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Executives

Robert Williams - Director of Investor Relations

Michael S. Dell - Founder, Chairman and Chief Executive Officer

Jeffrey R. Clarke - Vice Chairman of Operations & Technology

Brian T. Gladden - Chief Financial Officer and Senior Vice President

Analysts

Benjamin A. Reitzes - Barclays Capital, Research Division

Richard Gardner - Citigroup Inc, Research Division

Keith F. Bachman - BMO Capital Markets U.S.

Brian Cho - Goldman Sachs

Katy Huberty - Morgan Stanley, Research Division

Kulbinder Garcha - Crédit Suisse AG, Research Division

Amit Daryanani - RBC Capital Markets, LLC, Research Division

Brian G. Alexander - Raymond James & Associates, Inc., Research Division

A.M. Sacconaghi - Sanford C. Bernstein & Co., LLC., Research Division

Chris Whitmore - Deutsche Bank AG, Research Division

Maynard J. Um - UBS Investment Bank, Research Division

Shannon S. Cross - Weeden & Co., LP, Research Division

Jayson Noland - Robert W. Baird & Co. Incorporated, Research Division

Dell (DELL) Q3 2012 Earnings Call November 15, 2011 5:00 PM ET

Operator

Good afternoon, and welcome to the Dell Inc. Third Quarter Fiscal Year 2012 Earnings Conference Call. I'd like to inform all participants that this call is being recorded at the request of Dell. This broadcast is a 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. [Operator Instructions]

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

Robert Williams

Thank you. With me today are Michael Dell; Brian Gladden; and Jeff Clarke, Vice Chairman of Global Operations and End-user Computing. We posted our web deck on dell.com and we're shifting the focus of our VLogs on DellShares to our guest speakers. So I encourage you to review these materials for added perspective and incremental information.

In Q4, we attended the Credit Suisse Technology Conference on November 30, the Barclays Tech Conference on December 7, the Raymond James IT Supply Chain Conference on the 13th and CBS on January 10.

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 our most 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 web deck. We assume no obligation to update our forward-looking statements.

Please note that on today's call, we will also 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 our press release included in our 8-K filing today. I encourage you to review these documents. Also please note that unless otherwise mentioned, all growth percentages refer to year-over-year progress.

Now, I'd like to turn it over to Michael.

Michael S. Dell

Thanks, Rob. We're pleased with our results in Q3 and year-to-date. This is a new Dell, and we are much better equipped to give our customers a clear path to productivity-enhancing solutions. We're growing Enterprise Solutions and Services, including developing and acquiring key IP and sales capability, and the result is growing earnings and cash flow.

In Q3, our enterprise solutions and service business grew 8% to a record high $4.7 billion and increased 13% excluding third-party storage hardware. Enterprise solutions and storage now account for 46% of our gross margin dollars.

Our improved profitability and cash flow have enabled us to move forward with strategic investments, both organic and inorganic. Innovation in both hardware and software is fueling our new product pipeline. We're now investing in R&D at an annual run rate approaching $1 billion. Dell now has 5,000 patents granted or pending around the world and has over 20 R&D labs globally. We've made 5 acquisitions since the beginning of this year. This is enhancing our capability as an enterprise solutions provider with a focus on servers, storage, networking and security.

This year, we've also increased the number of sales resources focused on Enterprise Solutions and Services by about 30%. This, along with our approximately $1 billion commitment to deliver enterprise solutions and cost-based delivery options, is making a real impact on our business.

Finally, we delivered revenue of $15.4 billion for the quarter. We're choosing not to participate in low-value opportunities which have put short-term pressure on revenue growth but have been a real driver of our expanded margins and growing earnings. We continue to believe that increasing our share of industry profits is the right strategy. Our year-to-date GAAP operating income is 7.6% of revenues, and our year-to-date GAAP EPS has increased 16%.

Now Brian and Jeff will provide more details on all of this.

Brian T. Gladden

Thanks, Michael. I'm pleased with the progress we're making this year on our financial and strategic priorities. Our year-to-date results are a strong indicator of our progress towards our stated goals, especially in a tougher economic environment. We've clearly made progress in driving to more consistent profitability and expanding our cash flow generation.

For the third quarter, our GAAP operating income was $1.1 billion or 7.4% of revenue, and we delivered EPS of $0.49, which was up 17%. Consolidated revenue was flat at $15.4 billion and down slightly versus the second quarter. This was below our view heading into the third quarter, but I'm pleased with the trade-offs that we made in the quarter. We grew in the right places, specifically in Enterprise Solutions and Services, while continuing to migrate away from lower value-added segments of the client in S&P businesses.

As we expected, the pricing environment was slightly more aggressive in the third quarter, but our teams executed well to maximize our profitability. In addition, we faced challenging demand dynamics in certain parts of our business, namely Consumer in developed countries, U.S. Federal and our Public business in Western Europe.

