It's Bad to Worse at Dell

On the surface, the Oct. 31 news out of Round Rock, Tex., is bad: On Oct. 31, Dell (DELL) said it would fall short of both revenue and earnings expectations for its fiscal third quarter. Look beyond the surface, and the long-term situation at the world's largest PC maker may be even worse.

After years of heady growth, Dell may be coming back to earth. As the computer giant approaches $60 billion a year in sales, it has now missed expectations for two consecutive quarters. The shortfalls are a sign it may be struggling to slash costs enough to maintain rich earnings, while also lowering prices enough to gain share and keep top-line growth racing along.

"SNOWBALL" EFFECT? "At that size, it's difficult for any organization to grow at high rates, so now you see the top-line growth rate coming down," says Jason Maxwell, portfolio manager at Los Angeles-based TCW Group, which owns about 29 million Dell shares. "Does today's news worry us? No, but we were already closely monitoring whether Dell has reached the point where it's too hard to outgrow the market.... Our No. 1 concern is, are they getting close to being so large to make the hurdles to outperform the market too high?"

Many observers, including customers, partners, and analysts, fret that Dell may have been cutting costs so much in order to hit financial targets in recent quarters that it has compromised other measures of performance, including customer support and, possibly, product quality. "The key is to keep customers happy in an efficient fashion," says Maxwell. "Not getting the processes right can really snowball through the system quickly."

Meantime, companies with more innovative products and better support, such as Apple (AAPL), are growing at a faster pace. Even once-beleaguered rival Hewlett-Packard (HPQ) grew faster than Dell last quarter. HP's unit-growth rate was 17.9%, just beating Dell's 17.8% -- a remarkable turn of events considering Dell for years was the only PC maker able to consistently turn a profit.

"[Dell is] too much of a one-trick pony," says a former high-ranking Dell executive. "They're not innovating, or building enough new businesses. They've executed flawlessly for 10 years, but that's kind of an impossible thing to continue." Many customers have complained that Dell's once-acceptable customer service has slipped (see BW, 10/10/05, "Hanging Up on Dell?").

NICKED BY RIVALS. Part of Dell's expected third-quarter earnings shortfall will result from a product-quality problem: It will take a $300 million charge to cover costs associated with replacing and fixing two OptiPlex desktop computer models. Dell spokesman Jess Blackburn said that a faulty electronic part called a capacitator in the two models, the GX 270 and GX 280, frequently caused the PCs to malfunction and shut down. He wouldn't say how many machines have this problem.

Of course, by many measures, Dell still rules. It generates much thicker margins than other PC makers. It has the largest share in PCs worldwide, claiming 18% of the market, according to research firm IDC. In the U.S., Dell's share is even larger, at 33.2%.

Still, Dell's recent performance is quite a comedown for a company that for the last 15 years has been largely able to define the PC industry -- at times racking up huge profits while maintaining share, at other times making off with huge slices of the market when hurting rivals were defenseless against a Dell-led price war.

But Dell's rate of growth in unit shipments is slowing as competitors, including Acer and Fujitsu, gain share. In the third quarter, Dell's year-over-year unit-growth rate worldwide was 17.8%, vs. 23.7% year-over-year growth rate in the second quarter. In the U.S., too, its unit-growth rate slowed to 12.2% in the third quarter, down from the second quarter's 16.3%, according to IDC.

MISSING PENNY. Dell said revenue for the fiscal quarter ended Oct. 29 would fall short of an already lowered estimated range. It noted it would post revenue of about $13.9 billion, lower than the expected range of $14.1 to $14.5 billion. It blamed its U.S. consumer business and British businesses for the shortfall. The news drove down Dell shares 4.1%, to $30.58 in extended trading. The company expects to announce third-quarter earnings on Nov. 10.

Blackburn wouldn't elaborate on the revenue miss, nor would he comment on whether it resulted from the low pricing that contributed to a second-quarter shortfall. In the second quarter, Dell's sales also suffered from poorer-than-expected performance in the businesses selling to the federal government.

Dell also said that third-quarter charges would cause it to fall short of earnings expectations -- a marked contrast with last quarter, when CEO Kevin Rollins proudly noted that his outfit had backed away from aggressive pricing in time to make its bottom-line target. This time, it expects to post earnings of 39 cents a share, missing Wall Street's consensus expectation of 40 cents a share, and coming in at the low end of its own expected range of 39 cents to 41 cents.

EXEC EXODUS. Besides the $300 million to pay for replacing the bad capacitors, Dell will take a $150 million charge to cover the costs associated with recent layoffs worldwide and writing down an "excess" inventory of parts for machines that Dell doesn't sell anymore. While a 1-cent miss may sound insignificant, it's likely to be a clear signal to investors to continue ratcheting down once-high expectations for Dell. Share prices have dropped more than 25% since July.

There are other challenges as well. It has suffered from executive defections in recent months, including the departure of its chief information officer, Randy Mott, to HP earlier this year. Just last week, Michael George, the vice-president and general manager of Dell's U.S. consumer business and a key executive overseeing a planned overhaul of Dell's technical-support operation, left the company to head up QVC.

Some rivals think Dell could also face increasing challenges in the corporate market. With Internet traffic booming, many customers are looking for more powerful servers to handle the traffic, rather than stringing together reams of the lower-end models in which Dell specializes. For example, IBM (IBM) and HP are enjoying brisk demand for so-called blade servers -- high-tech servers on a motherboard that can be slid side-by-side into a console. Dell has largely pulled out of this market, which requires sophisticated software for managing workloads and more power consumption than the stand-alone boxes Dell is known for.

WANTED: NEW HORIZONS. Another problem: Dell is the only major server maker that isn't selling systems based on Advanced Micro Devices' (AMD) Opteron chip, which is rapidly winning over a higher share of corporate customers. "Dell is stuck with only Intel (INTC), and Intel is just not competitive right now," says Sun Microsystems (SUNW) Chief Technology Officer Greg Popodopolous.

Unless Dell comes up with big new ideas -- say, a plan for making faster headway in other tech markets such as networking, storage, or consumer electronics -- it's in danger of putting up a performance that's more in line with the rest of the industry. And that would be a gigantic letdown after so many years of being far out in front.


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