The Real Problem With Dell's Earnings Miss

| About: Dell Inc. (DELL)
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Lost in the coverage of Tuesday's first-quarter earnings miss at Dell (DELL) was just how rare - and how incredible - a one-day, 17% drop is for a mature company with trailing annual revenue over $60 billion. Rival Hewlett-Packard (NYSE:HPQ) pulled off a similar trick last August, dropping 20%. But Hewlett-Packard was killing off an entire product line (its webOS hardware) and spinning off its legacy PC business, two moves that shattered confidence in then-CEO Leo Apotheker (indeed, Apotheker was fired within days and both decisions were eventually reversed).

At first glance, Dell's bad news hardly seemed to compare with the August bloodbath at Hewlett-Packard. All Dell did was miss estimates and acknowledge tremendous competitive pressures for both IT spending as a whole and its products (notebooks in particular). Of course, there was more to it than that. Not only did revenue and profits both fall, but the company's reported trends -- such as the impact of tablets on notebook sales and a clear struggle in its enterprise business -- looked bleak. Confidence was not helped by the performance of its rivals; Hewlett-Packard beat estimates on Wednesday and jumped 9% in after-hours trading. The same day, Lenovo Group (OTCPK:LNVGY), which has surpassed Dell as the No. 2 PC vendor in the world, announced a record-setting fiscal 2012 with sales up 37% year over year. As such, Dell management's complaints on the conference call about spending being "delayed" and "channel inventory rebuilding" following the Thailand floods rang hollow, given that its competitors seem to be adjusting far better than Dell is.

That said, do this week's results really change the thesis for Dell? A 17% drop represents some $4.5 billion in market capitalization -- a staggering sum. Much of the coverage surrounding Dell's miss focused on its consumer PC and notebook businesses, and the company's admission that it was losing notebook sales to the iPad from Apple (NASDAQ:AAPL); as CFO Brian Gladden put it on the call, "We're seeing more consumer IT spending diverted to alternative mobile computing devices." And, indeed, the consumer segment was weak; revenue fell 12% and operating margin fell 380 basis points, according to the company's earnings presentation [pdf].

But this should not have been a major surprise, nor a major driver of the stock's fall. First, Dell has - as it has emphasized previously - lowered its focus on lower-priced, lower-margin sales, both in enterprise and, in particular, in the consumer segment. (Gladden noted pricing pressure in the low-end notebook segment from "Asian manufacturers," which is buttressed by Lenovo's year-over-year revenue growth.) Second, as I argued last month, the consumer PC business is nearly irrelevant to Dell's current cash flow (operating income from the segment was less than 7% of the company's total in 2011). Nor is there any evidence that the segment will show even moderate growth in the future.

Rather, the future of Dell is in its transition to becoming a full-service provider of enterprise-wide solutions and services, while cherry-picking profitable business in its legacy PC and notebook product lines. It was the disappointment in the performance of the enterprise segments that truly led to Dell's sharp drop. The Servers & Networking segment showed double-digit year-over-year revenue growth through the first three quarters of fiscal 2012; growth slowed to 6% in the disappointing fourth quarter and a paltry 2% in the April quarter. Services revenue showed 10% and 12% growth in the third and fourth quarters, respectively; its growth fell to 4% last quarter. Software and Peripherals sales fell 7% year over year (another decline chalked up to "pruning" lower-margin product lines). Only Dell-owned Storage products -- the legacy of Dell's 2010 acquisition of Compellent -- showed promise, with growth up 24% year over year.

These segments represent Dell's future. Yes, Windows 8 and the ultrabook may provide a short-term boost for revenue for hardware products; CEO Michael Dell confirmed that his company will produce a Windows 8 tablet later this year. But, in the long term, Dell stock will only be a worthwhile investment if the company can successfully transition to being a full-service provider of enterprise solutions rather than a manufacturer of increasingly lower-margin hardware. This quarter's results cast some unwelcome doubt on Dell's ability to reinvent itself.

All that said, the stock's drop seems far overdone. While disappointed in the results, CFO Gladden noted that the company had done of poor job of staffing and utilizing its sales force, leading to missed opportunities. This is not a perfect excuse, but it does tend to happen when a company hires a few thousand new sales people, as Dell has done over the last two years. As Gladden pleaded at the beginning of his opening statement: "There were some areas where our execution was not as expected ... we want to acknowledge that our progress will not always be linear."

At Wednesday's close of $12.49, Dell is, as several analysts noted, trading at levels not seen since the 2008-09 stock market collapse. With about $4 per share in cash net of debt (and the bill for its acquisition of SonicWALL, which closed in Q2) and trailing free cash flow of $4.9 billion, investors should remain patient with Dell. Even after a terrible quarter, its trailing free cash flow is about 27% of its enterprise value. At those levels, Dell doesn't need explosive growth or a substantial rebound in IT spending. It simply needs to execute -- something it clearly did not do in the first quarter.

If Dell can execute in the long run, and if this quarter is just a bump in the road, the stock remains drastically undervalued. Enterprise solutions and services accounted for 31% of revenue in the quarter -- but 50% of margin, even while underperforming. With storage growing strongly, a rebound in servers and networking could have a real effect on those numbers going forward, improving the bottom line even without overall top-line growth.

And if Dell doesn't execute, it's hard to see the stock going too much lower. It is still a markedly profitable company; it retains about $7 billion in net cash (vs. a $22 billion market cap), and at its recent pace will generate its $15 billion enterprise value in free cash in four to five years. The stock has been stagnant and this quarter frustrating. But for patient investors, the risk/reward profile for Dell is still strongly in their favor.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.