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Executives

Lynn A. Tyson - Vice President of Investor Relations

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

Michael S. Dell - Chairman of the Board, Chief Executive Officer

Analysts

Bill Shope - Credit Suisse

Kathryn Huberty - Morgan Stanley

Richard Gardner - Citigroup

Benjamin Reitzes - Lehman Brothers

Toni Sacconaghi - Sanford C. Bernstein

Bryan Alexander - Raymond James

Keith Bachman - Bank of Montreal

Maynard Um - UBS

David Bailey - Goldman Sachs

Chris Whitmore - Deutsche Bank

Louis Miscioscia - Cowen & Company

Jayson Noland - Robert W. Baird

Jeff Fidacaro - Merrill Lynch

William Fearnley - FTN Midwest

Clay Sumner - Friedman, Billings, Ramsey & Co.

Mark Moskowitz - J.P. Morgan

Shannon Cross - Cross Research

Dell Inc. (DELL) F2Q09 Earnings Call August 28, 2008 5:00 PM ET

Operator

Good afternoon and welcome to the Dell Incorporated second quarter fiscal year 2009 earnings conference call and strategy update. (Operator Instructions) I’d like to turn the call over to Miss Lynn A. Tyson, Vice President of Investor Relations. Miss Tyson, you may begin.

Lynn A. Tyson

Thank you, Cara. With me today are Chairman and CEO Michael Dell and Senior Vice Chairman and CFO Brian Gladden. Brian will review our second quarter results and the progress we’ve made on our cost initiatives, and then Michael will follow-up with his perspective on our enterprise portfolio, and then we’ll move to Q&A.

Please make sure to review our web deck on dell.com/investor for additional information on our results and I would also like to point out that we have expanded the disclosure in our cash flow table.

References we make on this call to Dell's unit growth as a multiple of the industry growth excludes Dell and all growth rates are year over year, unless otherwise noted.

Our IR calendar for the balance of the year includes Michael Dell at Citigroup next week, and Mike will also be at CFSB in December, and then Brian will be at B-of-A next month.

Finally, 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 current expectations. Actual results 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.

I’d now like to turn the call over to Brian.

Brian T. Gladden

Thanks, Lynn. When I joined Dell three months ago, I had a view of the fundamental advantages of this company, as well as opportunities for improvement. On the advantages side, our products and solutions portfolio is well-aligned with the growth opportunities we see in technology. We have an increasingly large broad-based share presence around the world which translates to more customers and the ability to expand the products and solutions we sell to them. We have superior cash generation capability and we have an engaged and experienced leadership team.

On the opportunity side, we can improve our global competitiveness, which includes our total cost structure. We can improve the consistency of our execution across all aspects of the business and we can improve our return on capital.

Our performance this quarter really highlights these advantages as well as the areas where we still have much work to do. Our current focus to grow faster than the industry in the five key areas of global consumer, enterprise, notebooks, SMB, and emerging countries, enabled by improvements in our competitiveness will drive improving growth in earnings and cash returns for our shareholders over the long-term.

So let me turn to the quarter. We had a great growth quarter this quarter, as we generated $16.4 billion in revenue, an 11% increase on a 19% increase in units. Growing at 1.4 times the industry, we gained share in all major product categories and in all major regions, gaining one full point of share globally. We displayed particular strength in notebook and server units, which were up 44% and 19% respectively.

On a regional basis, unit growth was fueled by a 53% increase in units in our global consumer business and in BRIC countries, where a major portion of the industry growth will come from in the next five years, revenue was up 41% on a 46% increase in units. This was more than three times the rate of the industry, driving a 2.4 point share increase for the region.

Our revenue mix from BRIC countries is now over 9% of our revenue and our revenue outside of the U.S. is 47% of our total mix. Our global commercial business was approximately 80% of our unit revenue mix for the quarter.

We know we can improve our performance on profitability, as operating income was $819 million, or 5% of revenue. Margins declined sequentially, driven by a decline in gross margin rates, which was partially offset by improvement in operating expenses.

Let me spend a minute on the dynamics on this line, as I know many of you are concerned that our growth initiatives will come at the expense of long-term profitability. As I mentioned earlier, our goal was to improve earnings over time and this will be driven in part by an optimum balance of revenue growth and improvement in operating profit. Gross margins declined sequentially by 120 basis points as we took strategic pricing actions in EMEA ahead of cost improvements. In EMEA, we also had an increase in the deferral of service revenue, driven by changes in how we market our service offerings in the region. While this had a negative impact on reported profit in the quarter, it was neutral to cash and the revenue and profit will be recognized in future periods.

Gross margins were also impacted by the retail mix shift in our consumer business as we continue to expand our global footprint in this business.

The sequential decline in gross margin was partially offset by a 70 basis point sequential decline in OpEx, or 160 basis points year over year, reflecting some of the strong progress we’ve made towards our $3 billion in cost initiatives.

As we’ve mentioned in the past, I think over the next several quarters, you will continue to see some non-linearity in the improvement in our operating income margins as we rebalance our portfolio, harvest cost improvements, and drive growth. As I’ll talk about in a few minutes, we have clear line of sight to the $3 billion in cost opportunities and I think you will start to see them manifest themselves more in the back half of this fiscal year.

