Dell Disappoints Once More

The PC maker says it will use more AMD chips, but that did little to make up for disclosures of slumping profits and a regulatory probe

Say this much for Dell: It delivered on at least some expectations when it reported earnings Aug. 17. For starters, the computer maker said second-quarter profit tumbled to $502 million, or 22 cents a share, in keeping with an earlier warning that analysts' average projections were too optimistic.

Then there was the disclosure that Dell (DELL) would expand its relationship with chip maker Advanced Micro Devices (AMD). Dell had already begun using AMD chips for servers, the computers that run Web sites and corporate networks. It was long rumored that Dell would also use AMD chips in other computers. Dell confirmed the scuttlebutt, saying it would use AMD chips in desktop PCs.

What wasn't expected was a probe by the U.S. Securities & Exchange Commission. Dell said the SEC is conducting an informal investigation into revenue recognition practices for past fiscal years. The company said it's cooperating and that it doesn't expect the matter to have a material impact.


  But on the heels of a report this week that Dell has to recall more than 4 million defective batteries and amid ongoing concerns over poor customer service, news of slumping profit and an SEC investigation left investors dismayed. Shares dropped more than 5% in extended trading, to $21.55.

"I'm disappointed with how management has not been able to articulate in detail their strategy to fix the problems," says Nirav Parikh, an analyst at TCW, which holds shares in Dell. "[Chief Executive Kevin Rollins] definitely has the job of explaining to us what's occurring, and I don't think he's done a good job."

Dell blamed the downward spiral in profitability on itself, saying it cut prices too quickly at a time when overall PC demand is dropping. "We are not pleased with our performance," Dell Chief Financial Officer James Schnieder said on a company conference call. "We priced too aggressively in a face of slowing industry demand, and component costs came down less than we had expected."


  Another number that raised eyebrows: a drop in gross margin to 15.5%, from 18.6% a year earlier. Some analysts speculated that at least part of the margin squeeze came as a result of Dell's changing relationship with Intel (INTC). The theory is that as Dell began using AMD chips, Intel cut back on contributions to Dell's marketing efforts. Intel has a long-standing program, called "Intel Inside," that gives PC makers financial help to advertise their products in exchange for touting the fact that they contain an Intel chip. For many years, Dell had built systems exclusively with Intel microprocessors.

"I think it took Dell such a long time to get to using AMD chips because it was getting a pretty big subsidy," says Charles Wolf, analyst with Needham & Co. in New York. "I assume that when they decided to go with AMD they figured how much they would have to achieve in order to offset the difference." When asked whether a change in its relationship with Intel had anything to do with the drop in gross margin, Rollins declined to answer. "We will not comment on our agreements with suppliers," he said.

For its part, AMD issued a statement saying that Dell intends to produce new two- and four-processor servers with AMD chips as well as an AMD-based Dimension Desktop in the next month. AMD Vice-President Marty Seyer was quoted in an AMD statement as calling Dell's decision a "win for Dell, for the industry and most importantly, for Dell customers." AMD's stock has been rising all week as rumors circulated. On Aug. 17, it rose $1.63, more than 7%, closing at $24.20.

Brent Bracelin, an analyst with Pacific Crest Securities in Portland, Ore., said he was surprised by Dell's rising head count, which increased by 5,400 in the quarter, and 14,000 from a year earlier, to 75,100. "I think it's disappointing to see this pace of hiring and to see the head count growing so much faster than revenue," Bracelin says. "Hewlett-Packard is growing faster than Dell right now for the first time in four years. There seems to be a changing of the guard at the top of the PC growth curve, and I'm not sure that Dell is going to be able to regain that crown for at least three or four quarters until they fix their structural issues."

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