilities. Commercial profit margins in this area have improved in each of the last three quarters, and this provides strong validation of our strategy here. We also continue to see a broad corporate client refresh. This growth, coupled with an improving cost environment, provide an opportunity to continue to deliver strong results while also making the critical investments to further our strategic initiatives.

In the fourth quarter, we would normally expect some consumer-driven seasonal growth heading into the holiday season somewhat offset by normal U.S. Federal business seasonality. While we do expect consumer revenue to be up sequentially, we expect more muted growth in Consumer relative to our previous views. As a result, we expect revenue overall to track in line to slightly up with what we saw in the third quarter.

As we think about margins moving forward, we believe the improved component pricing will work its way through the industry supply chain. This effect, coupled with a seasonal mix shift to consumer/client will likely temper our product margins. We are managing OpEx in a disciplined way and are comfortable with the level of spending we've had for the business over the last year.

For the fourth quarter, we'll continue to make investments in enterprise solutions, services and sales capabilities. We expect Interest and Other to swing back to approximately a $50 expense. And we continue to see our tax rate in the 25% to 26% range.

Finally, we expect revenue growth for the full year to track towards the middle of the 14% to 19% growth range we've shared with you in June. As you know, our year-to-date operating income growth is approximately 32%. Given our strong operating results in the quarter and year-to-date and a continued favorable component environment, we now expect our total year operating income growth to be between 28% and 32%.

While we don't intend to regularly provide updates to our annual outlook, we're doing so now given the magnitude of the change in the environment and our improved operating income performance.

With that I'll turn it over to Michael.

Michael Dell

Thanks, Brian. I believe the third quarter results are beginning to demonstrate that the strategy we've described to you over the past year is the correct one. We have a differentiated strategy around the enterprise that is open, capable and affordable, and this is resonating very well with our customers.

We are pleased with the improvement in operating margins in our commercial business driven by improving execution and increasing mix of services and data center solutions.

Over the past few weeks, I've spent a great deal of time with our customers across U.S., Asia and Europe. More than ever, CIOs are telling us that investing in IT is a driver of strategic advantage and is necessary to enable efficiencies and savings longer term.

Our data center and solutions portfolio continues to grow as does our own field and channel partner capability to deliver these around the world. Our customer engagements are evolving from solely being a supplier of IT hardware to a true provider of IT solutions with a deep understanding of customer verticals. This change will take time, but we're making progress and we're well on our way. Fast growing economies like China, India and Brazil are an area of strength for us and should continue to grow rapidly for many years to come.

While we're pleased with the performance during the third quarter, we see a great opportunity ahead and have multiple engines of profitable growth and remaining improvements in many areas of our business. We believe we're well positioned to profitably grow in the right areas and navigate the opportunities ahead. It's a great time for Dell, and I see this quarter's result as a strong indicator of what's to come.

With that, we'll open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question will come from Katy Huberty with Morgan Stanley.

Katy Huberty - Morgan Stanley

Nice job on the gross margins this quarter. Just a couple of questions, Brian, for you as a follow-up on the guidance. The first is when you say that you're happy with the OpEx range you've operated in so far this year, are you referring to OpEx in dollars or OpEx as a percentage of revenue?

And then if we do assume that operating expenses are flat sequentially in the fourth quarter, that implies a high 18% gross margin range. Is that a sustainable level going forward or do you think it will take a couple of quarters for the component costs to work their way into industry pricing?

Brian Gladden

On the OpEx, it's really a range around the percentage of revenue that we would talk about. So I think your math really does make sense. I would say that as we look at component pricing, we saw what we would call a more normalized commodity deflation environment in the quarter. And as we think about how that trend is going forward, we will continue to see a similar environment as we head into the fourth quarter.

We will begin to see, I believe, that deflation will really work its way through the supply chain and affect pricing over the next couple of quarters. I think that's the way we think about it.