Excluding the impact of acquisitions, our headcount was down 8,500 since Q1 of last year, which is when we shared our target of 8,900 with you. We’ll effectively reach our goal this quarter. On a sequential basis, headcount was down about 1,500 people. Over time, we will continue to improve productivity and scale our headcount as we grow. In the quarter, we absorbed $27 million of expense for the amortization of purchased intangibles and $25 million in business realignment costs. They were each worth about $0.01.

Our tax rate was 26.4%, reflecting a 290 basis point increase versus last quarter. The increase in the rate was primarily driven by a shift in the mix of our income to higher tax rate jurisdictions.

Earnings per share were $0.31 and cash flow from operations was $1.1 billion. Our ability to generate cash remains robust, evidenced by our trailing four quarter cash flow from operations of $3.4 billion, or $1.61 per share. On an annualized basis, we believe we will continue to generate cash flow from operations in excess of net income.

We ended the quarter with $9.5 billion in cash and investments and in the quarter we spent $1.4 billion to buy back 60 million shares. This helped to drive our weighted average share count to 2 billion shares, which is over an 11% reduction from Q2 of last year. About $5 billion remains in our current share repurchase authorization and we expect to use a portion of this authorization in the second half of this fiscal year.

Our cash conversion cycle was negative 29 days and we believe for this year it will be generally in the negative 30 day range, and our return on total capital was 33%.

So now let me turn to an overview of our regional and product performance. In our Americas commercial business, we’re the number one provider of systems in the region and our revenue increased 5% to $8.1 billion on a 7% increase in units. While operating income dollars were down year over year, the region improved profitability sequentially by almost 20%, reflecting balanced growth across products and regions.

Server shipment growth of 18% was against the backdrop of no growth in the industry, garnering us three points of share in the X86 space. Our share in servers now stands at 37.8%. Mobility growth was up 12%, roughly in line with the industry.

In EMEA commercial, revenue was up 11% to $3.5 billion on a 20% increase in units. Operating income declined on a year-over-year and sequential basis. As I mentioned in the gross margin discussion, in the quarter we took advantage of some strategic growth opportunities in advance of cost improvements and we had a larger than usual accrual for deferred services.

We’re confident that our focus on expanding our footprint in this region will yield sustained improvement and profitability in the future as we improve our mix of products and services and realize cost improvements.

Server units in the region were up 18%, the fastest growth among the top five vendors and almost 1.6 times the rate of the industry. Growth in notebooks also outpaced the industry with a 52% increase in units. And from a country perspective, we experienced double-digit unit growth in the U.K., France, and Germany.

In APJ commercial, revenue was up 16% to just over $2 billion on a 16% increase in units and operating income was up more than 10% year over year. Growth and profitability were driven by a very balanced mix of country, segment, and product performance, as our share in this region increased by 1.7 points. Our growth in total units was over three times the rate of the industry as we strengthened our position as the second-largest provider of servers in the region.

Global consumer revenue was up 28% to $2.8 billion on a 53% increase in units, which was over twice the rate of the industry and driven by a better than 100% increase in notebooks.

Profitability was roughly break-even, as the business expanded its retail presence and absorbed a litigation expense of $18 million in the quarter.

On the product front, revenue from mobility products was up 26% on a 44% increase in units, which was at a premium to the industry. The growth in mobility was driven by our expansion in consumer and also the layering in of a 50% increase in notebook platforms this year. We also grew at a premium to the industry in desktops, which were up 5% in terms of units.

Growth in enterprise products and services, which Michael will talk more about later, accelerated nicely in the quarter. Server revenue was up 5% on a 19% increase in units. We’re almost three times the rate of the industry. Our X86 server share grew by three points as we strengthened our position as the number two vendor in the world, and we significantly outperformed our main competitors in all major regions.

Growth in the quarter was aided by the success of our cloud computing initiatives. These Dell custom solutions are built around web 2.0 technologies and now power among other organizations three of the top four search engines in the U.S. Over time, these solutions will drag an increasing amount of Dell services and software.

Storage revenue was up 11% in the quarter. This growth, which yielded improved profitability, was fueled by our power vault disc products and equal logic ISCSI network storage solutions.

Enhanced services revenue was up 14% to $1.5 billion, driven by an 18% increase in our support services, which deliver customizable support solutions for end users and IT professionals in Dell and non-Dell environments.

Our deferred revenue balance grew 22%, or by $1 billion year over year, driven by the growth in as-sold services.

Software and peripherals revenue grew 17% with improving profitability. This is the fourth consecutive quarter of double-digit growth for our S&P business. This product category enjoyed gains across all of our regions, fueled by our acquisition of ASAP and improved performance in our displays business, where we regained our number one worldwide position in flat panel displays.

Before turning to the outlook, let me briefly go over some of the progress we made on the $3 billion in cost initiatives announced earlier this year.

As you know, these initiatives cover three large areas -- how we design and price our products, OpEx, and finally manufacturing and logistics. I now lead the bi-weekly global planning and interlock sessions where we review detailed scorecards and tracking models that identify and calendarize the opportunities. We also have tracking metrics to quantify how these opportunities flow through the business.