Let's take a closer look at the third quarter P&L. Our key performance metrics are provided for your reference on Pages 6 and 7 in the web deck, and as a reminder, I'll refer to non-GAAP financial measures for the balance of the call. We delivered 23.1% gross margins, up 310 basis points year-over-year and 40 basis points sequentially after normalizing for the favorable vendor settlement included in the second quarter. OpEx was 14.7% of revenue, up 230 basis points and flat sequentially. On a dollar basis, OpEx was down $39 million sequentially or 2%, which was in line with our revenue decline.

Given the more uncertain macro economic backdrop, we reduced discretionary spending and reduced general and administrative expenses across the business. We continue to make investments in sales, marketing and R&D, and we're comfortable with our investment trajectory in these areas.

Going forward, we'll be closely monitoring productivity to be sure our investments here are delivering on our return expectations. You can count on us to be prudent with additional investments until we see improvement in the broader economic environment.

Operating income was up 80 basis points to 8.4%, with OpInc dollars up 10% to $1.3 billion. Interest and other expenses were $70 million. Our tax rate was 19.3% and was driven by an increase in earnings in lower tax jurisdictions. And earnings per share increased 20% to $0.54 per share.

Our cash conversion cycle was a negative 31 days. Inventory increased 1 day relative to the second quarter. Days payable decreased 2 days from the second quarter, driven by linearity within the quarter and quarterly seasonality. Days receivable was flat sequentially.

In the quarter, we generated $851 million in cash flow from operations and have now generated $5.2 billion for the trailing 4 quarters. We ended the quarter with $16 billion in cash and investments, and we repurchased $600 million in stock in the third quarter and now have repurchased $2.2 billion or 142 million shares year-to-date. As we close the year, we'll continue to take a disciplined approach to capital management, balancing cash needed for key organic and inorganic investments with repurchase activities.

Now let's take a look at our lines of business and regional performance, which you'll find detailed on Pages 11 through 14 of our web deck. As I've mentioned previously, we've had record revenue in our Enterprise Solutions and Services business. Server and Networking revenue increased 13%, with accretive margins and rising average selling prices. There continues to be a lot of momentum in server virtualization. Customers are partnering with Dell to provide mission-critical services and solutions around the server, resulting in competitive differentiation, richer configurations and continued strong profitability. This is particularly evident in our small and medium business, which had Server and Networking growth of 18%.

Total Storage declined 15% while Dell-owned IP storage increased 23% to $388 million, led by a refreshed EqualLogic solution suite and our Compellent Fiber Channel SANs. The favorable mix shift in our Storage business continues to drive significantly improved profitability and this will continue.

Dell Services revenue grew 10% to $2.1 billion and now represents 14% of our business. Our transactional services business increased 10% as we saw very strong attach rates of Dell premium services. The outsourcing business grew 9% and our projects increased 15%.

Total value of new services contracts signed is $1.9 billion on a trailing 12-month basis. Services backlog increased 11% to $15.5 billion, led by contracted services backlog growth of 12%. These leading indicators continue to position us well for strong services, long-term growth going forward.

Our Desktop revenue was down 6% while our notebook revenue was down 2%. Client gross margin dollars are up over 20%, driven by a focus on high-value products and solutions.

Our Software and Peripherals business continues to be an example of an area where we're enhancing our profitability by exiting portions of the business where the solutions are not strategic or are lower value-added. Revenue for the quarter declined 2% to $2.5 billion. However, gross margin dollars increased double-digits. Our focus on disciplined pricing is also evident in this space.

A good proof [ph] point for this is our Displays business where we saw revenue increased 5% with gross margin dollars increased 46%. Growth markets continue to be key driver for the company. Revenue for these geographies grew 11% in the third quarter and is up 14% year-to-date.

Turning to our segment level performance, which is detailed on Pages 16 through 19 of the web deck. Large Enterprise revenue was up 4% to $4.5 billion, led by Enterprise Solutions and Services growth of 11%. Services revenue increased 14% as we continue to expand our vertical expertise and develop solutions relevant to our customers' business needs.

We remain focused on strategic business opportunities and are not chasing those that are non-strategic with price. Operating income as a percentage of revenue improved 60 basis points to 9.8% of revenue, and we delivered $441 million of operating income in the quarter.

Our Public business delivered revenue of $4.4 billion, which was down 2%. The primary drivers are continued weakness in U.S. Federal and Western Europe. For U.S. Federal, we experienced the normal end of the fiscal year revenue ramp in September. However, in October, which is the first month of the Federal fiscal year, we saw slower spending pattern that was softer than historical norms.

The pipeline of opportunities focused on government productivity continues to be good, but deals are not closing at the rate that we've seen in previous years. Despite the overall revenue decline, Services revenue increased 7% to a record level for the business, and Dell IP Storage revenue was up 35%. Both of these are good examples of this productivity focus. Operating income was $463 million or 10.6% of revenue, which is up 40 basis points from the previous year.

