The technology industry is one filled with innovation. But that innovation has a price. Every time a customer chooses an iPad or a Mac over a PC, some company prospers at the expense of another. Every time someone chooses an Android smartphone over a Windows Phone, one company thrives while another withers. If Dell's (DELL) first quarter results have shown us anything, it is that Dell is suffering.
After the markets closed on May 22, Dell announced its first quarter results for fiscal 2013. The company posted GAAP EPS of $0.36 on revenues of $14.422 billion, representing year-over-year growth of -27% and -4%, respectively. Non-GAAP EPS of $0.43 missed estimates by 3 cents, and revenue missed estimates by $490 million, a huge miss that the company cannot simply sweep under the rug. Dell's CFO Brian Gladden stated that "We continued to shift the mix of our business during a challenging environment...our enterprise solutions and services businesses now account for 50 percent of our gross margin, and we'll continue to make the necessary investments to maintain our progress."
So where did the problems lie for Dell this quarter? Almost everywhere. Soft PC sales to consumers and enterprise. Sluggish growth in services and flat growth in the Asia-Pacific region. Dell posted a 12% year-over-year revenue drop in its consumer business, admitting that it its PC sales are suffering due to consumers buying smartphones and tablets. And the company's consumer operating margin fell to just 1.1%, down 3.8% from a year ago.
Dell's projection of just 2-4% growth in revenue fell far short of expectations. The company forecast revenues of $14.7 to $15 billion for the second quarter, against expectations of $15.4 billion. So what was to blame for this miss? In a word, execution.
Poor Macroeconomics or Poor Business?
Many were quick to point the finger at the broad global economy, and the increased levels of uncertainty that have crept up in the past few months. And as a global IT company, surely Dell's miss was caused by macroeconomic headwinds outside of its control. The answer is not so simple. Many companies use macroeconomic conditions as an excuse for sloppy execution and poor business decisions. And this quarter at Dell was marred by poor execution. As CFO Brian Gladden said on the call that, "while we continue to make strong progress in the transformation of the company, our first quarter results were mixed, and we fell short of our own expectations. There were some areas where our execution was not as expected, and there also are some market dynamics that created some headwinds for us. We want to be clear that we remain committed to our strategy, and we want to acknowledge that our progress will not always be linear." Dell's sales force made mistakes in this most recent quarter that the company will need to rectify going forward.
In addition, Dell faces pressures across multiple business lines that will likely intensify in the months to come, particularly on the consumer side. CEO Michael Dell was cautious on the call about Windows 8, noting that since corporations are still adopting Windows 7, the sort of enterprise boost the company has seen in the past is unlikely to be present this time around. While Dell may see opportunity in Windows 8 on the consumer side, so does every other PC maker. The fierce competition surrounding the Windows 8 launch will likely put pressure on Dell's pricing and margins. And with mobility and desktop PC's accounting for 52% of Dell's revenue (as of this most recent quarter), the company can ill afford pricing & margin pressures.
Furthermore, it seems that Dell's problems in the PC market are Dell's alone. HP (HPQ), which reported its earnings after the markets closed on May 23, posted flat PC growth in this most recent quarter. And Lenovo, which just announced record 2011-2012 results, posted PC growth of 44% in its most recent quarter. Lenovo's PC sales in North America grew 26% year-over-year. While the PC market as a whole may be anemic, it seems that it is Dell that is having real trouble with growing its PC business. We do not believe that blaming macroeconomic conditions is appropriate here. The results Dell's peers have posted are inconsistent with the weakness that Dell has experienced, which indicates that the problems Dell has are internal, not macroeconomic in nature.
Cash Flow Questions
As we analyzed Dell's financial results for this quarter, one line item in particular stood out to us: the company's operating cash flow for this quarter. Though Dell may have posted GAAP income of $635 million this quarter, the company used $138 million in its operations. If this were a newly public technology ramping up its business, negative operating cash flow would be unlikely to raise eyebrows. But for a Fortune 50 company like Dell to post a quarter of negative cash flows from operations is a rarity. This issue was brought up on the company's conference call, and analysts questioned what this means for the company's finances going forward. Dell is set to close several acquisitions in the next quarter, taking more cash out the door, and the company's buyback is perhaps the only thing supporting its stock price. CFO Brian Gladden responded that he feels good about the company's cash flow positioning for the remainder of the year, noting that "we had challenges, obviously, with the working capital dynamic in the quarter and coming off the 14th week from the fourth quarter that affected first quarter cash flow..." Based on the company's cash flow statements for this quarter, it seems that the company experienced difficulty in collecting its accounts receivable. Its collections for the quarter dropped over 65% from previous year levels, and even a reduced pace of paying down accounts payable (down by 37.85%) was unable to generate positive operating cash flow this quarter. Dell has argued that the cash burn this quarter was due in part to seasonality and the effects of a 14th week in the company's fourth quarter. We, however, find that explanation lacking. We find it difficult to believe that an extra week in the fourth quarter could push first quarter operating cash flow this year to negative $138 million, compared to $465 million in the previous year's first quarter. What concerns us more than the cash burn (which is minor compared to the company's overall cash position) is what it says about Dell's managerial abilities. For a Fortune 50 company to post such a steep decline in operating cash flow year-over-year calls into question the competence of its management in overseeing the company's finances. Should this instance of negative operating cash flow repeat itself again, we believe that would raise significant concerns.
That being said, Dell's cash position is solid at this point in time. The company ended the first quarter with net cash of $8.217 billion, which works out to $4.63 per share in net cash. Based on the company's share price of $12.49 as of this writing, more than a third of the company's market capitalization (37.07%) is in cash. That being said, we believe that Dell needs to deploy that cash either in the form of more meaningful share buybacks or stepping up the pace of acquisitions. But for that to occur, the company cannot post more quarters of negative operating cash flow.
Valuation & Conclusions
Based on Dell's trailing 12 month EPS of $1.75, the company trades at a P/E ratio of just 7.14x, hardly expensive. When the company's $4.63 per share in net cash is backed out, that valuation becomes even cheaper. But so far, Dell has been a value trap, and will likely remain so until the company can prove that it can grow again. Low valuations mean little if a company cannot put the reasons for its low valuation behind it.
Investors should not assume that Dell's weak quarter was caused by macroeconomic headwinds. The company's management and its financial statements, as well as the results of its peers HP and Lenovo show that Dell's issues are caused by Dell alone. And until the company can definitively show that its execution issues are behind it, and make a more rapid transition away from PC's, we believe the shares will be range bound at best. In the technology industry, competition is fierce, and companies that do not innovate and stay a step ahead will quickly find themselves too far behind to ever catch up. Dell is in danger of falling too far behind. For the time being, the company can afford to drift, with anemic growth in revenues and profitability. But if Dell does not flawlessly execute on its strategic change towards enterprise services, cloud computing, and away from PC's, the company will find itself backed into a corner with nowhere to turn.
Disclosure: I am long HPQ.
Additional disclosure: We are long shares of HPQ via the SPDR Dow Jones Industrial Average ETF.