Let me give you a few examples. On the product design and pricing front, which largely sits in cost of goods sold, or COGS, as you know we are designing cost-optimized products with more competitive features. This is a two-part process. First, we are designing products with features customers want and are willing to pay for. We are eliminating the complexity and features our customers did not value and are adding more features that they do value. We call this designing to value, pricing to value, and selling to value.

A recent example is our Vostro 1510 notebook designed for our SMB customers. This product is cost-advantaged versus its predecessor, as we use more industry standard materials for the chassis and we also optimize feature sets specifically for our SMB customers versus leveraging feature sets from our consumer business.

The second part of the process is how we approach our procurement process. We now have a clean sheet approach that identifies process and material procurement inefficiencies. These opportunities are independent of the typical decline in component costs that we see.

When you take this approach to product design and the pricing of products and apply it to every single unit we sell, it yields a tremendous opportunity for us that accrues to the P&L as we grow our business and launch new products.

Turning to OpEx, we’ve made significant progress and are at our lowest dollar level in over one year. This improvement was aided by a reduction in headcount of 8,500 as we made over the last 14 months, which helped drive our revenue per employee up by 24%. And as part of our global initiative to improve sales execution and coverage through better alignment with customers, we made investments in front line or customer-facing capability. Over the last six quarters, we increased the percentage of front line personnel considerably from 54% to 62% of our people.

On an ongoing basis, we will invest in strategic growth areas while scaling expenses and improving productivity.

And lastly in manufacturing and logistics, which is the smallest on a dollar basis of the three cost initiatives, we’ve improved efficiencies by consolidating some of the company-owned sites in the U.S. and Canada and we continue to review our global manufacturing network to ensure we have an optimized structure.

To summarize, we’ve made significant progress on our cost initiatives and are confident in our ability to hit our target of $3 billion by the end of our fiscal 2011. No doubt there is much more work to do and we are vigorously pursuing those opportunities, though some of these initiatives will show results sooner than others.

Now, before I turn it over to Michael, let me give you some perspectives to think about relative to our performance for the balance of the year. First, we’ll continue to incur costs as we realign our business to improve competitiveness, reduce headcount in certain areas, and invest in infrastructure and acquisitions. Second, we see continued conservatism in IT spending in the U.S., which has extended to some extent to Western Europe and certain countries in Asia. Changes in currency rates could also affect the demand environment and our results. Third, we continue to benefit from improving performance in areas like emerging countries, notebooks, enterprise, and services, which collectively are driving a more diversified portfolio of geographies and products. And fourth, we are working aggressively on our cost initiatives which over time will benefit our P&L with improved growth, profitability, and cash flow.

With that, I will turn it over to Michael.

Michael S. Dell

Thank you, Brian. Let me start by saying that I am pleased with our broad-based growth, especially in the global commercial business. Over the past year, this business has generated about $53 billion in revenue and $3.7 billion in operating income, and we’ve been the number one provider of commercial systems worldwide for eight years running.

Looking at the IT industry as a whole, in four years global IT spending, which includes services, labor, and hardware, will approach $1.5 trillion. The lack of innovation in two-thirds of this spending, specifically services and labor, is robbing resources from IT, from customers’ IT spending.

We are making investments that will enable us to participate more broadly in that two-thirds but in a very distinctive and disruptive way. Our goal is to enable flexibility, configurability, access to industry-leading innovation, and value by leveraging technology arbitrage versus labor-based services.

To address this opportunity, we are deploying an expanded solutions portfolio via organic growth and with acquisitions. I spend a fair amount of my time with commercial customers around the world and there is no doubt that they believe we have the strongest solutions portfolio in our history, from client products through to servers, storage, and services. Our growth in the enterprise this quarter is evidence that we are now in the consideration set by more customers -- by more current customers and existing customers are turning to us to provide more robust offerings at an increasing rate.

So let me give you two examples of how we partner with our customers to provide them with differentiated customized solutions to help simplify their environments. The first is salesforce.com. Here we recently won a very large opportunity for our enterprise hardware and services that essentially replaces a proprietary Unix system from a key competitor, resulting in significantly lower cost and an easier-to-manage environment for the customer. The creation of this solution involved collaboration across our enterprise sales organization, high availability database and custom engineering teams, and our pro support services teams.

We will bring up a new data center for them in Singapore that will run entirely on Dell from the start and our teams are collaborating with Salesforce to support the multi-vendor hardware and software stack that they require. Their U.S. production data centers that are currently adding new databases are going on Dell and those will migrate to Dell over time for the existing databases.

The second example is that of a very large global retailer where our advanced systems group partnered with onsite systems engineering, virtualization experts and sales teams to create a very large virtualized infrastructure solution that includes remote access, a flexible computing platform based on our power edge servers, 10-gigabit ethernet switches, equal logic SANS, VMWare virtualization, and Citrix Zen Desktop as the connection to the virtual cloud. All of this is supported by our enterprise services team, providing support desk, operational expertise, open managed systems management monitoring, and ongoing customer training. This is a solution that we could not have offered to this customer 18 months ago.

Two other areas of rapid growth for Dell in the solutions area are data center consolidation, including blades, where we recently launched our power edge four-socket M905 blade server, and cloud computing solutions. Recent wins in the cloud include companies like Microsoft, Facebook, Amazon, and Yahoo!, and this business is poised to grow exponentially over the next few years in terms of hardware, infrastructure, and services.