Small and Medium business revenue grew 1% to $3.7 billion. Client growth was lower than expected as we saw muted spending in medium businesses in both the U.S. and Western Europe. There continue to be industry-based channel inventory challenges, particularly in Europe as competitors aggressively move product out of the channel, we did not match the level of pricing aggression in most cases. SMB had a very strong quarter and Enterprise Solutions and Services with revenue of $1.1 billion, an all-time high and up 18%.

The improved mix is resulting in continued strong operating income performance. SMB delivered $386 million in operating income or 10.4% of revenue. Despite facing growth challenges, the Consumer business expanded margins both sequentially and year-over-year and reduced OpEx spend from the second quarter to deliver $76 million of operating income or 2.7% of revenue. Consumer revenue declined 6% to $2.8 billion as the Consumer European business stabilized, Asia-Pacific had very strong growth but the Americas business had a decline as we continue to exit low-value segments of the Consumer space that aren't profitable.

The migration to higher-value products has proven to be effective. Our high-end Consumer notebook line, XPS, grew revenue 207% overall and is now approaching 20% of our total Consumer notebook revenue and 30% of our Consumer notebook margins. Through 3 quarters, the Consumer business has delivered operating income of 3.3% compared to negative operating income for the first 3 quarters of last year.

Our global commercial channel business grew revenue in the third quarter, and we now have close to 100,000 partners in our partner program, with over 2,000 of them at the preferred and premier levels. This has proven to expand the reach of our solutions to the broadest set of customers and provides them with more choice and flexibility. We continue to build a very strong reputation in the channel, exemplified by receiving CRN's award for Best Midrange Servers for the second consecutive year.

Now I'll turn it over to Jeff Clarke to discuss the End-User Computing business and operations.

Jeffrey R. Clarke

Thanks, Brian. In June, we shared 3 initiatives that are primary focus for End-User Computing team. First, strength in our core. We have massively simplified our offerings with a dramatic reduction in configurations, simplified our supply chains, enhanced our online ordering process and achieved more than a 30% reduction in supply chain cost since the end of fiscal 2009. We have grown our pre-configuration offerings from 19% of client shipments at the beginning of FY '11 to approximately 40% today. We are now shipping 60% of eligible units on the ocean in Consumer, Small and Medium business on our way to a 70% exit rate by year end, and systems going through contract manufacturing have averaged greater than 70% this year, up from 53% at the beginning of fiscal '11.

Second, we are also delivering a broad range of solutions and services. In addition, we have deliberately reduced our exposure to low end of the client business, redirecting those resources on OpEx to higher value opportunities. For example, the revenue mix of Services and S&P tied to the system is up 50 basis points. We have exited over $2 billion of low-value clients across our business and premium products gain share year-over-year for the fifth consecutive quarter. These 2 initiatives have allowed us to maintain operating margins well above 5% throughout the year.

Third, over the coming year, we will closely work with key partners like Microsoft, Intel, Google and ARM suppliers to introduce new and innovative solutions that will resonate with our core commercial and prosumer customer base.

Turning to the topic of hard drives. We want to express our concern for those affected by the tragic flooding in Thailand. As all of you know, the flooding has significantly impacted the hard drive supply chain but the complexity of the issue and the current state of affairs in Thailand where the floodwaters are still receding, makes it very difficult for the industry to pinpoint the magnitude or duration of shortages, so that puts the industry and allocation environment at least through Q1.

Last month, we made strategic purchases of inventory and pulled in supply from our hubs. This drove an increase in our end-of-quarter DSI. We also have teams working with the impacted suppliers to manage our hard drive supply chain and qualify new sources of supply. Our goal is to mitigate any impact to our customers in Dell, and our teams will be working throughout the quarter to do just that. We have worked through various forms of industry supply shortages in the past, and each brings different variables into play but we have found our operating model has proven to be very adaptable and effective at managing through these situations in an optimized manner.

With that, I will turn it back over to Brian to provide the business outlook.

Brian T. Gladden

Thanks, Jeff. Let's turn to our outlook for the remainder of the year. I'd like to remind you that every 6 years, we have a 14th week in the fourth quarter to effectively align our calendar and fiscal years. For this fourth quarter, we believe the 14th week will be worth approximately 3 percentage points of revenue growth, driven primarily by the transactional businesses. Our relationship-driven businesses have historically shown little benefit from these dynamics.

We're pleased with our year-to-date non-GAAP operating income performance as we've delivered $4 billion of operating income, which represents growth of 39% year-over-year. We're committed to the strategy we communicated at the Analyst Meeting in June, and we're trending above our outlook of 17% to 23% full year non-GAAP operating income growth. The teams are aligned and incentivized to sustained pricing discipline and maximize operating income and cash flow.

Given the uncertain macroeconomic environment and the complexity in working through the hard drive issue, we are trending to the bottom of the range of our revenue outlook of 1% to 5% full year growth. We'll continue to be very diligent in managing operating expenses. We've invested significantly over the past several quarters in key strategic areas of the business, and we've tightly managed less strategic spending to enable this.

Given the scale of these investments and the weaker demand environment, you can expect that we'll moderate incremental investments and focus on driving productivity from our recently added resources as we head into FY '13. We anticipate interest and other to be around $70 million in expense in the fourth quarter, and we expect our fourth quarter tax rate to be between 17% and 19% on a non-GAAP basis.