As we look at year-to-date performance, we've revenue up 21% and gross margins around 18.3% for the first three quarters of the year is a relatively good sort of framework. And I think as we move towards the long-term value creation, commitments with 7% operating income, it's good progress towards that.

Katy Huberty - Morgan Stanley

And just to be clear to be follow up on the OpEx, typically in the fourth quarter OpEx does rise sort of low to mid single digit sequentially. Would you expect a similar uptick or do you think you can hold OpEx relatively flat with revenue?

Brian Gladden

We were managing within a range based on a percentage of revenue. So we kind of like where it is right now.

Operator

We'll take our next question from Toni Sacconaghi with Sanford Bernstein.

Toni Sacconaghi - Sanford Bernstein

Brian, you alluded to the improvement in gross and operating margins by default is coming from three sources: supply chain, pricing, and component cost declines. Given that some of them are quite interrelated, I was hoping that you could define what you mean by each of those. And if you had to dimension the 280 basis points improvement in gross margin sequentially, how much might be attributable to each of those factors?

Brian Gladden

I guess I wouldn't get into that, because they really are very interrelated as you think about that. And as we talked about coming out of the second quarter earnings call, we did say that we expected gross margin improvement and there were some good external dynamics. Component inflation was about what we expected, maybe a little bit better in the quarter, and we saw some of that coming out of the second quarter. Again, we think that will continue for at least the next quarter.

And as we think about supply chain and all the things we've been doing on cost, we saw the benefit of that kind of come through in the quarter. And at the same time, we were also working pricing and pricing discipline as we exited the second quarter and had the favorable carryover impact to that. And that's the benefit of that.

But I would also say, Tony, the mix and strong performance we see on the enterprise side of the business as a part of the strategy is also a good, positive dynamic that's affecting it.

Toni Sacconaghi - Sanford Bernstein

It looks as though your guidance is implying a fairly material sequential deceleration in gross margins, 150 basis point plus or minus, assuming OpEx is going to be relative flat. I think you thought operating margins would be 2% in Q4. So that would be positive to you. In light of the fact that consumer looks like it's going to get better on the operating side and hopefully that means also on the growth side, what it's accounting for what appears to be a fairly significant deceleration in Q4, is it really all the pricing rolling through in the industry or is there something else there? It strikes me as being more than one might anticipate.

Michael Dell

Tony, I think consumer will continue to make progress. Maybe Steve could talk a little bit about where we see that going. But clearly the mix of consumer in general in the fourth quarter will be a bit higher. As we see, there is sort of typical seasonality, even though it's a little weaker demand. It'll be a bigger piece of our revenue and therefore margin.

I think as we look at the component environment, we expect it to continue to be pretty good. There will be some areas where I think it will bottom out a little bit in maybe LCDs and hard disks, as we see those markets play out.

And then the third thing obviously is as this pricing sort of works its ways through, Tony, we would expect to see a little bit more challenging competitive environment

Toni Sacconaghi - Sanford Bernstein

The mix shift is maybe minus 20 basis points sequentially, and it sounds like you feel pretty good on components. So you're basically saying that pricing playing through may negatively impact things? There are 150 basis points sequentially. And I am wondering if you have high conviction in that number or you might be conservative or it's still not entirely into (inaudible)?

Michael Dell

I think those are the dynamics that between mix and pricing playing out and the overall consumer piece. I think those are the main elements that are going to drive gross margin as we look into the fourth quarter.

Operator

We will take our next question from Richard Gardner with Citigroup.

Richard Gardner - Citigroup

I was hoping that you might be able to give us a little more color on the competitive environment. And specifically, are you seeing less competitive pressure out there right now? Given a strong demand there in the marketplace, is there something on the competitive pricing front that makes you comfortable that margins will hold and you'll be able to keep a little bit of this component favorability for a little longer than you typically might?

Steve Felice

We are moving to a more value-based pricing methodology and you saw some of that this quarter. And while the competition is always tough out there, I think we're doing a better job of segmenting the business, the types of offerings, the customer sets we're going after. And we think that that will continue to help us as we've talked about in the past in improving margins over the long term.

