Talking a Good Game Gets You Nowhere

By Chad Henage - September 4, 2012 | Tickers: CSCO, DELL, EMC, HPQ, IBM | 0 Comments

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I've expressed my doubts in the past about Dell's (NASDAQ: DELL) ability to go head-to-head with some of the largest names in the technology industry. The company is trying to engineer a turnaround the likes of what IBM (NYSE: IBM) did years ago when they sold their PC business to concentrate on services and higher-margin businesses. The company's CFO Brian Gladden reaffirmed this move in the recent earnings release by saying, “We continued our progress in shifting the mix of our business to higher-margin enterprise solutions, led by solid growth in our server, networking, services, and Dell IP storage businesses.” While on the surface this sounds like the company is moving in the right direction, the real numbers paint a different picture.

With overall revenue down 8% and non-GAAP net income down 13%, you can see that positive talk has yet to have a positive effect on the bottom line. Now I know that proponents of Dell would say that this won't happen overnight, and that a transformation of this kind will be gradual. There is just one big problem, by the time Dell converts itself to more of a services and networking company, the market will have shifted again. In the meantime, Dell is still very much a hardware vendor, and 50% of the company's revenue is still derived from selling desktop and laptop PCs. In fact, while Dell reports results based on the size of business it is selling to, I think it's more instructive to look at the company's sales based on product line.

Both Dell's CEO Michael Dell and now its CFO (mentioned above) have said that they see the company's strategy to move toward server, networking, services and storage sales. Looking at the company's product lines, let's see what type of growth the company is experiencing in each line of business.

If server, networking, services and storage are the company's future, these represent just 34% of the company's current total. In addition, the weighted average growth of these divisions is 5.46%. Considering this is the future of the company, this future doesn't sound very promising. While I'm aware the company expects to close its acquisition of Quest Software, this will only slightly improve an already struggling division. Quest has sales representing just 1.5% of Dell's current quarter sales. The point is even if Dell managed to double Quest's sales, a 3% increase in sales isn't going to move the needle very much. For now though, let's give Dell the benefit of the doubt and assume that the company does continue to transform itself into a more enterprise focused company. There are just a few companies that stand in the way.

In the realm of servers the company faces the likes of Hewlett-Packard (NYSE: HPQ), which though this company is also struggling, has some strong divisions to fall back on. HP's server lineup is strong, and the company's printing division is a consistent money-making business. This company won't just give away market share to Dell, and from a valuation standpoint, HP sells for just over 4 times forward estimates. In addition, HP pays a better yield than Dell at 3.06% versus 2.88%.

When it comes to networking there are multiple competitors, but the clear leader is Cisco Systems (NASDAQ: CSCO). Cisco is a leader in virtually every networking category, and recently turned in a respectable quarter. The company produces 200% more free cash flow than Dell, and in a consistent theme, Cisco spends much more on research & development (R&D) than Dell. In fact, Cisco consistently spends around 10% of their revenue or more on R&D. Dell by contrast spent just 1.62% of their revenue in the recent quarter. This is at the heart of why Dell finds itself trying to buy its way back to relevance, the company isn't looking for the “next big thing,” instead Dell is waiting to buy it.

In the services arena, the model that Dell is attempting to emulate is IBM. The company set the standard for how to exit a losing business (PCs) before it dragged down the company too much, then transformed itself into a services company. Keeping with the theme, IBM also outspends Dell on R&D by investing about 6% of their revenues in this line item. Where the storage business is concerned, Dell can talk about this business all it wants, but the company isn't in the top five players. The clear leader is EMC Corporation (NYSE: EMC), which at last count holds the number one position in network attached storage at 41.7%. While EMC's relationship with VMware is somewhat similar to the pending Quest acquisition, the difference again is EMC is investing in the future spending about 12% of revenues on R&D. With Dell spending virtually nothing on R&D and holding just over 1% of the storage market, this competition was over before it even started.

The bottom line is, Dell talks about becoming an enterprise leader, but their competitors aren't going to just give away business. Dell needs to invest in their future by spending a little more time on R&D trying to develop their business, and a little less time talking about what they want to do. Of the competitors we've mentioned, they all appear to be better investments than Dell. HP offers a better yield, and Cisco offers a better yield, and better growth. IBM has already made the transformation that Dell envisions, and EMC is both growing faster and dominating its market. Unless Dell makes a bold move to jettison its PC business, this company is all talk.

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