As I mentioned, many of these solutions start with a client. Two weeks ago, we launched our new Latitude E-Series notebooks, the largest global commercial platform rollout in our history and we will be following it up with a complete refresh of our commercial desktop and workstation portfolio.

So these are just a few examples of how we are designing solutions and discrete products to help simplify IT for our customers.

Growth in our enterprise portfolio demonstrates that customers are increasingly confident in our ability to design and support complete solutions and as a result, they are expressing interest in deeper relationships. That’s translating into growth today and opportunity in the future.

Not only do we see a big commercial opportunity in servers and storage due to data center consolidation, virtualization and cloud computing, but also strong growth in enterprise services and a more mobile commercial customer base.

And all of the activities I’ve talked about are squarely focused on building broader and deeper relationships with commercial customers, again this business that has generated $53 billion for us in the last year.

Beyond the commercial business, we continue to see tremendous opportunity as consumers transition to mobile computing, wireless broadband, and smaller devices.

Now let me turn it back over to Lynn.

Lynn A. Tyson

Thank you very much. Cara, I think we’re ready for Q&A, please.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Bill Shope with Credit Suisse.

Bill Shope - Credit Suisse

Obviously I have a question on the gross margins -- can you help us quantify what portion of the gross margin decline came from the deferrals you mentioned versus pricing?

Brian T. Gladden

The Europe services deferral, and again it’s cash neutral to us and it was driven by the way we market and present our service offerings to customers in Europe, it forced us to defer more. It really was a $0.02 to $0.03 per share impact in the quarter.

Bill Shope - Credit Suisse

And how is that going to play out the rest of the year? Is this going to be a headwind for the rest of the fiscal year as well?

Brian T. Gladden

You know, as we continue to grow the services business, we will have some continued impact of that -- not going to talk about how much but it will continue to be a potential issue for us.

Bill Shope - Credit Suisse

Thank you.

Operator

Your next question comes from Kathryn Huberty with Morgan Stanley.

Kathryn Huberty - Morgan Stanley

I want to follow-up on margins -- if not for the EMEA region segment profitability would have grown by half-a-point sequentially versus the 50 bps reported decline. So can you help us better understand what went into the decision to invest so aggressively in EMEA and why those investments had to occur in July such that it was worth taking such a big hit on profits at the reported level?

Michael S. Dell

I think it’s a fair question. I think whenever you are restarting growth, what I can tell you is that it’s an imprecise process and we certainly see some parts of our business where we were probably a bit too aggressive and we are kind of modulating for that now.

Kathryn Huberty - Morgan Stanley

How quickly can you go back and fix that in the coming quarters?

Michael S. Dell

We can fix it right away.

Kathryn Huberty - Morgan Stanley

Okay, thanks.

Operator

Your next question comes from Richard Gardner of Citigroup.

Richard Gardner - Citigroup

Michael, I just wanted to follow-up on Katy’s question and it sounds like you feel like you were overly aggressive in Europe. Should we infer from your comments that you do intend to modulate back the growth in Europe in the coming quarter? And could you talk about whether what you did in Europe was a response to a significant weakening in demand in the region or was it that there were some large strategic customers? Could you just provide anymore detail on exactly why these particular opportunities were so strategic for you?

Michael S. Dell

Well, it’s a multi-dimensional equation. On the one hand, you have expectations of improvements in cost and on the other hand, you have the opportunity to grow the addition of new products, new countries, and new customer segments. And then you have the competitive overlay.

We’ve been expanding rapidly throughout EMEA and also I think it’s fair to say that some of the Western European economies have slowed a bit, creating some pressure in that environment. But when we look at it on balance, we believe that our margins can certainly improve quite a bit in Europe.

Richard Gardner - Citigroup

Could you expand at all on the comments regarding the competitive overlay in Europe and what you are seeing there?

Michael S. Dell

Well, it’s just one of the factors in the multi-dimensional equation. I wouldn’t call it out as being particularly more significant than any other region.

Richard Gardner - Citigroup

Okay, you’re not saying that there’s been a significant increase in competitive pressure in Europe though?

Michael S. Dell

I mean, I think if I look at the situation in the second quarter, I think we’d have to say it was more self-inflicted.

Richard Gardner - Citigroup

Okay. All right, thank you.

Operator

Your next question comes from Benjamin Reitzes of Lehman Brothers.

Benjamin Reitzes - Lehman Brothers

Thank you. My questions center around cash -- I believe if my math is correct, year over year year-to-date your cash is down about 24%. I know you talked about trailing four quarters but cash flow year-to-date may be running below at least my expectations. I was wondering how big a snap-back are you guys expecting in the back half? And you bought back $1.4 billion, so does that mean that you have to borrow anymore or do you feel like you will generate it all back in the back half? And I have a follow-up, if I may.

Brian T. Gladden

I would say again, we have $3.4 billion of cash flow in the last four quarters. I would expect some improvement in the second half of the year. The cash conversion cycle dropped by about a day in the quarter and most of the impact in the quarter was really linearity around sales. We had a relatively back-end loaded second quarter in terms of shipments, so we hope to get some of that back.

