Good Not Good Enough at Dell

The company beats on revenue, meets on earnings, and the stock falls.
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Investors voted with their feet after

Dell

(DELL) - Get Report

failed to do anythingbut match earnings expectations in its just-completed first quarter.

The stock -- one of the few major technology issues still in the green for 2004 -- was recently down $1.13, or 3.2%, to $34.67 on the Instinet premarket session. Dell was downgraded to sector perform from outperform Friday by CIBC, which cited margin pressures created by price cuts by large competitors.

CIBC analyst Ali Irani wrote that while Dell's execution in the areas of profit growth, share gains, and entry into new businesses remains solid, factorsbeyond its control are putting pressure on margins. Not only have the prices of components like computer memory and flat panel displays proven surprisinglystrong, but rivals like

Hewlett-Packard

(HPQ) - Get Report

and

IBM

(IBM) - Get Report

have restructured over the past couple of years and become capable of competing against Dell at ultra-low profitlevels.

The combination has led to what Irani calls "a steady erosion in gross margins," from a peak of 18.3% in April 2003 to 18% in the just-reported quarter. Though the slippage is small, the downtrend is especially disappointing given Dell's sharp gains in unit volumes and revenue, he said.

In Irani's view, Dell doesn't deserve to trade at more than a 50% premium to the price to earnings multiple of the

S&P 500

. "In fact, better revenues have been entirely offset by lower margins, and more recently, earnings expectations have required further support from accelerated share buybacks," he wrote in a downgrade note. "We expect Dell shares to prove dead in the water through at least the summer, within a tight range (perhaps $30 to $40). The shares should be supported by low-risk in earnings on one hand, but tempered by lack of enthusiasm for margins on the other." His firm has no investment banking business with Dell.

But other analysts proved more forgiving. At First Albany, Joel Wagonfeld predicted Dell will be able to handle higher component costs better than its peers. "Dell's ability to offset those forces and drive profitable top-line growth via share gains and market expansion should enable it to maintain a multiple premium relative to its peers," he concluded. He maintained a buy rating on the shares; his firm has no investment banking business with Dell.

The computer hardware maker beat the Wall Street revenue forecasts in the April quarter but posted earnings in line with expectations, its expense side swollen by higher prices for memory chips.

Kicking off the first quarter of fiscal year 2005, the company posted $11.54 billion in revenue. That was up 21% from a year ago and above the consensus estimate for $11.4 billion. Dell

raised its guidance by $200 million, to $11.4 billion, in early April. Net income grew 22% to $731 million, or 28 cents a share. The profit performance disappointed many analysts, who had speculated the company could squeak in a penny of upside.

Management said on the conference call that the price of components, such as dynamic random access memory (or DRAM) chips, stabilized after falling for the first two months of the quarter, which precluded Dell from wringing out an extra cent of earnings.

"Probably in the month of April there were no net cost declines

in components when we planned on there being some," said Chief Financial Officer Jim Schneider, who added that the company "would've had a good shot" at a penny of EPS upside if that hadn't happened.

At Pacific Crest Securities, analyst Brent Bracelin called reaction to the results "a minor setback," adding that "Dell continues to be one of the few companies growing in excess of 20% year over year." He has a buy rating on Dell; his firm doesn't do any investment banking business for the company.

Bracelin noted a few disappointments in the postclose report. Dell's gross margin checked in at 17.9%, below his expectation for 18.15% (Bracelin started the quarter with a forecast of 18.3%, which he reduced slightly after the company's midquarter update.)

Though Dell attributed the slight shortfall to stronger-than-expected DRAM pricing, Bracelin said he believes robust sales in software and peripherals may have played a role. Revenue from software and peripheral products rose 39%, partly due to strong demand for Dell printers.

Dell said it now claims 10% share in inkjet printers and has share in the upper teens in all-in-one printers, both areas in which the company has sought to make inroads against

Hewlett-Packard

(HPQ) - Get Report

.

"That

software and peripherals business came in about $150 million above my estimates, so that much upside in a lower-margin business is going to impact margins," said Bracelin.

Another factor that may have slightly weighed on Dell's margins is North American servers and storage sales not having grown as fast as they had in the last quarter. Operating margins in Dell's North American business checked in at 9.8%, down from 10.6% in the prior quarter, he noted.

Dell also reported after market close that first-quarter shipments of notebook computers rose 39%, which the company said was 12 points above category shipments for the rest of the industry. Desktop computer volumes increased 21%, more than double the industry average.

Dell said it generated $1 billion in cash from operations in the quarter.

For the fiscal second quarter now under way, Dell expects revenue of $11.7 billion, reflecting 20% year-over-year growth, and earnings of 29 cents. Its guidance is higher than the consensus estimate of $11.6 billion but in line with the outlook for 29 cents EPS.

Dell expects to spend at least $700 million to buy back stock in the quarter, down from $1.1 billion in the first quarter. Continued stock repurchases and lower options grants will combine to reduce the company's shares outstanding, management said.