On the consumer business, we're certainly seeing competitive juices slowing in different parts of the world, emerging countries. China has seen some increased pressure, but again we're doing a pretty good job of being selective, and how we're growing, our China business was profitable. So I think, the competition continues to be strong, but we're doing a better job of picking our fights, and knowing where to grow.

Richard Gardner - Citigroup

Can you talk a little bit about pricing, specifically for large enterprise and public as well?

Steve Felice

I can speak to that in general, that's not the area that I manage. But the dynamics there are very similar to what we're seeing in other parts of the world, a lot of our public business is mid-market. And so those dynamics are similar to the mid-market and SMB and there's a good case again, where the growth is pretty healthy. And so if we're selective about where we choose to sell and the solutions we have, we've been able to hold up the margins pretty well and the pricing has not been as big of a battle is, as it has in the past.

Michael Dell

I also think, we're seeing a pretty material shift in the way we're conversing with our customers. So we use to kind of start the conversation around the box and we're moving the conversation much more to solutions. And as we get deeper-vertical expertise in understanding about customer requirements, that's giving us a much healthier opportunity to drive up the margins back. And you're seeing that certainly in the commercial businesses and we continue to add more and more horizontal and vertical solutions into the mix.

Brian Gladden

We're really across the business. We saw strong pricing really in the quarter. With the cost pressure we saw in the first half of the year, we started working on that early in the year and continue to drive it through the summer.

Richard Gardner - Citigroup

Then the follow-up was on public and large enterprise which were actually strong year-over-year, but down sequentially. I know you talked about European government. But I'm curious whether you view those two results as normal seasonal. It seems like they're not. Would you characterize that as a cooling in the corporate upgrade cycle? What's the right way to think about the results?

Michael Dell

I think one of the trends you see across the business is a crooning of the portfolio where we're taking out revenue that has no margin or very little margin associated with it and you see that across many aspects of our different products and segments. So what you saw is that those businesses improve their profitability in absolute dollars and margin percent sequentially, while their revenue might come down.

Brian Gladden

There is some flattening too of seasonality as our Asia businesses and our European businesses grow faster, because they typically don't have big upticks in Q3 and they're becoming a bigger portion of our business.

Operator

We will take our next question from Brian Alexander with Raymond James.

Brian Alexander - Raymond James

Just on the sustainability of the performance this quarter, which was obviously strong and better than everybody expected, if I just take the midpoint of your new operating income guidance for the year and compare it to your old guidance, the delta is basically the upside you just reported in the third quarter. So it basically implies no flow-through or upside to Q4 relative to where most models were.

Pricing may get more competitive, but it could take a few quarters. So that's not really a big impact right now. You're making strides in the supply chain cost structure. Perot is tracking ahead of plan. Those are all good things. Why wouldn't your op income guidance be going up by more than the Q3 upside we just saw?

Michael Dell

Well, I think as this component pricing dynamic is going to continue as more normalized, we would expect that to bottom out in a couple of places. And as we talked about it, I think we're a bit concerned in terms of how that's going to play out the supply chain and what pricing does for the quarter. We also do see weaker demand in consumer than we expected coming into the quarter.

So those are the dynamics that I think dampen the fourth quarter a bit. But as you said, there are some pretty good external dynamics to drive the business in the fourth quarter.

Brian Alexander - Raymond James

Can I just clarify, Brian, on the outlook for Q4? I know you said consumer will be more muted. Are you saying then that the non-consumer business will be up with normal seasonality in Q4?

Brian Gladden

Yes, that's generally our view. I mean we see normal seasonality around the commercial business in the fourth quarter.

Operator

We will take our next question from Maynard Um with UBS.