We are kicking off internally a regular working capital council that will be focused on driving the key levers there for cash flow in the second half of the year and again, one of the things we are going to do as well as change the comp metrics for the company to include a cash-based metric in 2010.

So cash is a big focus and we will continue to work to improve it.

Benjamin Reitzes - Lehman Brothers

Do you still have the expectation that cash flow will equal EPS for the year?

Brian T. Gladden

We think cash will be better than net income from the year.

Benjamin Reitzes - Lehman Brothers

Okay, and then Brian, just you’ve been on board now for at least a few months and any progress on the DFS assessment and anything that you might want to talk about what you are looking at? That portfolio has close to 20% sub-prime receivables. I was wondering if there’s just any comment on whether we can expect a write-down there, given the environment?

Brian T. Gladden

We don’t expect any write-down. We feel like we are adequately reserved. We are watching it closely. We are in the midst of a strategic assessment. As we’ve said, we’ll be ready to talk about something there during the third quarter and that’s still on track.

Benjamin Reitzes - Lehman Brothers

All right. Thank you very much, Brian.

Operator

Your next question comes from Toni Sacconaghi with Sanford Bernstein.

Toni Sacconaghi - Sanford C. Bernstein

Thank you and good afternoon. I’m sorry, I’d like to revisit the EMEA and gross margin questions, if I could. On the EMEA side, the market data says EMEA PC units grew 24% in the quarter. That was the highest in the last five quarters. Dell's growth rate in revenue terms is actually the lowest in the last five quarters. That points to one or potentially some combination of two things.

On the surface, it points to a fundamentally uncompetitive operating -- a fundamentally uncompetitive offering from Dell or an increasingly uncompetitive offering from Dell given the market is getting stronger and your performance is getting weaker. Alternatively, it points to a dramatic fall-off in the month of July because the Gardner data is calendar data. Can you comment on it? But this notion that you -- I mean, you commented as though you were aggressively pricing and you tactfully did that to accelerate your growth rate but in fact the opposite happened.

Michael S. Dell

Toni, there is one possible scenario that you left out, and that is that Dell has a high share of the commercial space in Europe but a very low share of consumer. And that’s exactly what you will find was the anomaly.

In fact, we gained share in the commercial segment in Europe and we are almost infinitesimally small in consumer in Europe.

Toni Sacconaghi - Sanford C. Bernstein

But Michael, wouldn’t that have been the case for the last four quarters as well, where you were growing at a much higher rate -- that is essentially all of your business so you clearly were doing better relative to the market in the rest of Europe for the last four quarters as well. I’m not so sure why that would have been different this quarter than the last four.

Michael S. Dell

Well, if you are talking relative to the industry, I mean, our commercial units were up 20%, which all the data from IDC would suggest that that’s faster than the industry growth in commercial. The biggest difference relative to the industry is that we have a really, really small consumer business. Consumer is growing quite fast in Europe and we are not participating in it. We chose to prioritize Asia and the United States.

Toni Sacconaghi - Sanford C. Bernstein

Again, not to go tit for tat but my sense is, given your overall revenue growth didn’t accelerate and you are essentially saying it’s all commercial and your European growth rate was the lowest in five quarters, yes that still is pretty good relative to the industry per se but it’s still not as strong as it was over the last four or five quarters, despite the fact that you seemingly were really stepping on the gas in terms of pricing here. And I’m wondering if that points to something.

Michael S. Dell

And we gained share in the commercial segment.

Lynn A. Tyson

Toni, we have to go to the next question. Thanks.

Operator

Your next question comes from Bryan Alexander of Raymond James.

Bryan Alexander - Raymond James

I guess to follow-up and perhaps belabor this point, the comment that you priced aggressively ahead of cost improvements, I assume the cost improvements that you are referring to relate to product design, so were you late with the product launch and you had to ship based on previously agreed upon pricing?

And in terms of the margins improving in Europe going forward, does that happen because you are going to start to realize more significant cost declines or that you are just not going to price as aggressively as you did this quarter?

Michael S. Dell

We didn’t really have any late products. I think the going forward answer is really a combination of better pricing execution and we believe improving cost footprints on new products, and if you’ve been reading the news in the last few days, you know we are deep into product introduction season. We are introducing a large, large number of new products last week, this week, and you’ll see that continue.

Bryan Alexander - Raymond James

I guess I’m not sure -- why aren’t the cost improvements more lock-step with the revenue performance? Why we are seeing a lag between the aggressive pricing, I guess, and the cost improvements? And going forward, are they going to continue to be mismatched so that we are going to see more volatility in the model?

Michael S. Dell

Well, our goal is certainly not to mismatch them and I think I kind of reported earlier that we didn’t match them as well as we would have liked to in Europe.

Bryan Alexander - Raymond James

Okay, thanks.

Operator

Your next question comes from Keith Bachman of Bank of Montreal.

Keith Bachman - Bank of Montreal

Along the same themes, I wanted to talk about the consumer side of the business -- I was hoping first of all if you could just clarify -- when you talk about cost improvements, you’ve mentioned Europe quite a few times. Was that part of the retail business profit challenges? And then related, you had a fairly healthy step-up in the global consumer, both on a year-over-year basis -- well, certainly on a year-over-year basis and yet it stepped back into a loss mode. So why wasn’t there, based on volume variance or revenue variance in the consumer business, why was there no improvement there in terms of the profitability? And I have a quick follow-up, please.

