Dell: Don’t Mind the Margins

Dell (DELL) reported fiscal first quarter results on Thursday afternoon, and instead of recognizing the strengthening fundamentals, the market has send shares lower because of margin concerns.  Shares are down more than 5% as of the time of writing because gross margins were underwhelming at 17.6%, meanwhile the Street had been expecting anywhere from 17.7% to 17.9%.  We share disappointment at the slightly lower than expected margins, but we believe the rest of the quarter was far more impressive and more than cancels out the margin squeeze.

Sales of $14.87 billion were 21% higher than last year, and an impressive $600 million beat from consensus Wall Street estimates.  Adjusted earnings per share were 30 cents also beating analysts’ estimates by 3 cents or 11%.  Dell credited “the early stages of a corporate IT refresh” for the strong performance, and they expect to continue to benefit from this trend throughout the remainder of the year.  Furthermore, services revenue grew, particularly among public sector clients which increased sales 22%.  This is an important sector as it represents higher margin sales than their hardware products, and it suggests the company is seeing the benefits of its recent acquisition of Perot Systems.  In contrast, the consumer division currently about one-third of sales generates operation margin of only about half a percent, as computer and netbook prices continue to slide.  Dell is working to as much as quadruple those margins through wider distribution of higher end units such as that of its Alienware gaming PCs.

All other things being equal, of course we would like to have seen better margins, but we are not distressed by the slight miss because Dell is in the midst of evolving its business model into a more diversified technology company more akin to Hewlett-Packard (HPQ).  Dell has consciously backed away from the consumer market, ceding its number one market share to HP and also behind Acer in terms of unit sales.  As the services and higher end hardware (servers, etc) sales become a bigger portion of revenue, margin will grow.  They have already grown dramatically from the mid-single digits where gross margin lived for the better part of the last decade.

We recently downgraded Dell to Fairly Valued as the stock’s price reached more than $17 per share.  Since that time, the stock has fallen nearly 22% or roughly twice the amount of the iShares technology sector ETF (IYW), and Dell is starting to look more attractive in comparison.  The valuation picture has improved to the point that we may consider an upgrade in the coming weeks.  The market has historically awarded Dell price-to-cash earnings of 15.5x to 27.4x, but based on current estimates for this year Dell trades at just 11x.  That valuation multiple only becomes more attractive when you extract the more than $5 per share in cash and cash equivalents on their balance sheet.  Furthermore, with sales expected to come in just under $60 billion for this fiscal year, the current price-to-sales .44x is well below the historical range of .78x to 1.32x.

The market is punishing Dell for a slight miss on gross margin, but we think that provides an opportunity to buy a growing technology company for well below historically normal valuations.  We expect Dell will continue to utilize their cash stockpile for both buybacks and possibly mergers and acquisitions.  Dell management said that they will continue to be “acquisitive” as the continue to transform and diversify their business model to more profitable ventures.  We think investors should be patient because margins will continue to improve as services and other high margin businesses expand, potentially through acquisitions.

Read the original story at Ockham Research