Maynard Um - UBS

You pre-bought inventory heading into the last quarter. Are you pre-buying here? And then obviously you've worked down that inventory sometime into the quarter. And I'm curious this next quarter you should be getting a full quarter of component pricing benefits. So if you look at that decline in the gross margin, it actually implies a bigger drop maybe on pricing from competitors. And typically, the industry doesn't cut pricing unless there is some elastic benefit to units and revenue. So I am just curious if there is just some layer of conservatism there or if there is some other dynamics that are in play there.

Michael Dell

We took the inventory out early in the quarter as we saw pricing coming down. So the declines we saw, most of that fell through within the quarter. We got most of the benefit we did in the third quarter. We are trying to move forward in terms of how the supply chain and how competitive dynamics will play around pricing. And there is some degree of uncertainty there. That's what we'll watch for the fourth quarter.

Maynard Um - UBS

Can you just clarify what kind of currency you're assuming in the outlook for next quarter as well?

Michael Dell

Currency in the quarter was relatively minor on the topline as well as in the income statement. As you know, our hedging approach is designed to mitigate short-term volatility. And as we head into the fourth quarter, we've got our typical coverage and we would expect it to be a minimal impact to the fourth quarter as well.

Operator

We will take our next question from Steven Fox with CLSA.

Steven Fox - CLSA

First of all, you've highlighted Perot in a couple of spots. But can you talk a little bit more color around on how successful Perot has been for you? Especially, you mentioned pull-through of additional services. But what about on the hardware side, how it's helping so far and what's the opportunity going forward over the next year?

Michael Dell

I'd we are seeing some nice opportunities across both of the businesses as we bring them together. The integration has gone well and we're able to provide customers with a much broader suite of offering that's yielding new opportunities that neither organizations were able to go access.

We still have a big organic build-out in front of us around the world and services. We have roughly 1% share in IT services. So there is a lot of white space for us to go cover there. But we're very pleased with the integration, particularly in the verticals where Perot had strength. We're seeing tremendous success for example in health care, and we can grow this a lot more.

Steven Fox - CLSA

Secondly, on the enterprise cycle, you are talking about normal seasonality for the January quarter. But the last two or three quarters have continued to show more momentum in enterprise spending. Are you suggesting it's slowing down into a more normalized rate or is this just seasonal and we can expect we could be looking at more attractive growth rate next year?

Michael Dell

I thank what's going on in the global economy, one would take a bit of caution looking into next year. What we see in our business is that the refresh cycle is very much in full bloom. You look at Windows 7, Exchange 2010 on the server side, you see enormous adoption there. You look at Office 2010. We continue to see a healthy refresh cycle.

And the things that we are selling to our customers yield very high ROI and we're able to sell a broader range of them at increasing margin. So we feel pretty good about the commercial business.

Operator

(Operator Instructions) We will take our next question from Ben Reitzes with Barclays Capital.

Ben Reitzes - Barclays Capital

Brian, on your slide on the consumer, you said there was $120 million one-time revenue gain in the quarter. I was just wondering what that was. Does that mean that the baseline that we should be judging our gross margin on was actually 19.2 for how we grow sequentially with your outlook?

Brian Gladden

What we're talking about is that the one-time $120 million increase was tied to a change in accounting from a sell-through to a sell-in model. As you accumulate data in a relationship like this, the accounting basically says you move ultimately to a selling model once you have enough information to do that.

So that was a one-timer, and that would affect the baseline. And as we think about the fourth quarter, the consumer business, that's one of the things that I'll have to kind of manage through.

Ben Reitzes - Barclays Capital

Okay. And then with regard to Perot, the services line, I don't know was like a little below expectations. And I was just wondering if your services revenues are meeting your expectations and what did Perot specifically do in the quarter?

Michael Dell

As I think we've said, it's become very, very difficult for us to continue to parse out the Perot standalone business. Much of that has been integrated, and transactions with be through the different systems now to the point where it's hard to tell.

Steve Felice

It's no longer a standalone business. That's a fair way to say it.

Michael Dell

We look at it now, and the elements that we talked about in terms of transactional versus outsourcing versus projects consulting. And with the numbers we talked about there generally, and especially on the synergy side that's probably the best place to look at it. We continue to track above our commitments around synergy there for the deal.