Brian T. Gladden

You know, we grew at two times the industry, we increased our share in consumer to 9.1%, and again we are making investments and strategic pricing decisions to get into markets ahead of some of the cost that we see coming. We launched seven new products in consumer in the first half of the year. By the end of the year, we’ll have launched 24 new products, so there is a load of new product introductions coming in the second half of the year that are going to give us a better cost position and improve our competitiveness there.

We would say that the OpEx is, with the litigation expense, generally about flat with where it was, so we continue to invest in that business by getting into share position.

Keith Bachman - Bank of Montreal

Brian, I know you’ve only been there a short period of time but it sounds eerily reminiscent of some of the comments HP used to make in a previous administration. You’re talking about share gains but there’s no profit to show for it so can you just confirm that some kind of profit metrics that you anticipate the consumer business moving into a period of profitability? Because otherwise if we just have quarter after quarter of share gains without profit, it’s meaningless.

Brian T. Gladden

We’re in the consumer and the retail business to make money and generate cash flow and if we didn’t see a path to do that, we wouldn’t be in the business.

Keith Bachman - Bank of Montreal

Will you show consumer profitability in the second half of the year?

Brian T. Gladden

I think you will see over the next four quarters improving profitability.

Keith Bachman - Bank of Montreal

Okay. Thank you.

Operator

Your next question comes from Maynard Um of UBS.

Maynard Um - UBS

-- focus on your OpEx here; you’ve done a good job in the quarter but if you look, you launched a number of new desktops, notebooks, server products all in this current quarter. Is it safe to assume that we should expect more investments into the sales and marketing around these new products into this quarter and the next?

And then just related to that, as you ramp those new products which you say are better on the cost structure, will that help to offset the deferrals and the other issues and help to stabilize the gross margins over the next let’s say couple of quarters? Thanks.

Brian T. Gladden

On the second part, definitely. In terms of OpEx, we are making strategic investments and adding resources on the commercial side of the business, on product development, as we’ve taken out G&A and other OpEx costs in the business. So realigning the cost structure and focusing it more on the new products and commercial capability in the field is clearly a big part of what we are doing.

Maynard Um - UBS

Do you think those will offset each other or from an absolute dollar perspective, should we expect an increase because it’s a pretty large product launch that you’ve done?

Brian T. Gladden

I think with the magnitude of growth that we are seeing, I think you will see OpEx dollars ultimately growing and scaling with the business once we get it to the right level.

Maynard Um - UBS

Great, thanks.

Operator

Your next question comes from David Bailey of Goldman Sachs.

David Bailey - Goldman Sachs

Your comment about pricing more aggressive than was necessary sounds very familiar to what happened a year-and-a-half or so ago. What management systems are you putting in place to prevent this going forward?

And then related to that, given the need for strategic investments to drive your longer term growth, how much of the $3 billion in cost savings do you actually expect to hit the bottom line when you get there?

Brian T. Gladden

You know, we are actively managing the decisions around where we are going to grow and where we are going to invest in strategic pricing and we look at that really every week as a leadership team. Sometimes it’s difficult to judge whether you are pushing it too far. I think that’s really the only answer.

David Bailey - Goldman Sachs

And what about the $3 billion? How much of that do you expect to actually hit the bottom line?

Brian T. Gladden

Well, I mean, again we’re actively managing the process. We have clear line of sight to deliver the $3 billion. We’re making trade-offs really on a regular basis as to where the most effective place to put those dollars are. You know, we’re not going to talk about specifically where it goes but it’s got to drive improved profitability in the business ultimately by supporting growth and allowing us to be competitive in the marketplace if we don’t drop it through.

Michael S. Dell

Either it drops to the bottom line or it goes into investment that we believe drops to the bottom line later in the form of more dollars.

Brian T. Gladden

Better returns.

David Bailey - Goldman Sachs

Thank you.

Operator

Your next question comes from Chris Whitmore of Deutsche Bank.

Chris Whitmore - Deutsche Bank

Following up on the $3 billion, Brian, you mentioned you have a series of tracking tools that allows you to track progress of attaining that $3 billion and how it flows through the model. Can you give us a sense as to where you are regarding that $3 billion as a percentage of completion basis?

Brian T. Gladden

Well, I would break it into two pieces in terms of identifying and working on projects, you know, we’ve got it fully in our sights so actually frankly more than $3 billion is sort of targeted to give ourselves some cushion there. In terms of actually realizing it and bringing it through and finding ways to redeploy that benefit, it’s early in the process and again, much of it is tied to the product launches that we have coming.

Michael S. Dell

It’s very levered to new product introductions where we’ve made a much better feature value trade-off, as Brian mentioned earlier, and we believe that derives a significant portion of this.

Chris Whitmore - Deutsche Bank

Perhaps to follow-up, can you give us a sense as to the percentage of total units using the new model currently and any targets you have towards year-end in terms of percentage of units using the new manufacturing model, that would be great.

