Margins on the Verge of a Nervous Breakdown
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If you should find yourself running with the bulls in Pamplona, Spain, any July in the near future, you would do well to have a pre-determined strategy when rounding corners. The bulls thunder down the ancient cobblestone streets, enraged and indiscriminate, chasing a horde of adventurous Spaniards clad in traditional white linen and blood red waist-sashes and neckerchiefs. The thousand-pound bulls take corners wide. You should do the opposite.
Sometimes a corporation finds itself at a significant juncture in which a small set of actions can mean the difference between prosperity and long-term irrelevance. Missteps may result in a fate worse than trampling: that of market bulls running away from the company's shares, never to return. Dell (NASDAQ: DELL) finds itself at such a crossroads, contemplating its most important decisions in years, which revolve around future margins.
Below is a line chart, by quarter, of Dell's revenue growth since its initial public offering in 1988. In that year, Dell averaged roughly $40 million in revenue per quarter. Recently, Dell has averaged over $15 billion in revenue per quarter.
DELL revenue data by YCharts
Notice the ghost of your high school math textbook in the lovely exponential curve from 1988 to the early 2000s. In the 1990s, Dell made customized computers for consumers and made more than a few fortunes for investors. During the time frame of this chart, one would assume that operating margin and profit margins would have gradually increased, if incrementally. Here's what actually happened:
DELL revenue data by YCharts
For the last 19 years (since roughly 2004) Dell's margins have been consistent and range-bound. One could interpret this data broadly in two ways. The first is that Dell exhibits stability in its operations and has the commendable ability to scale revenue while producing predictable financial results.
A second, less charitable interpretation is that Dell has managed its costs to match its revenues. That is to say, its pricing is set by the market and it engineers costs to make a profit. That Dell's PC business has been a drag on overall margin as of late is no secret. Yet I believe the chart reveals to us Dell's managerial mindset. At its heart, Dell still revels in the logistics of optimizing costs and overhead expenses given a certain amount of product sales. Even now, the most substantive discussion of margin in Dell's quarterly and annual reports is devoted to reporting how the company manages its rebate program with vendors. There was a time when Dell's innovation at assembling customized computers (and realizing a decent profit) was celebrated the way we laud Apple for its sheer idea-prowess today. Margin optimization was one of Dell's most enviable strengths.
Yet optimizing margin is a different strength than creating or building margin, which involves the top line of the P&L; the ability to price according to perceived value. IBM (NYSE: IBM), often cited as an example of the type of company Dell aspires to be when it grows up, succeeds by defining global problems and offering up its services as potential solutions. The most fascinating example of this thematic approach to revenue and profit is the "Smarter Cities" campaign, an attempt by IBM to assist the largest cities in the world with infrastructure management. If you'd like to see just how wide is the gulf between IBM's and Dell's strategic thinking, read this article.