We're on track for another outstanding year. With our third quarter results, we have delivered $8.9 billion in operating income over the past 2 years. And for this fiscal year, we're on track to exceed the long-term value creation operating income target of 7% on a GAAP basis.

We've made significant progress in building a more diversified and competitive set of enterprise-focused businesses that now represent almost 50% of the margin of the company. We look forward to providing you with an updated outlook for FY '13 in February and continuing to update you on the progress that we're making.

With that, let's open it up for Q&A.

Question-and-Answer Session

Operator

[Operator Instructions] We'll take our first question from Shannon Cross with Cross Research.

Shannon S. Cross

These are questions regarding or a question regarding the HDD shortage. So I'm not sure who wants to take it. But I'm curious as to how much has been baked into your guidance? And if you're hearing from any of your vendors on changes of length of contract or pricing regarding the HDD shortage?

Brian T. Gladden

Yes, Shannon, it's Brian. I'll take the first part, and then Jeff can take the second. The outlook that we provided fully contemplates what we know now, and so we've incorporated everything we know and how we think we're going to manage through that in the outlook that we provided for the fourth quarter and the total year.

Jeffrey R. Clarke

And Shannon, I think your second part of the question was what's changing in terms and how different individuals are working with the hard drive supply base. Is that correct?

Shannon S. Cross - Weeden & Co., LP, Research Division

Correct. If there's any change.

Jeffrey R. Clarke

Well, I think from our point of view, nothing has really changed. We've had strategic partnerships in place with long-term agreements with our key partners. We've managed this as a strategic commodity. It's clearly an important area given our Storage and Enterprise business as well as our Client business. We've committed to those partnerships over the long run, in these times of crisis, they tend to pay a dividend. With specific to the crisis at hand, we've acted, I think, very decisively and promptly, within 24 of being notified of a potential flood situation, we pulled in all inventory from our hubs into Dell, our warehouses in Dell locations. So we moved within 24 hours. The potential of this occurring into the strategic inventory that Brian made reference to earlier on the impact to our DSI for the quarter. Within 48 hours, we actually had a risk management team in place that began the process of how we manage our business. The ability to manage business continuity was the solid processes and skills that we've developed over the years, we've put in place. Matching supply with customer needs, understanding how to shape demand, understanding the availability of the parts coming in with the pending needs of our customers and balancing that cut in the supply with the needs of our different business units. That's how we responded, we continue to do that today, and I'm optimistic that our team is working through the situation at hand, which is, it's a difficult one of that. But we're in a position where we think we can mitigate the impact to our customers for the quarter.

Shannon S. Cross - Weeden & Co., LP, Research Division

And then just a one follow-up, did you just change at all your thoughts on timing for Ultrabooks or SSD adoption?

Brian T. Gladden

Well, I think it will be pretty obvious when you see the response by the industry. SSD attach rates will go up. They're at low-single digits today so I don't expect that to be a huge aide in solving the shortages that are in the disk drive industry today. And we'll have an Ultrabook that will be later out and will arrive late in the fiscal year.

Operator

Your next question is from the line of Scott Craig with Bank of America.

Brian Cho - Goldman Sachs

This is Brian Cho in place of Scott. It looks like your operating margin in the fourth quarter could come down more than 150 bps quarter-over-quarter. Could you provide us with more details on the drivers behind that, please?

Brian T. Gladden

You say operating income, operating income levels?

Brian Cho - Goldman Sachs

Yes, operating margin.

Brian T. Gladden

Operating margins, yes. Well, I mean, look, I think we've been consistent throughout the year as we look at the dynamics that we see and a bit somewhat conservative in how we're playing our outlook as we move forward. We've delivered strong gross margins, we've shown that we're going to be prudent with our OpEx investments, and I think we've been trying to capture the uncertainty that exists in the market.

[Technical Difficulty]

Operator

Your next question is from Keith Bachman with Bank of Montreal.

[Technical Difficulty]

Operator

Your next question is from the line of Chris Whitmore with Deutsche.

Chris Whitmore - Deutsche Bank AG, Research Division

Hoping you can comment on your outlook for IT spending growth heading into next year. You flagged some areas of caution. Do you think we're looking at a flat to down IT spending environment in calendar '12?

Michael S. Dell

I think IT spending is still an enormous driver of productivity and we would expect a reasonably healthy spend environment. And certainly, we're indexing our solutions activity around those things where there is a strong appetite. If you look at our business, the Enterprise segment is growing very nicely. Services are growing very nicely. Servers and Networking, we had a 13% increase in the quarter. Very strong growth at Networking, 43% without Force10 acquisition and EE3 mid-servers, which is very core part of our business is up 12% and Services was up 10%. So we feel in a $3 trillion industry, there's plenty of opportunity for us to grow and grow our profits.