Brian T. Gladden

Well, I mean in terms of new products that have been cost-optimized, it’s a significant minority of our current portfolio and shipped product, so we’ve got a lot more to do there.

Chris Whitmore - Deutsche Bank

Do you have a target for year-end?

Brian T. Gladden

In terms of how much, what percentage?

Chris Whitmore - Deutsche Bank

Yes.

Brian T. Gladden

No, I can’t say that we do. We have that clearly laid out product by product as the launches -- I just don’t have the math in terms of what percentage it is.

Michael S. Dell

Virtually every new product introduction that you see will have to some extent gone through this process and over time, that kind of goes to 100%.

Chris Whitmore - Deutsche Bank

Maybe the easier question here is when do you expect these manufacturing driven cost savings to start to improve the gross margin and actually start to show up in the financial results?

Brian T. Gladden

I mean, again, the $3 billion commitment was really between now and 2011 and I think we continue to work through that and you will see more in the second half of this year than you saw in the first half. It’s accelerating and the momentum is good.

Chris Whitmore - Deutsche Bank

Thank you.

Operator

Your next question comes from Louis Miscioscia with Cowen.

Louis Miscioscia - Cowen & Company

Michael, you said that the European situation from a margin perspective can get fixed right away and I think if we look back to fiscal ’07, you actually also had a quarter where European profitability dropped off very dramatically and then bounced back rather quickly. It bounced back I believe $150 million quarter to quarter. Do you think that that is possible here?

Michael S. Dell

Well, to be clear, I’m referring to pricing changes and kind of let’s say overly aggressive pricing. I think that’s something that we can fix rather rapidly.

As far as what’s the improvement going to be quarter to quarter, I’m not going to give you a forecast.

Louis Miscioscia - Cowen & Company

Okay. One other quick follow-up question on your comment about demand out there, you know, it has obviously been a couple of quarters where you’ve been talking about a weak tech demand environment and your printed numbers actually look okay, so would you be able to make a prediction as to whether your comments are obviously going to hurt either revenue or pricing, or is it just trying to set the stage and you would expect obviously revenue and at least margins in other areas beside Europe to obviously be holding up?

Michael S. Dell

Well, our belief is that we’ve been growing faster than the industry for a couple of quarters now. We believe that will continue. Of course, a fair question is what is the industry growth going to be? A lot of moving parts there and we don’t quite frankly know. We have a good sense for what our demand picture is and all of the indications we have tell us with the products we have and the efforts we are putting forth, we’ll continue to grow faster than the industry.

Louis Miscioscia - Cowen & Company

Okay. Thank you.

Operator

Your next question comes from Jayson Noland with Robert Baird.

Jayson Noland - Robert W. Baird

Thank you. Just to change gears here a little bit, could you give us a general update on progress with resellers? And then maybe specifically talk a little bit about EDS, if you can give us a feel for the percent of business you do with EDS and if that’s at risk now?

Michael S. Dell

The partner business is running at about a $12 billion annual run-rate. We’ve got about 23,000 partners in the Americas and about 43,000 globally. We’ve got partner direct -- the partner program running basically all across the world now and it’s a compelling program. It’s easy for these partners to sign up. They take advantage of our build-to-order capabilities. They are taking advantage of our services. We are seeing a healthy mix of products with these customers. They tend to sell our enterprise products and so that’s going pretty well.

EDS is a small portion of our business. It’s not material on an annual basis and we certainly believe that there are a number of EDS competitors where we are strengthening our relationship. We’ve already seen some of that and also the customers where Dell and EDS have engaged in the past. It’s our belief that in many of those cases, the customer is quite committed to Dell product architecture and we don’t see those accounts as all flipping over, if you will.

Jayson Noland - Robert W. Baird

Thank you.

Operator

Your next question comes from Jeff Fidacaro with Merrill Lynch.

Jeff Fidacaro - Merrill Lynch

Good afternoon. I was wondering if I could just touch back on the OpEx side -- when you look at your customer-facing employee growth, I believe you talked about it going from 54% to about 62% of the mix, and yet the -- what’s left on the headcount reduction target is 1,500 this quarter and you’re going to reach 8,900 next quarter. Where we do stand here as far as expansion into new markets and where do you have to sort of increase that headcount as far as resources on the customer facing side? Or is there more headcount reduction to come post the 8,900 person target?

Brian T. Gladden

I would say during the course of the headcount reductions we’ve done over the last six quarters, we’ve been adding resources in terms of that customer-facing capability in emerging countries and in new products lines, supporting our enterprise growth, supporting the services business. So we’ve been making that trade-off and reducing the customer-facing -- or improving our customer-facing mix during that period of time.

We’ll continue to look at the scaling and our mix of resources going forward. There will be a continued focus of adding front-line growth oriented resources while we continue to look at our G&A structure.

Jeff Fidacaro - Merrill Lynch

Great. Thank you.

Operator

Your next question comes from William Fearnley with FTN Midwest.

William Fearnley - FTN Midwest

-- if I could to the gross margin, any effect on gross margins here from less of an upselling opportunity as you move to a more direct and indirect model, and as you move towards more fixed and standardized SKUs and share some of the up-sell opportunity with the channel, does that have any effect here on margins either this quarter, on the near-term as you share the up-sell opportunity with partners?

