Dell, which has been trying to diversify its business to be less dependent on PC sales, reported a 11% y-o-y drop in net revenues for Q3 as revenues came in at $1.37 billion. The weak PC market was blamed for the 47% y-o-y drop in net income, reported at $475 million.
Spending on PC’s was low on both the consumer and enterprise front with the consumer PC sales declining 23% y-o-y to $2.5 billion and enterprise sales declining 8% to $4.2 billion. Dell, which is now concentrating on mid and high-end PCs, experienced the brunt of this downturn as weak macro-economic conditions have users, especially in the emerging markets, shift to low end PCs – a segment that Dell is steering clear of. The Q3 results are lower than expected and the market has punished the stock, sending it lower by nearly 7% to $8.9
Dell’s enterprise solutions revenue rose 3% to $4.8 billion while servers and networking revenue climbed 11% y-o-y to $2.3 billion. Storage products revenue dropped 16% y-o-y to $386 million and software and peripherals revenue fell 11 y-o-y t0 $2.25 billion%. The drop in PC sales is expected to be helped by the Windows 8 release in the current quarter, and the company issued a 2%-5% y-o-y growth in revenue for Q4 and says it is still on track to hit the minimum EPS guidance of $1.70.
The company’s decision to steer clear of low-end PC’s, has led to loss in market share in terms of units sold to players like Lenovo and Acer Group. This is not entirely bad news as it is likely to improve margins in the long terms and make its business less sensitive to the slowing PC market and allow it to concentrate on the more lucrative services business.
Changing Business Model And Weak PC Sales Leading To Short Term Pain
Dell’s decision to focus on mid and high-end consumer products may help margins in the long run, but it is currently losing market share in terms of units to players such as Lenovo and Acer Group. This business is likely to pick up on the strength of hybrid tablet-notebooks and Ultrabooks in the long term, but the company will show slow PC sale growth in the short term. According to Gartner, Dell owns about 10% of the PC market as of Q3, down nearly 14% y-o-y from 11.2% same time last year.
Some of the business model changes are already paying off with the servers and networking business doing well in this quarter. According to our analysis, PC hardware now constitutes nearly 27% percent of its value, while services accounts for nearly 26% of its value. We expect the acquisitions made in the services space to be the main revenue drivers for Dell in the long term.
Changes To Our Model
Our valuation is contingent of its performance in the services business and is based on the long term potential of its high margin businesses. We detailed our previous analysis here, but based on the current quarter filings, we update some revenue and cost drivers below.
1) Updated PC Market Share
According to the Dell’s historical PC share report, its market share in the desktop PC space has fallen from 13% to 12% currently and the portable PC market share has stayed flat at 10%. We have updated our analysis to reflect these numbers. The overall PC market shrunk 8% y-o-y as well. We expect the PC market share to remain at these lower levels as the company will not go after low margin- high volume PC’s and will continue to concentrate on mid and high-end PC’s. We expect the long term market share to fall to 5% for the desktop and notebook business.
2) Downside From Previous Estimate Driven by Increasing SG&A Expenses
Dell has entered into a whole slew of businesses via acquisitions. Dell is targeting $5 billion in software sales in coming years and it plans to achieve this by targeting key areas such as network security, cloud storage, systems management, business analytics, virtualization and thin client systems. The company expects security and systems management to be a billion dollar business in the next few years. Efforts to build up these businesses is likely to lead to increasing costs and according to the three quarter run-rate, SG&A expenses have increased nearly 10% on a y-o-y basis, and we currently estimate it to be around 15% of revenues. This is the most significant change for Dell’s cost drivers and is primarily responsible for the lowered valuation.
3) Dell Services Business Growing Slower Than Expected
The services business is a high margin business with margins nearly twice that of the product business. We estimate that the services business margin is about 34% and is potentially a high growth business as well. The business however shrunk by 1% this quarter and this has led to a lowered growth estimate in the short term.
4) Lower PC, Desktop and Server Gross Margins
We estimate that the gross margins will drop to 18% by the end of the forecast period from its current level of 21% due to increasing commoditization of the hardware business.
We currently have a $12.12 Trefis price estimate for Dell, which is nearly 50% above the current market price.
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