Ben Reitzes - Barclays Capital

Revenue or cost synergies? Sorry.

Michael Dell

Both of them; both of the developments.

Operator

We'll take our next question from Keith Bachman from Bank of Montreal.

Keith Bachman - Bank of Montreal

Brian, I wanted to just see if I go back to OpEx for a second. I understand your comments around the upcoming January quarter, but if you could talk a little bit about how you are thinking about it for the balance of calendar year '11. Is it a percent of revenues, such as, as revenues grow you'll keep pace with it? And if growth moderates a little bit, because as Michael said, the global economy, there's some risk there.

How should we be thinking about that OpEx line and the variability of it as we think about calendar year '11?

Brian Gladden

Keith, I think as we've said, as you move towards our long term value creation model and really where we're going, longer term we would expect gross margins are going to trend up as a function of the mix of our business moving. And at the same time OpEx will move up as we have more investment in R&D and at higher end, more costly selling costs within that kind of a business model.

So we'll obviously give you a little bit more clarity as we get to the end of the fourth quarter and provide an outlook for FY '11. But I think we will continue to make investments around R&D, around solution selling and around the things we have noted as important to our strategy.

Keith Bachman - Bank of Montreal

Okay. But then Brian, if I could just follow up on cash flow. I think you mentioned that you anticipate tweaking down the cash cycle. If you could just talk a little bit about how you are thinking about cash flow over the next couple of quarters specifically.

Brian Gladden

I think the good news is the cash P&L is very strong, and that was the key driver of the cash in the quarter despite pressure in working capital and accounts payable. We think the DPO moved back a few days in the positive direction for us as linearity improves and as the inventory changes and is dramatic in the quarter and as we get back to sequential revenue growth.

And we should see strong continued mid negative 30 kind of cash conversion cycle, and therefore cash flow should be significantly better than net income as we move forward in the next couple of quarters.

Operator

We'll take our next question from Aaron Rakers with Stifel Nicolaus.

Aaron Rakers - Stifel Nicolaus

Yes, two questions, one and then one follow up. First, on the demand front, I think you guys talked in your presentation about server shipment growth of 4% year-over-year, what looks to be against a pretty easy comp a year ago. I'm curious, IDC actually estimated about 16% to 17% growth in server shipments for the calendar third quarter.

Could you help us bridge the gap there? Did October slow down, or why the differential in your overall growth relative to the market?

Brian Gladden

Server revenues were up 19% year-over-year. We don't particularly think units are a great way to measure the server business, particularly virtualization. We're more focused on the profit. And the revenue with server is not the units.

Aaron Rakers - Stifel Nicolaus

Okay, the follow up then would be, can you characterize the demand environment in the month of October relative to what you saw in September?

Brian Gladden

It was pretty good. I think there are certainly unit-driven deals that come and go that we make use to take or not take. In the quarter, there were certainly some low-margin high unit deals that we chose not to take.

I mentioned earlier the kind of pruning of the business. And it occurred across many parts of Dell, and you could see it in the rising operating and gross margins in the business.

Operator

We'll take our next question from Mark Moskowitz with JPMorgan.

Mark Moskowitz - JPMorgan

The question revolves on the storage business. Kind of two parts here; one, it just seems that the growth on a relative basis did decelerate. Can you just kind of talk a little about that what some of the puts and takes were? And then more broadly speaking, in terms of the recent M&A activity in storage, Michael, could you kind of just weigh in on what your view is post 3PAR?

You have also seen (ICE1) go away here. What's Dell's strategy going forward to keep pace with some of the other technology players?

Michael Dell

If you look at our storage business, we had EquilLogic growing 66%. It's now over $800 million run rate. We continue to invest in that business. You've seen how we have purchased Exanet to add NFS file system capability, Ocarina to add deduplication and compression capability. We are going to continue to build out that portfolio. We have a ten-year relationship with EMC. That relationship continues to evolve, and believe that we'll continue to be working with them as well.

