Dell's Quarter Saved by Cost Cuts

Revenues were $1 billion shy of Wall Street's estimates, but the computer maker's earnings exceeded expectations

Defying investors' fears that its earnings would fall victim to slumping tech demand, Dell turned in a surprisingly profitable third fiscal quarter by taking a big ax to costs.

Although Dell's (DELL) sales were more than $1 billion short of Wall Street estimates for the quarter that ended Oct. 31, a combination of job cuts, a hiring freeze, and lower materials costs helped earnings reach 37¢ per share, beating analysts' modest expectations of 31¢ per share. Shares of Dell gained more than 5% in extended trading. Earlier, the stock had lost 54¢, or 5.2%, to close at 9.81, amid a market slump.

Revenue and net income declined from a year earlier, but investors said Dell was successfully protecting profit amid a global economic slowdown that's sapped business and consumer demand for new computers and other tech gear. "In previous quarters it looked like the company was willing to grow share at any cost," says Bill Kreher, a technology analyst at Edward Jones who has a buy rating on Dell. That's what happened in the second quarter, when profit fell 17% on overly aggressive price cuts (, 8/29/08). "In this environment they're aware that investors are more concerned with the bottom line," Kreher says.

Tough Act to Follow

For now, Dell may need to keep running the cost-cutting play, one of its few options in an environment that's forced other tech bellwethers, including Intel (INTC) and Cisco Systems (CSCO), to issue dour forecasts. Dell sliced 2,200 jobs and took advantage of lower PC component prices, analysts said. "Can they continue to cut costs like this?" says Jayson Noland, an analyst at Robert W. Baird, who has a neutral rating on Dell shares. The company may have to do so to boost its stock performance, since "nobody expects the economy to be a benefit to anyone."

From a cost-cutting perspective, the third quarter will be a tough act to follow. Sales declined 3%, to $15.16 billion, missing analysts' consensus expectation for $16.22 billion in sales. Net income fell 5%, to $727 million. But operating expenses fell 11%, and operating income rose 22%, the biggest gain in two-and-a-half years. Dell's consumer PC business, which it's counting on for future growth, posted an operating profit of $112 million, more than the last six quarters combined, according to Baird's Noland.

During a conference call with analysts, CEO Michael Dell said the company would continue to emphasize profit over market share. "Given the choice between profits and growth, we're going to go for the profits," he said. That's in large part because of "deteriorating demand" for tech products, Chief Financial Officer Brian Gladden added. "We had a stronger August than we had September or October," he told analysts. Cutting costs "is the one lever we can control."

Thriving in a "Tough Environment"

Gladden forecast weaker demand for the foreseeable future, but said Dell has more room to cut expenses on its way to reducing costs by $3 billion a year by 2011. The company has "well surpassed" a previously stated goal of laying off 8,900 workers, or 10% of its workforce, he said. It's also imposed a hiring freeze, and has asked employees to take unpaid leave around the holidays or accept severance packages to leave the company. "These results give me confidence that Dell can operate efficiently in a tough environment," says Edward Jones analyst Kreher.

Wall Street analysts had been scaling back their expectations for Dell in recent days, and many had cut revenue and profit estimates even as rival Hewlett-Packard (HPQ) offered a bullish preview (, 11/19/08) of its fourth-quarter results, due next week. HP shares have risen 4.5% so far this week, even as the broader market has swooned.

HP has advantages Dell doesn't: a growing IT services business, a broad portfolio of business computing products, and fat margins from printer ink. Other tech firms have signaled recently that they're faring poorly, too. Intel slashed its fourth-quarter sales outlook (, 11/12/08) on Nov. 12, citing weak global demand. Cisco Systems on Nov. 5 told investors it expects a 5% to 10% drop in sales for its second fiscal quarter, which ends in January. And Sony (SNE) on Oct. 23 said operating profits for its fiscal year, which ends in March, would fall 58% (, 10/23/08).

Growing Threat from Netbooks

Soft demand for PCs and chips are partly to blame. Worldwide PC shipments grew 15% in the third quarter, according to market researcher Gartner (IT). But discounts at retail are deepening, and much of the growth came from low-priced netbooks that lack the functionality of full-fledged laptops (, 11/18/08), analysts say. The PC industry is worried that low-priced, stripped-down netbooks are eating into sales of full-fledged notebooks. "This doesn't surprise us as the next step down" in the PC price wars, Dell Americas Region President Paul Bell said in a Nov. 4 meeting with reporters.

In the chip market, the Semiconductor Industry Assn. trade group on Nov. 19 predicted 2009 microchip sales would fall 5.6%, to $246.7 billion, the first annual decline since the tech slump of 2001.

The bright spot for Dell investors is that its stock is trading at a lower multiple of the company's expected earnings than it has for the past three years, analysts say. On Sept. 16, Dell warned of "further softening" in third-quarter demand, and its shares are down 60% this year. While sales may not firm up anytime soon, Dell's ability to keep whacking costs could give Wall Street reason to believe.

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