Chris Whitmore - Deutsche Bank AG, Research Division

So my follow-up would be around consensus expectations for calendar '12 suggest earnings will be down for Dell yet you seem pretty optimistic about growing your higher margin product areas. So is this the Street or is consensus missing something about your outlook for next year? Or can you help us kind of circle the square, if you will?

Brian T. Gladden

Yes, Chris. I mean, we haven't provided an outlook for FY '13. We intend to do that for you in February just like we have in the past. And until we do that, I'm not going to comment on what consensus is right now.

Operator

Your next question is from the line of Toni Sacconaghi with Sanford Bernstein.

A.M. Sacconaghi - Sanford C. Bernstein & Co., LLC., Research Division

HP faced tremendous organizational uncertainty this quarter, and I think at the surface, it would really seem that it was right for Dell to gain share but it appears that the company lost share, particularly in PCs and revenues were flat year-over-year. Now I fully understand your desire to focus on profitability and not participate in low-value segments and I heard when Jeff said that you appear to walk away from $2 billion in business in the client area. But I guess the question is how much more unattractive business do you have in your portfolio that you actually want to deemphasize going forward because that's going to continue to put a drag on your revenue growth? So how do we think about how much more unattractive business you have? And how long until you're kind of through that and we can see you growing at a market rate or better?

Brian T. Gladden

Yes, Toni, I think this is stuff that, clearly, we've been doing for a while, and I think as we work through the portfolio, it's fairly broad based. I mean, it's clients but there are other areas too. One of the areas that we'll continue to work through is third-party software. I think that's an area that we have a fair amount of revenue today with relatively unattractive margins, and we'll work through that over the next several quarters. I think low- [indiscernible] client continues to be a place that I don't think we're going to be very aggressive. There may be some selected opportunities there where we can see strategic benefits but I think it's going to continue. I'm not going to give you a view on when we stop because I think it's going to continue for a while.

A.M. Sacconaghi - Sanford C. Bernstein & Co., LLC., Research Division

But is the implication of that ultimately, if you're going to be walking away from chunks of your business, we should be thinking about Dell growing at below market revenue rates. I appreciate the focus on operating profit, and you've shown an ability to grow operating profit very strong and above market. But the implication on the top line is we should be expecting you to grow below margin, is that correct -- below market, excuse me.

Brian T. Gladden

Yes. Well, I think you got to look at the individual pieces. I think there clearly are areas where we're going to see above-market growth, and if the business mix is up and that Enterprise Solutions and Services portion of the business becomes bigger, as we grow share in the higher-priced, higher-value areas client space. I think those are all places we should grow faster than the market. So I'm not going to give you a longer-term view but I think we can grow the company, and I think there are clearly places where that's where we're making the investments for the future.

A.M. Sacconaghi - Sanford C. Bernstein & Co., LLC., Research Division

And then my follow-up, please, if I may. You've been a little coy about saying where you actually expect any impact from HDDs in Q4. So could you comment on whether you expect an impact? And is the bigger risk to revenues or the margins because of the shortfall and what's your rationale and your thinking?

Michael S. Dell

Well, Toni, I think one of the challenges we're working through is the situation is quite dynamic. It changes every day. The floodwaters haven't receded yet. Our risk management team is in looking at the Tier 2 and Tier 3 supply base from base plates, motors, actuators, bearings, top covers, et cetera. And we're also working with each of our partners to understand what our recovery plans look like or their recovery plans look like from building to equipment overhaul, to reinstall, to requalification. It's a very dynamic world out there and with this hard drive situation. Our view is given the nature of our fast we acted, how promptly we pulled in inventory, how we manage our business, which you very well know, but from everybody else, 70% of our business is still direct. We can manage lead time availability. We know what customers have an urgent deployment and an urgent need and match up that supply so we don't miss key customer deliverables. That's how we're managing through the current situation. We prioritize our businesses. We prioritize our customers, all the things that you'd expect us to do to mitigate the impact to our end users. I know that's not answering your specific question of how we're positioned. The team, we believe, we're in good shape to mitigate the impact our customers for the quarter. The financial outlook that Brian gave actually has our look of availability and supply and our ability to deliver it to our customers.

Operator

Your next question is from the line of Kulbinder Garcha with Credit Suisse.

Kulbinder Garcha - Crédit Suisse AG, Research Division

A couple of questions. First of all on the server business, I appreciate you grew year-on-year but if you look over the last 4 quarters, it really hasn't grown sequentially, so we are clearly concerned, difficult comps. Can you speak about how much, first of all, is in the revenue growth outlook, how you think about that over the next year or so? And in addition, I think you've been exiting some of the lower end server business as well, and how much more potential margin improvement there, there is. And then for Brian, just a specific question. You mentioned kind of a sensible caution, let's say, on OpEx going forward. Could SG&A go for example, back down to levels we saw close to 11% or is this going to be just a very minor adjustment depending upon the environment? Any kind of clarity there would be helpful.