Dell has grasped that services and software -- higher margin businesses -- are integral to its future, but the hodgepodge trail of acquisitions it has embarked on (until quite recently) suffer from lack of a unifying purpose. Some promise is emerging in the leadership of a former IBM employee, John Swainson, the recently appointed president of Dell's software group. As Reuters reported last month, Swainson wants to grow software revenues from $1.2 billion to $5.0 billion in the coming years, and realize net profit of 30%, bringing $1.5 billion to Dell's bottom line. I find it hard to overstate how important such results would be to the company if Swainson were to hit these marks. Take away the complexity of Dell's sundry businesses for a moment and picture all revenue as pouring into a funnel, with net income as the result that leaks out the narrow end:
Nice work if you can get it. But before awarding any magic bullet swag to Swainson, let's first challenge a near-myth -- the oft-repeated idea that margins for software companies hover around 30%. This is neither true on an operating nor net profit basis. It's more accurate to say that "best in class" software companies achieve operating margins of 30%, and a select few can realize this as an after-tax profit number. Take a look at recent trailing twelve month operating margins and accompanying quarterly profit margins for some notable companies in the applications software industry:
| Application Software Industry | Operating Margin | Profit Margin |
| Intuit (NASDAQ: INTU) | 27.56% | 37.74% |
| Verisign (NASDAQ: VRSN) | 47.26% | 31.98% |
| Oracle (NASDAQ: ORCL) | 36.92% | 31.61% |
| Adobe (NASDAQ: ADBE) | 25.71% | 19.91% |
| SAP (NYSE: SAP) | 25.99% | 16.96% |
| Red Hat (NYSE: RHT) | 17.37% | 11.90% |
| BMC (NASDAQ: BMC) | 23.12% | 10.73% |
| Microsoft (NASDAQ: MSFT) | 29.52% | -2.72% |
The top three performers not only lead this list, they are among a scarce few out of over 90 companies in this industry to enjoy profit margins of 30% or higher. Dell's impending acquisition of Quest Software (NASDAQ: QSFT) illustrates the inherent difficulty of using 30% margin as an assumption. Quest's last annual report before acquisition (Dec. 30, 2011) reveals an exceptional gross margin of 85%, yet operating profit margin of only 10.5%, and profit margin of just over 5% -- right in Dell's profit margin territory. I'm wincing too. The drag on profit for Quest pre-acquisition has been a combination of no holds barred R&D expense (19.4%) and a lead-weight selling expense of 40%:
| Total Revenues | $857,415 |
| Less: | |
| Cost of Revenues | 123,118 |
| Sales & Marketing | 343,411 |
| Research & Development | 166,191 |
| General & Administrative | 110,198 |
| Income Tax | 33,657 |
| Other Expense | 36,865 |
| Net Income | $43,975 |
For a software and services company some 70 times smaller than Dell, to spend 60 cents of every dollar on product development and sales acquisition is not abnormal. But it doesn't equate to 30% margins on a net basis either. You can assume that Swainson, a veteran of the industry who ran the middleware division at IBM, will look to amplify Quest's margins by utilizing pre-existing Dell sales infrastructure to sell its IT solutions to Dell clients. Don't be surprised to see some sales force attrition from the Quest side, and cross-selling of existing Dell software solutions to current Quest clients. Parachuting into Dell's ecosystem of outside sales muscle, distribution partners, resellers and affiliates may allow Quest to retain more of that attractive 85% gross margin.
Reading Between the Transcript Lines
In a recent analyst call, Dell CFO Brian Gladden projected that Dell's end user computing business -- still the largest segment of revenue for the company -- was projected to grow at what he deemed a sustainable rate of 5% for the next three to four years, bringing in a reliable $2 billion of net income annually. And then he hedged a bit:
But again, this is a 5% operating income priority that we're laying out for this part of the business. And as Jeff will talk about it, if we can grow on that level of profitability, it's a big, big contributor to the business. We've also laid out here a thought that if this business even shrinks, if you see 5% declines in revenue over the next 3 years, we also -- we still could have a business with 5% operating income that generates $2 billion of operating income for the company.
In my opinion, Gladden just subconsciously projected for you what will really happen with the lion's share of Dell's current business. The picture makes sense. Revenues from PCs and other end user products and services (excepting tablets) have been vulnerable for the last year. Gladden is telegraphing that this business will continue to shrink, but through cost management, Dell intends to squeeze reasonable cash flow out of it while attempting to grow the higher margin businesses. Incidentally, Mr. Gladden sold 68,750 shares of Dell common stock this month. He still holds over 400,000 shares of Dell stock.
As consumers continue to shift to tablets and mobile devices as reasonable proxies for personal computing, and Dell's potential for offering services and software is countered by purchasing weakness in the European corporate market (and bone-crushing international services competition from established providers such as IBM), it appears that Dell is striving against time to right its business. Dell's tight operating and profit margins over the last couple of decades are unlikely to hold up much longer. Both types of margins are only a few percentage points away from sparking balance sheet deterioration, and conceivably, losses. These margins are on the verge of a nervous breakdown. I'm curious to see if Dell's quarterly report next week gives them (and shareholders) any respite.
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