Dell: Confounded by Costs

Restructuring expenses will take further toll on the computer maker's earnings, likely weighing on shares and delaying its turnaround

Disappointment with Dell (DELL) isn't over yet. The world's second-largest computer manufacturer posted fiscal third-quarter sales results that exceeded Wall Street expectations, but its profit performance and outlook for coming quarters left investors dismayed. Shares tumbled about 10%, to $25.25, in extended trading on Nov. 29, after the results were released, and continued the slide the following day. By late afternoon, Dell stock had lost more than 13% from the previous close.

Back under the watch of founder Michael Dell, who returned as chief executive early this year, the company unnerved shareholders with news it will "continue to incur costs as it restructures" and "these actions may adversely impact the company's performance." Dell's expenses are "still considerably higher than we want," Chief Financial Officer Don Carty said during the company's first conference call with analysts in a year.

The results suggest a long-running turnaround attempt at the Round Rock (Tex.) company may be proceeding more slowly than Wall Street anticipated. The company is struggling to emerge from almost two years of slowing growth and slipping market share. Dell's results contrast sharply with those of key competitor Hewlett-Packard (HPQ), which reported robust quarterly results and issued a rosy forecast on Nov. 19 (, 11/20/07).

Key Expense Measures Rise

In the quarter ended Nov. 2, Dell recorded sales of $15.65 billion, exceeding Wall Street's estimate by about $300 million and representing a healthy 9% increase from a year earlier. Net income jumped 27%, to $766 million.

But expenses as a percentage of revenue, a key measure of how well the company is managing costs, rose noticeably. Selling, general, and administrative expenses rose to 12.2% of revenue from 10.6% a year ago. Total operating expenses rose to 13.2% of revenue, up from 11.5% a year ago. "People are disappointed that the revenue increase did not flow through to the bottom line," says Brent Bracelin, analyst at Pacific Crest Securities. "It doesn't look like the company has trimmed enough fat." Dell's operating income of $829 million was 5.3% of revenue, well below the 8% level that Dell posted in years past.

Earlier this year, Dell said it wants to reduce its workforce by about 10%, but as of Nov. 2, Dell had cut only about 2.5% of the 84,000 employees it had on Aug. 3. Carty insisted, though, that the company "is still driving to that [10% reduction] number." Carty added: "We've identified a considerable amount of low-value work." The company also is working to automate certain tasks to help it eliminate more employees. "We have more manual work going on than we need," he said. At the same time, he said that other initiatives, such as acquisitions or "new strategies," may mean keeping or hiring certain kinds of employees.

Gross margin performance, too, didn't meet some analysts' expectations. Gross margin inched up to 18.5% of revenue, from 16.6% a year ago, but still fell below the 19% analysts were projecting. The company blamed component costs, saying they didn't decline as steeply as the company was projecting. Shaw Wu, analyst at American Technology Research, questions why that's the case, when some of Dell's main competitors, including HP and Apple (AAPL) have recently enjoyed the benefits of low component costs.

Investors Doubt "Ultimate Litmus Test"

Dell has been struggling with falling market share and profitability problems since 2005. Former CEO Kevin Rollins and other top executives, including many veterans, left this year, and Dell was forced to restate four years of results following a lengthy internal accounting investigation. Over the last six months, the company has hired a raft of outside executives and has begun making acquisitions, a strategy it almost never used in the past. It also has changed its sales model and over the summer began selling PCs in retail outlets around the world, including Wal-Mart Stores (WMT) in the U.S. and Gome in China. That move has helped to slow the decline in Dell's consumer business. In the most recent quarter, revenue for its U.S. consumer business fell 6%, a smaller decline than in recent quarters.

Despite the problems with its expenses, Dell reported some brighter news: It said revenue growth in overseas markets was robust. Combined sales in Brazil, China, Russia, and India, four crucial markets, were 32% of overall revenue. In all, overseas sales accounted for 46% of revenue, up from 44% a year earlier. Dell generated $1 billion in cash for the quarter, which Carty called "the ultimate litmus test" of Dell's performance.

But judging by shareholder reaction following Dell's announcement, investors clearly are using other standards.

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