Brian T. Gladden

I'll take the OpEx point and then maybe Michael could comment on servers and sort of what's going on there. I think we continue to invest. In the quarter, we made incremental investments in selling, in R&D, in many cases, aligned with some of the acquisitions and new technologies that we're developing internally. That will continue. I think we've done a good job of basically managing effectively G&A and managing discretionary spending in this environment, and in some cases moderating some of those investments in line with what we're seeing in the demand. So I think that's how we're going to continue to manage it quarter-over-quarter. We'll continue to make progress in making these investments, and I think that's the disciplined approach, to take the OpEx spending in this environment.

Michael S. Dell

Okay. If you look at our revenue growth, it's been pretty consistently -- it's actually been double-digits every quarter for the last 5 quarters, except for the second quarter where it was 9%. So we're then 20%, 16%, 11%, 9%, 13%. With respect to units, we talked earlier about in the client business how we are prioritizing profit share over unit share. I would say in servers, this is even more true, and I would tell you that the unit measurements are almost to the point being irrelevant. And the reason is that there are many different types of servers. There are $500 servers, there are $5,000 servers, there are $50,000 servers. And if you want to sell a lot of units, you sell a lot of $500, that's not how the way you grow profits and earnings, that's what we're not focused on. We're focused on how do we capture the value which are the higher revenue, higher-margin and more intense workloads.

Operator

Your next question is from the line of Brian Alexander with Raymond James.

Brian G. Alexander - Raymond James & Associates, Inc., Research Division

Just on Enterprise storage, it looks like your Dell-owned IP revenue was down sequentially, but it sounds like you're happy with acquisitions that you've made there, Compellent, EqualLogic, et cetera. Can you elaborate on the lack of revenue momentum that you're seeing? I thought you expected it to bounce back this quarter? And when do you expect to see that headcount additions, which have been substantial, translate to more meaningful growth in storage?

Michael S. Dell

Yes. It was okay. It wasn't completely up to our expectations. There's some room for improvement there. Growth in Dell IP storage was 23% year-over-year and it's now 84% of our overall storage business. We had good demand from Compellent, we launched a whole new product cycle in EqualLogic. There's definitely more to do here and you're right, we have put a lot of new people into the organization, and they're becoming productive and we still remain very optimistic about our ability to grow that business.

Operator

Your next question is from the line of Keith Bachman with Bank of Montreal.

Keith F. Bachman - BMO Capital Markets U.S.

The first one I have is on Services. It looks to be the standout performance there. What's the trajectories you look at going forward? And what's the driver of that in terms of the various segments within the context of Services? In particular, backlog was -- it looks like flat sequentially and yet even Services was up about 4% sequentially. So just hoping you could offer a little bit of color there, and I have a follow-up, please.

Brian T. Gladden

Yes, I think that we continue to make progress with the Services business. As we talked about, we completed the majority of the integration work with Perot Systems and Dell Services over the last couple of quarters. I think the team has made some nice progress. We've had very strong new services contract signings over the course of the -- over the course of the last 12 months, we talked about $1.9 billion. I think the teams has also done a nice job improving profitability, and we saw a sequential nice improvement in overall profitability of the Services businesses. Our backlog, I think, quarter-on-quarter was up $100 million and it was up 11% year-over-year. The deferred balance on the transactional services side continues to move up, I think, double digits in the quarter. So overall, I think the services again was a highlight of the quarter.

Michael S. Dell

To put it in perspective, you go back a couple of years ago, the Services backlog was $5 billion, $5.5 billion, now it's $13.5 billion. We have really changed the business pretty substantially. We got 14% of our revenue in Services, it's growing nicely. We changed the conversation with our customers and made a lot of progress towards this solution focus that we've been telling you about.

Keith F. Bachman - BMO Capital Markets U.S.

Well, my follow-up, Michael, then perhaps is for you. The desktop numbers continue to lag in terms of year-over-year growth in revenues, and I was just wondering how you could comment or if you could comment, rather, on, are you seeing inflections in terms of the upgrade cycle that companies are interested in because the economic cycles? And is that showing up in the desktop numbers? And then how should we think about Win 8 next year in terms of that upgrade cycle?

Jeffrey R. Clarke

Keith, this is Jeff. So when we look at the deployment of Windows 7 in corporate and where it is relative to the installed base, I believe last month was the first month we've seen Windows 7 outpace Windows XP in our deployments out of our factories. It showed that there's continued movement and the refresh is well underway. Most estimates have the refresh of Windows 7 in the installed base in corporate less than 50%. I think our estimate is somewhere right around 40%, so there's still quite a bit of corporate refresh on the desktop and the notebook in business to migrate to the newest operating system, which is Windows 7. Then we have Windows 8 coming out next year, which we think is a tremendous upgrade opportunity around the touch interface. When I look at the opportunities of our XPS products, potentially new mobile products that will be out by the Windows 8 timeframe, there's an expansion opportunity that Windows 8 enables around the touch interface enclosing the competitive GAAP that exist today.

Operator

Next question is from the line of Maynard Um with UBS.