Michael S. Dell

Well, on the VAR channel, we’ve actually seen pretty good partnership on services and they tend to take a richer mix of products with enterprise products, so on an operating income basis, that’s a healthy business for us.

On retail, that’s a different story and really lots going on on the product side to engineer products that allow us to improve the overall portfolio of profitability of consumer.

William Fearnley - FTN Midwest

And a quick follow-up, if I could -- when you look at the direct and indirect mix, you keep talking about investments worldwide and improving momentum there. How should we be thinking about the indirect/direct sales mix here from a channel perspective? Should we see any dramatic changes here in the next year, year-and-a-half here? Or do you just see the channel becoming a gradual part of your business, or do you see big moves in percentage of business going through the channel overall? Thanks.

Michael S. Dell

If it’s op income neutral and we can expand our footprint rapidly, then we’re sort of [indifferent] on the commercial side and so we are watching that very carefully to make sure that the P&L stays healthy. But we are seeing pretty good acceptance from these VAR partners and it’s growing nicely for us.

Operator

Your next question comes from Clay Sumner with FBR.

Clay Sumner - Friedman, Billings, Ramsey & Co.

I want to return to the gross margin and look at it from a sequential basis from the April quarter. Overall revenue was higher sequentially. Revenue was higher in every category except for notebooks, where it was essentially flat. ASPs sequentially appear to have been flat to up for both desktops and notebooks, and global consumer business sequentially was actually down in the mix from 18.3 to 16.9. So I’m still trying to understand -- it was the pricing, the aggressive pricing you are talking about, was that restricted to services pricing in EMEA? Is that the issue?

Brian T. Gladden

No, the pricing impact in Europe was really -- a lot of it frankly was in the notebook business and on the client side of the business. That’s the major driver, obviously other than this increase in EMEA service revenue deferral. Those would be the two major drivers.

Clay Sumner - Friedman, Billings, Ramsey & Co.

But sequentially speaking, were notebook ASPs down?

Brian T. Gladden

Yes, sequentially notebook ASPs were down. I’m not sure where you got the fact that they weren’t.

Clay Sumner - Friedman, Billings, Ramsey & Co.

Okay, thanks. I’ll go back and look at that.

Operator

Your next question comes from Mark Moskowitz with J.P. Morgan.

Mark Moskowitz - J.P. Morgan

A question on inventories -- you had a prolonged up-swing, as I presume the inventory uplift has been related to your indirect channel build and this quarter you did have a down-tick. Can you talk about what happened there? Are you losing momentum in the indirect channel build or a better management style?

Brian T. Gladden

No, the indirect channel build is a small piece of the inventory balance. The major driver quarter on quarter in inventory reduction was a specific decision to reduce our strategic [volume] where it made more sense for us to do that.

Mark Moskowitz - J.P. Morgan

And then lastly on storage, can you talk a little more about the storage business in terms of the puts and takes behind the growth? Do you expect any sort of reacceleration as the mid-range product line was refreshed earlier this summer?

Brian T. Gladden

Storage had a great quarter. There was some portfolio balancing toward the higher margin products. You know, power vault was up quite strongly, with power vault disc growing very, very strong. Equal logic grew year over year more than 150% and operating income levels at storage were at kind of record levels. So we’re seeing strong growth in that business and investing heavily in it.

Mark Moskowitz - J.P. Morgan

Thank you.

Operator

We’ll now take our final question from Shannon Cross of Cross Research.

Shannon Cross - Cross Research

Thank you. Got in under the wire -- a question for you on R&D levels. You’ve obviously has several new products that you’ve launched. I’m just kind of curious as we’ve seen it tick up what we should think about in terms of R&D on a going forward basis.

And I’ll just throw this follow-up question in before you cut me off, because I know you guys want to be done here -- the compensation you had mentioned changed to cash, Brian -- if you could just give us a little more color on that. Thanks.

Brian T. Gladden

In terms of R&D, again we continue to try and optimize the OpEx for the company and clearly that’s one of the places we want to be able to invest to support the growth of the portfolio, to support the product development activities around cost out, so those are -- in the context of OpEx, that’s what we’ll try and do is be able to fund that by cutting in other places.

What was the second question?

Shannon Cross - Cross Research

The second question was just you had mentioned something during the cash flow commentary about compensation changed to cash by 2010. I may have missed exactly what you said there but I didn’t know if there was some change in compensation or something we should be thinking about from a cash flow standpoint.

Brian T. Gladden

One of the things we are working with the board on is implementing a portion of the executive compensation and bonus plans for the company to be tied to our cash flow performance.

Shannon Cross - Cross Research

Got it.

Michael S. Dell

We had actually announced that at our shareholders meeting.

Shannon Cross - Cross Research

Right, right, okay. I misunderstood. Okay, thanks.

Michael S. Dell

Okay, so I want to leave you with a few thoughts -- we are focused on executing our strategy and improving our competitiveness with our sights firmly set on improving profitability over time. We have reignited growth in this business and expect more to come in the second half of the year. We are expanding our solutions portfolio tailored to customer needs and we expect this trend to continue. And we will continue to deliver business and financial results that deliver intrinsic value back to our shareholders.

Thank you very much and we look forward to seeing you again soon.

Operator

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

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