So when we look at the growth in the gross margins in our storage business we are quite pleased. The gross margin in this business has roughly doubled over the course of the last two years. So we are very focused on continuing to grow our storage business. And for us the measures of success are profitability. And pretty pleased with the progress we're making.

Mark Moskowitz - JPMorgan

And then just want to get a sense in terms of the follow up here as far as the operating margin associated with some of these enterprise solutions. Can you give us a sense in terms of your U.S. versus non-US exposure? How should we think about, as you roll out and deploy and then the years, your greater scale say in quarter two, quarter three, quarter four, after you have deployed some of these bigger enterprise solutions accounts. Will the operating margin run rate kind of be the same, U.S. versus non-US?

Brian Gladden

Operating margin is not dramatically different by geography, actually quite close with the U.S. being right about the average. And it takes us a few quarters to kind of roll these things all around the world. So they have different rates in terms of how fast we can localize the products and that kind of thing, but we are seeing strong adoption. For example, in China we had great success with EqualLogic. And Steve, you might want to talk about that.

Steve Felice

Yes, EqualLogic more than doubled in China. And the margins were very similar to what we are seeing in the U.S. And storage growth and server growth in Europe came at margins very similar. So I really see a very tight range of margin performance on our enterprise business globally.

Operator

We'll take our next question from Brian Marshall with Gleacher & Company.

Brian Marshall - Gleacher & Company

I'd like to follow up on the storage side. It looks like you grew about 7% year-over-year. And relative to some of the larger competitors it seems a little bit lightened. I was wondering, if you are doing well in your branded business, are you potentially de-emphasizing some of your partner programs?

Michael Dell

There is no question that the portfolio of the business is shifting somewhat. As we mentioned, the profitability of the business is increasing in a significant way. And again, we're managing our business to grow our operating profits and dollars. Operating margin and gross margin percentages are going up. And there will be shifts inside the revenue mix as we index into more profitable solutions.

Brian Marshall - Gleacher & Company

And if you look at your net cash balance, it looks to be about the fifth-largest in the entire tax basin. I was wondering, with regards to your appetite for M&A going forward if you are not disinclined to pay some of these 10x LTM revenue multiples going forward for some of these (half) properties.

Michael Dell

As we've said, we are going to have a bit of a discipline that we'll be patient in that approach to thinking about M&A. But we're also going to make organic investments in the business. And as we've done over the last several quarters, we'll continue with a relatively modest buyback program as well. So pretty disciplined with that approach right now.

Operator

We'll take our next question from Jayson Noland with Robert Baird.

Jayson Noland - Robert Baird

A question on the client refresh. Michael, I think you said it was in full bloom, I guess. How early are we in a refresh? It feels like it's mostly still in front of us. If you could just expand on that.

Michael Dell

All the data that we see would suggest that there is still a very large install base on Windows 7 PCs that are going to be replaced by Windows 7 PCs. And the preferred path is a hardware-driven upgrade for most customers.

We also see a huge wave of virtualization, Office 2010, and probably that we had talked about as much but the Exchange 2010 upgrade we believe is very, very strong. And we are right in the middle of all that with our customers.

Jayson Noland - Robert Baird

As a follow up, how does the virtual desktop discussion and tablets in the corporate world play into a client refresh? Does it slow things down at all?

Michael Dell

Well, virtual desktop is an option for many customers and we are working hard to make that a more viable option. We have next generation client architectures, solution set to go drive that. I would say that the virtual client is still in a very nascent stage of adoption and not seeing widespread adoption yet at that. But we'd be happy to, and we have good solutions for it.

As far as the tablet goes, we think there is obviously a lot of interest and excitement around tablets. And we are working on a number of new tablet products that we'll be coming out with next year to cover all the opportunity we see in both the commercial and consumer segments for tablets.

Operator

We will take our next question from Abhey Lamba with ISI Group.