Maynard J. Um - UBS Investment Bank, Research Division

On product gross margins, they look like they're down sequentially albeit on a GAAP basis, and I would have thought they'd be up as you walk away from lower-margin business. So can you just talk about why that is? And should we assume because of that, when you say you're tracking ahead of your Op income guide, should we be thinking about 10s of basis points rather than 100-plus basis points or, say, greater expansion, margin expansion, gross margin expansion opportunity in product next quarter?

Brian T. Gladden

Yes, Maynard, I feel -- again, I think we're talking about operating income, I think the reality is there are moving pieces within gross margin. As you know, in the second quarter, we talked about the benefit from a supplier settlement that affected our margins. I think obviously that's one of the elements moving around. I think we've driven very consistent to sustained margins for the last year on the product side and in total. And again, part of that is making cuts, trade-offs around growth versus margins, and I think we'll continue to balance that. So I think you can expect, you know what I'm saying, that's really how we're going to manage it, and I think, as you think about fourth quarter heading into next year, that continues to be a priority to focus on net profit and not necessarily focus as much off the unit shares.

Maynard J. Um - UBS Investment Bank, Research Division

And if I could just follow-up on your revenue guidance, can you just parse out how much of your guidance, at the low end, is comfort on the HDDs because of the inventory you've drawn down from the hubs versus your ability to actually procure drives from the drive manufacturers?

Brian T. Gladden

I don't think we can parse it for you that finally.

Operator

The next question is from the line of Richard Gardner with Citigroup.

Richard Gardner - Citigroup Inc, Research Division

I'm not sure if you can answer this one either, but I was hoping that maybe, Brian, you could talk little bit about puts and takes on the gross margin for the fourth quarter? And in particular, typically Consumer mix is a negative for you in the fourth quarter but I thought you might be diverting a little bit more HDD supply to your more profitable businesses. I'd also be interested to get some commentary on the net impact on your building materials from the HDD issue because on the one hand, drive prices go up but every other component probably comes down at an accelerated rate. And then also some comments on competitive pricing, as well, impact on gross margin.

Brian T. Gladden

Yes, I'll give you some of the pieces. Again, I think, again, we've done a pretty good job of managing a lot of these elements over the course of the last year or a year -- more longer. I think as you look at the fourth quarter, you did hit some of the points. We've highlighted the fact that the pricing environment has tended to be slightly more aggressive than what we've seeing over the last few quarters. I think that will -- obviously, we're watching that and we're trying to make sure that we manage for profit. There are places where we haven't necessarily jumped into some of those aggressive pricing dynamics. I think when we look at component prices, clearly we would expect the price per drive on the hard disk side to go up. We're seeing that, and I think the reality is that when you look at the overall aggregate component cost for the quarter, there's enough other inflation in other components that's going to more than offset that, is our current view. So we should see that deflation, albeit relatively small, within the quarter. That's how we're thinking about it right now. Consumer mix has traditionally been a bit of a headwind in the fourth quarter. I think given how we've been managing the Consumer business and the kind of business that we're taking in Consumer, I'm not sure that's going to be the biggest challenge we have. So a lot of sustainable improvements in the supply chain, that Jeff talked about, that will continue to contribute. And you put all these things together, and again, we're trying to manage consistently and sustain high margins and that's, I think, what you can expect in the fourth quarter.

Richard Gardner - Citigroup Inc, Research Division

And I guess the quick follow-up then, it just doesn't sound like gross margins should be down a lot sequentially this year. Is that a fair assessment?

Brian T. Gladden

I think that's sort of a net of everything I said, yes.

Michael S. Dell

I was going to add to what Brian mentioned. As the hard drive situation unfolds and we've had our risk mitigation team in place now for well over 4 weeks, we've been able to adjust pricings to reflect the cost. So we've been able to reflect the value of the strategic commodity in our products across our storage arrays to our servers all the way down into notebook and our desktop. And you've seen that in our Consumer business and our Small and Medium Business desktop and notebook business.

Brian T. Gladden

And I think, Rich, you hit the point, which is the higher supply chain, including the OEMs, are fairly focused on protecting their highest-value customers. I think that will play out across the quarter and over the next probably few quarters.

Operator

Our next question is from the line of Ben Reitzes with Barclays Capital.

Benjamin A. Reitzes - Barclays Capital, Research Division

Thanks for answering that last question in such detail because that was mine but I want to ask a second one. The repurchase rate, $600 million, what are you thinking about for fourth quarter and beyond? And any other thoughts about capital allocation and how you're thinking about things? Some of the companies in the space are also doing dividends of late, so those are my -- that's my follow-up, is going to be, what you're thinking of a dividend. So capital allocation, repo in the 4Q and then your thoughts on the dividend.

Brian T. Gladden

Yes, Ben. No real change in our messaging around capital allocation. We continue to focus on strategic investments, organic and inorganic, to really help drive the strategy and transformation of the company, and then secondly, returning capital to shareholders with a share repurchase program. The target that we gave -- we've been giving for a while is 10% to 30% of free cash flow. I think we did more than that the first half, by really higher cash flow generation and our ability to raise capital at favorable terms at the time. I think, when we'll head back as you think about the second half in total and aggregate, back into that 10% to 30% of a free cash flow number. So that's how we're thinking about it.

