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Why Dell Needs Drastic Action

Updated from 11:06 a.m. EST to provide additional analyst comments in the second and fifth paragraphs, and updated share price.

NEW YORK ( TheStreet) - Dell (DELL) is set to report earnings after the close on Tuesday, with analysts warning that it needs something drastic to convince investors of its growth credentials.

In a recent research report, Credit Suisse analyst Kulbinder Garcha suggests the company needs a "transformational acquisition," adding that the company needs to transform its profile with investors and drastically change the scope of the business. He notes that management has acknowledged this, but it could prove costly should it choose to take this route.

In 2010, for example, Dell lost out to arch-rival HP (HPQ - Get Report) in a high-profile battle for storage specialist 3Par.

The Round Rock, Texas-based tech titan has tried to transition itself away from being primarily a PC-centric company, pushing towards higher-margin offerings such as services. Analysts, however, warn that Dell's transition is not going as fast as planned, adding that gross margins may become an issue this quarter.

Sterne Agee analyst Shaw Wu said Dell is seeing companies like Apple (AAPL) gain market share in personal computing. It is also impacted on the lower end by Lenovo and Acer. "We view Dell as a company in transition that needs to take more aggressive steps," Wu wrote in his note. He downgraded shares to underperform with a $15 price target.

Sanford Bernstein analyst Toni Sacconaghi notes that the PC industry is challenged, adding that Dell is likely to report "tepid" revenue growth on Tuesday. "Many investors believe that we are entering a post-PC era, with PC growth likely to be anemic or negative going forward. Against this backdrop, many investors believe that Dell is unlikely grow revenues above or even at consensus's forecast of 1-2% for each of the next two years," Sacconaghi wrote in a research report. He rates shares outperform with a $21.50 price target.

Other analysts question whether the company can keep its gross margins at current levels. Dell's gross margins are currently in the 22% to 23% range, well above their historical level of around 19%. "Management has shifted the company's focus to profit maximization, which is driving EBIT upside against mediocre revenue performance," wrote Baird Equity Research analyst Jayson Noland in a recent research report. Noland recently downgraded shares to neutral, citing a possible headwind from weakness in the public sector, which accounts for about 28% of Dell's revenue.

Credit Suisse's Garcha also believes Dell's operating margins will move lower, as gross margins have likely peaked. "We acknowledge that Dell sees some top line challenges and the company's strategy is clearly to promote and develop its ESS [Enterprise Storage and Server] offerings (currently 29% of revenues), a mix shift away from PCs toward higher margin servers and networking, storage and services alone will not drive sizeable margin expansion over time," Garcha wrote. He rates shares underperform with a $16 price target.

Analysts polled by Thomson Reuters expect Dell to report earnings of 52 cents per share on $15.96 billion in revenue. Dell competitor HP is also reporting earnings later this week, with some analysts eyeing the tech bellwether as a turnaround stock.

Shares of Dell are up 24.46% year-to-date, besting the 13.3% return over the same time as the Nasdaq.

Dell shares are up modestly on Tuesday, rising 0.43% to $18.24.

Interested in more on Dell? See TheStreet Ratings' report card for this stock.

Check out our new tech blog, Tech Trends.

-- Written by Chris Ciaccia in New York

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