Abhey Lamba - ISI Group

Michael, you mentioned about pluming your product portfolio. Can you elaborate on that how far along are you, and how much margin upside can it offer. Also, what type of revenue growth impact should we expect from that?

Michael Dell

Sure, I can quantify that for you, except to say that we are very focused on continuing to have a higher mix of our own intellectual property and driving high value solutions.

We have more to do here, but we've made some nice progress. And our guide is going to be improving our overall profitability. I think there is more opportunity here as we look ahead into next year.

Abhey Lamba - ISI group

And secondly, based on your historical experience what type of impact do you think Intel's Sandy Bridge chip launch will have on pricing? Is that kind of baked into your acceleration and pricing drop, as people might look at flushing the inventory in the channel?

Michael Dell

Well, because we are 80% commercial and 20% consumer, we'd probably first think about it from a commercial standpoint. What I would tell you is, I think for those customers that have not kicked off a refresh cycle, the Sandy Bridge is a great entry point. And we are already having those discussions now. We are seeing a lot of customers planning as that kind of being the entry point.

I think it will excite the consumer base as well with the integrated graphics performance and some of the new capabilities there. So we see very nice things in terms of the product cycle.

Operator

We will take our next question from Amit Daryanani from RBC Capital Markets.

Amit Daryanani - RBC Capital Markets

Just coming back to the public vertical, maybe you talked about expectations of seeing a normal seasonal downtick in Jan. Could you maybe talk more specific what you expect to see in public spending in Europe versus the U.S. in the Jan quarter?

Steve Felice

As we said, it is a bit of a tougher environment for us in EMEA in public, in terms of the scale of our business and we have a much bigger public business in the U.S. and in North America. So despite the fact that it's a bit of a challenging environment in EMEA, the overall impact on our public business wont be that big. And we would be obviously much more heavily weighted towards the U.S. public sector.

Amit Daryanani - RBC Capital Markets

Going back to the gross margin question, if you look at the 280 basis point margin expansion, how much of that do you think is from sustainable drivers like better pricing or supply chain savings versus more unsustainable drivers that will go away like commodity deflation point through the industry over time?

Steve Felice

It's a hard question to really part the individual elements of that. And then I would just say, the benefits and the positive momentum we have on gross margins it's a function of multiple things, including a good component cost environment and good execution around cost, and solid momentum and pricing. And if you think about that as the key elements to drive it, those are the things that we're focused on. And as the environment continues to be good from a component cost standpoint, it's just a relatively good environment for us to sustain good momentum here.

Operator

We'll now take our final question from the Chris Whitmore with Deutsche Bank.

Chris Whitmore - Deutsche Bank

Is there a point where you change strategies and turn more aggressive from a market share standpoint given your gross margin performance just reported?

Brian Gladden

We're focused on profit share and not market share.

Chris Whitmore - Deutsche Bank

And second question, I wanted to come back to the tablets space and the overall smarter phone space given the management changes there. What should we expect from a strategy standpoint? Should we expect the meaningful strategy change going forward? And can you give us any color in terms of operating system strategy for that mobility space? Thanks.

Brian Gladden

Let me address a bit of the operating system piece and then I'll turn it over to Steve. We are very much in mobile space working with both Android and Windows Mobile 7. And encourage with the development of both of those and see those as great opportunities for us. So Steve, why don't you?

Steve Felice

From a marketplace standpoint we see a lot of potential here. And the changes that we announce are really driven to bring this capability into the mainstream of the business. So you can sort of think of it as the last year of us learning and doing it in an isolated fashion, but now being more bullish about the opportunity.

So we want to mainstream the supply chain, the sales capability, the marketing capability. And we see tablets having great potential, not just in our consumer business but in our commercial business.

So all of this is aimed at getting this more to scale at a faster fashion than we originally envisoned.

Michael Dell

Well, thanks Chris, and thanks everyone for joining us today. We look forward to speaking with each of you soon.

Operator

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

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