Michael S. Dell

That's on the dividend question and all.

Brian T. Gladden

Yes. Not something we would talk about right now, and I think one of the challenges that I think we have to face into is really U.S. liquidity and the dynamics that, that gives us around cash availability to do something like that. So we'll continue to look at that.

Operator

Your next question is from the line of Katy Huberty with Morgan Stanley.

Katy Huberty - Morgan Stanley, Research Division

As it relates to the price aggression you saw in the October quarter, was it largely a function of some of your PC peers defending their market as they made strategic decisions and work through some of their inventory? Or was the price aggression more broad across the Enterprise segment as well? And then also was it specific to any geographies?

Brian T. Gladden

Yes, I think we've highlighted in the business the talking points. I mean, clearly, the challenge in Europe, there were some challenges in terms of moving inventory through that channel, and I think we concluded we weren't going to match pricing in that space, and that affected our growth. I think that there were other areas. As you look at, for instance, midrange storage, as you look at, as Michael highlighted, higher volume server opportunities, those are all places we've seen more aggressive pricing.

Katy Huberty - Morgan Stanley, Research Division

And just as a quick follow-up, Brian, you had commented on OpEx earlier, and it sounds like you're trying to rationalize some projects in this macro environment. But do you think we can actually see OpEx continue to come down sequentially, understanding that fourth quarter has the extra week and so there will be a little bit of a blip in 4Q but beyond that, do you think that you can bring operating expense down sequentially as you rationalize some of those projects?

Brian T. Gladden

I wouldn't commit to that. I think we continue to make investments, and I think you're going to see some areas where we increase OpEx and other areas where we continue to reduce and take costs out of less strategic areas. So it will be a bit of a mix. Clearly, you have the 14th week that will put pressure in the fourth quarter, no question on that.

Operator

Your next question is from the line of Jayson Noland with Robert Baird.

Jayson Noland - Robert W. Baird & Co. Incorporated, Research Division

A quick follow-up on HDD supply and a question on networking. Brian or Jeff, is it fair to assume that F Q1 could be more of a challenge from a supply standpoint than the January quarter?

Michael S. Dell

Our view of the situation is the challenge in supply is through the first half of next year.

Jayson Noland - Robert W. Baird & Co. Incorporated, Research Division

Fair enough. Maybe an update on Force10 performance and anything you can say about your willingness to expand your networking portfolio in general either organic or inorganic?

Brian T. Gladden

Yes. We're feeling really great about the Networking business, we had 43% growth without Force10 and 83% with the addition of Force10. And the real play here for us, of course, is changing the conversation from a server conversation to server, storage, networking and orchestration software in the whole data center. And given the number of servers that we sell, there's a lot of pull that we can drive in our Networking business and certainly our ambition is to go beyond switching and you'll have to stay tuned for future announcements.

Operator

We'll now take our final question from Amit Daryanani from RBC Capital Markets.

Amit Daryanani - RBC Capital Markets, LLC, Research Division

Just a question on the extra week that you guys talked about. What sort of impact will that have on OpEx and EPS line in the Jan quarter?

Brian T. Gladden

Well, really, all the information we gave was we would expect some incremental revenue, and we basically said 3% of incremental revenue would show up as a result of that. That's recognizing that the transactional business likely will provide incremental revenue during that period. We don't expect a big impact from the relationship business. There are some other dynamics obviously playing out. One would be the Chinese New Year timing and that impact on the supply chain as well as Asian customer demand during really the 13th week of our quarter, we think also has some impact. I'm not going to provide any real input in terms of the OpEx dynamics and what we're going to see in other parts of the P&L.

Amit Daryanani - RBC Capital Markets, LLC, Research Division

And then if I could just follow-up, given the direct business that you guys have at least in the Consumer side, can you just tell me what you're seeing in terms of so far into [ph] the year-end Christmas sell-through in North America?

Michael S. Dell

Can you repeat the question, please?

Amit Daryanani - RBC Capital Markets, LLC, Research Division

I was just wondering if you could look at just the direct part of your business, the direct model, can you just tell what you're seeing in terms of U.S. consumer spending heading into holiday season this year?

Brian T. Gladden

I don't think, Amit, we have a real view that's different than typical sort of seasonality that we would expect to see, nothing exceptional here.

Michael S. Dell

Yes, I mean, the one thing that is -- is that we're focused on as we're focused on the higher profit areas of the client business is XPS, and we continue to introduce new products there, we have 207% increase in our XPS notebook businesses last quarter and stay tuned for future product announcements.

Jeffrey R. Clarke

And new product launches, XPS.

Michael S. Dell

Yes. We just launched the XPS 14/B.

All right. Thanks for joining us.

Operator

We'll now turn the call over to Mr. Williams for closing remarks.

Robert Williams

No closing remarks, we're wrapped up. Thanks.

Operator

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

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