Much to Be Thankful for at Dell

A better-than-expected third quarter earns Dell CEO Kevin Rollins some needed goodwill on Wall Street
by Louise Lee

In its first upbeat financial news in more than a year, Dell reported better-than-expected earnings for the third quarter, raising hopes that the PC maker may finally be finding its way out of a prolonged slump.

Some analysts said the results, which propelled Dell (DELL) shares up 8.6% in extended trading on Nov. 21, will buy more time and goodwill for company Chief Executive Kevin Rollins, who has faced heightened pressure to turn the company around.

Before the earnings release, Round Rock (Tex.)-based Dell had missed key financial targets in four of the previous five quarters. Although Chairman and founder Michael Dell has publicly stated his support for Rollins, analysts have been openly speculating whether Rollins, who has been CEO since mid-2004, may be pushed aside in light of Dell's recent performance and a sagging share price that's lost 12% of its value this year. According to industry sources, Dell has begun an effort to refresh the company's top management ranks (see BusinessWeek.com, 11/6/06 "Dell's Executive Search").

The world's second-largest PC maker didn't hold a conference call with analysts as it usually does when it announces earnings. But it appears to be concentrating on bolstering profitability instead of mainly increasing unit volumes, as it has done in recent quarters to try to boost market share.

Improving Margins, But How?
The company surprised analysts and investors with a jump in gross margin, which in the quarter ended Nov. 3 reached 17%, up from 16.2% a year ago and 15.5% in the previous quarter. Operating margin, another yardstick of profitability, was 5.7%—better than the 4.6% that some analysts were expecting. Analysts say that emphasizing profitability is the right move for Dell. "No one was expecting improvements of this magnitude," says Brent Bracelin, analyst at Pacific Crest Securities. "In terms of profitability, the worst of the company's troubles may be behind it."

Dell disclosed little specific information about just how it achieved those margin improvements. In a press release, the company said it "achieved a better balance of liquidity, profitability, and growth, which was driven by an improved mix of products worldwide." It cited increases in shipments of laptop computers and server and storage products. But it "said the same things in previous quarters," notes Shaw Wu, analyst at American Technology Research.

The company didn't disclose other details, such as the average selling price for its machines, or break out spending figures on research and general expenses, as it has done in the past. Dell also said that "in the near term, improvement in growth and profitability may not be linear due to a variety of factors, including the timing of continued investments" in customer service and new products. Translation: Margins and profitability increases might not be as strong in coming quarters because of increased spending, says Wu.

Rethinking Strategy
For the quarter, Dell posted revenue of $14.38 billion, up just 3.3% from a year ago. Net income rose 11.7%, to $677 million.

Dell's rate of sales growth is well below the year-ago level, when it posted an 11% increase. Evidence of slowing growth has made some investors and analysts wonder whether Dell needs to rethink its well-established "Dell way," which hinges on low-cost manufacturing and direct sales through an in-house sales force and over the phone and Internet.

Dell delayed a scheduled Nov. 16 results announcement, citing an ongoing Securities & Exchange Commission investigation. The probe, which has become formal after being an informal inquiry, centers on "certain accounting and financial reporting matters, including the possibility of misstatements in prior-period financial reports," Dell said, adding that results in its press releases "are subject to change to reflect any necessary corrections or adjustment."

For the moment, upbeat investors are "refocusing their attention forward to 2007 and 2008," when many business customers may be due for upgrading computer equipment to Dell's benefit, said analyst Bracelin. But if the company restates numbers substantially or reverts to the disappointing performance of recent quarters, shareholders may refocus attention once again, this time on selling Dell shares.

Lee is a correspondent in BusinessWeek's Silicon Valley bureau