Friday, August 18, 2006

Color on quarter: Dell Computer (DELL)

- Dell Computer (NASDAQ:DELL) threw investors yet another curveball last night announcing weak results (in-line with pre-announce) & an informal SEC investigation related to how it books revenue and other accounting matters. Stock took a 5% hit in after hours trading. I think there are two firms out with notes that describe the the Dell situation - one in long-term and one from trading perspective. Guess which is which!

* Merrill Lynch notes Dell reported in line with its negative preannouncement. The business is decelerating and incremental margins are step-function negative.

Key questions are: 1) When will the top line stabilize? 2) How does a company with historically modest operating leverage miss earnings by 30%+ on a mere 2% top line miss? 3) Are the forces causing margin deterioration reversible over a predictable timeframe? Firm notes they'd need more conviction in 1 and 3 to get excited.

Although management wouldn't talk about it, they suspect a cut in development funds from Intel to Dell explains a large chunk of the margin miss. Management also blamed aggressive pricing and said it would ease a bit going forward, though competitors didn't seem to notice much change in the first place. Weak demand in corporate PCs, better execution from competitors, less than expected component cost declines, and rising opex from Dell's efforts to fix customer service all combined for a margin squeeze in the quarter. Hard to reconcile alternating stance on elasticity Management's commentary on pricing has tended to alternate by quarter between an intention to get more and then less aggressive and seemingly back and forth again. All the while the goal of optimizing elasticity appears elusive and the common theme has been decelerating growth. This reinforces firm's view that pricing is neither the diagnosis nor the cure for Dell's difficulties. Instead, they believe the challenges are structural. See no need to rush into the stock Firm's margin and growth matrix suggests a margin snapback is needed to make the argument for owning the stock. They're not convinced. Neutral.

* Deutsche Bank notes Dell announced a highly-anticipated expanded relationship with AMD for desktop systems. More unexpected was an informal SEC investigation into Dell's revenue recognition, and that Dell's internal investigation has uncovered issues related to certain past periods (pre-FY06). Firm has raised their FY07 EPS to $1.05 from $1.00, and raised price target to $25 from $24.

Management cited slower ASP declines in components as putting a squeeze on margins this quarter, although when questioned would not give specifics. Despite significant price declines in processors (market pricing), they believe Dell suffered from fewer marketing dollars from Intel, which likely hurt results Q/Q. Perhaps not coincidentally, Dell announced an expanded relationship with AMD and will use AMD processors in its Dimension desktops starting in September.

Dell also announced that it received a notice in August 2005 from the SEC indicating an informal investigation into Dell's revenue recognition and other accounting and financial reporting matters for certain past periods. While responding to the request, which was made a year ago, Dell discovered information that raises potential issues around certain prior periods (pre FY06). Dell does not believe these issues will have a material impact on its financial position.

So what's really going on? Deutsche believes Dell saw the brunt of a transition of volume from Intel to AMD this quarter, and may feel the effects of this in the coming quarter. Although management would not comment on its relationship with Intel, they believe Dell likely lost significant "co-marketing" dollars from Intel this quarter, either as a result of Dell's decision to start using AMD processors or resulting from AMD's lawsuit against Intel. Firm believes the net effect was higher components costs for Dell on processors Q/Q, despite ASP declines in the larger market. Over the next quarter or two, they believe Dell could see a lingering impact from this transition, but that over the long term, Dell will benefit from the inclusion of AMD in its product line up. In addition, this move allows Dell to enter the AMD based PC and server markets, which to a large extent, have been dominated by HP. This move could create pressure on HP's PC margins as the firm believes it earns significantly higher margins on AMD based systems then Intel based systems (less competition).

Deutsche thinks the product transition issues around Intel/AMD will work themselves through and they expect Dell to try to offset higher overall processor costs in F2H07 through cost reductions in components, structural material and warranty costs. With the shares currently trading at 16x CY07 EPS x-cash, they believe the risk/reward is weighted to the upside, with most of the negative news factored into Dell's share price. Continues to view Dell as the best way to play a Vista-driven corporate upgrade cycle.

Notablecalls: Both firms make a good point. While I feel Merrill is right about the secular changes taking place in the industry, I feel Deutsche is pushing the right short-term trading buttons. One for the brave - buy DELL for a bounce today.

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