Like many other PC makers, Dell Inc. (DELL) has been suffering from commoditization in recent years. Of course, Apple Inc. (AAPL) has been able to maintain a premium for its desktop and laptop offerings, even while creating (and dominating) new categories with the iPad and iPhone. But of the traditional PC makers, only Lenovo has seen robust growth recently. For the most recent quarter of Q212, Dell saw an approximately 12% drop in unit shipments year-over-year (as did chief rival Hewlett-Packard Co.: HPQ), even though industry shipment volume was roughly flat over the prior year. While Hewlett-Packard certainly has its problems, at least it has a highly diversified business. This should (at least in theory) allow it to survive a slowdown in the PC business.
Dell, by contrast, still relies heavily on the PC business. In its most recent quarter, the Desktop PCs and Mobility segments combined to produce half of Dell's revenue (though a smaller proportion of the company's profit). The recent weakness in PCs has put pressure on Dell's bottom line. In the Q2 earnings press release, Dell dropped its non-GAAP annual profit guidance to at least $1.70 per share. That contrasts with the company's original forecast for non-GAAP EPS to exceed FY12's level of $2.13. In response to this dose of bad news, Dell shares have dropped by more than 15% since the earnings release, hitting a new 52-week low of $10.57 last Friday.
Dell has been trying to move into higher-margin businesses through a combination of organic growth and an acquisition spree. At every opportunity, Dell's management has been trumpeting the growth of the company's Enterprise Services and Solutons business. As management stated on last quarter's earnings call, more than half of Dell's total gross margin now comes from this segment. Furthermore, revenue and margins have been expanding in ES&S, whereas both are declining in the more traditional Dell PC business.
I think that Dell's move to a higher value-added product portfolio anchored by the ES&S business will pay off over the long run. Obviously, the company faces strong competition from established companies in those areas, such as IBM (IBM) and former partner EMC Corporation (EMC). However, Dell is a recognized name in the technology industry and it has seen success recently, particularly in its sales of servers. Furthermore, ES&S revenue has been growing (albeit slowly), and as Dell integrates its recent acquisitions, the company is well-positioned to compete in the enterprise solutions market. There is a lot of money to be made here, and room for many competitors to thrive.
On the other hand, Dell's troubles in the PC segment will continue to weigh the stock down in the near term. Management blamed weak Q2 sales in part on a pause in consumer purchases and a channel drawdown prior to the late-October launch of Microsoft's (MSFT) Windows 8. However, the company does not expect a quick bounce-back upon launch of the new OS next month. Today, Dell primarily sells to businesses, not consumers. Businesses tend to be slower to migrate to new operating systems. Moreover, the Windows 8 launch will likely be weaker than Windows 7 even for consumer-focused PC makers. Many other PC makers have joined Dell in toning down expectations for the second half of the year.
As long as weakness in the PC segment continues to drive revenue declines at Dell, I expect the stock to remain mired near its current lows. However, if the stock drops to single-digit territory in the next month or two, it would be worth consideration for investors willing to hold at least through the end of CY 2013. I think the PC portion of Dell's business will become less of a drag in the fourth quarter, and particularly moving into FY2014. Q412 results were boosted by a 14th week, but were otherwise relatively soft due to the industry-side hard-disk drive shortage. This should provide an easier comp for the launch of Windows 8 this fall.
More importantly, I expect PC sales to return to year-over-year growth in CY2013. As I have mentioned elsewhere, Microsoft will be ending support for Windows XP on April 8, 2014. Businesses and consumers have been holding off on replacing their computers on account of the economy, but they cannot do so indefinitely. With Windows XP still holding over 40% of the OS market, there will be a lot of people looking to replace their PCs within the next year and a half. This replacement cycle will mostly fall into Dell's FY14, and should lead to significant year-over-year improvement in Dell's PC business.
To be clear, I do not expect the PC business to be a long-term cash cow for Dell. The company's success in selling higher-value services will determine its ultimate fate. On the other hand, weakness in the PC business is holding back Dell's stock at present. Even after recent downward earnings revisions, Dell trades for just 6X expected FY13 EPS. As the 2013-2014 replacement cycle plays out, PCs will no longer be a drag on growth. This will give Dell some breathing room to execute its transition, and will likely drive the stock to at least $15 by the end of next year.
Disclosure: I am long HPQ.