Dell's Shortfall, Dell's Challenge

By Louise Lee It isn't every day that Dell, a poster-child for steady, predictable performance, has to explain a shortfall. But the world's biggest personal-computer seller was forced to do just that when it released fiscal second-quarter results Aug. 11. The company reported revenue of $13.4 billion, falling short of the $13.7 billion that analysts were expecting, thanks in large part to pricing its computers too low.

Dell (DELL) CEO Kevin Rollins repeatedly cited miscalculations during a conference call with analysts. "The pricing was our fault. We made an execution error."

STOCK SLUMP. What's more, the pricing misstep could spill over into the current period. For the third quarter, ending in October, Dell is projecting revenue between $14.1 billion and $14.5 billion, an increase of 13% to 16% from a year ago.

That estimate falls short of the 17% revenue growth the Street had been expecting. And it left analysts wondering if Dell -- for years the only PC maker to put up consistent revenue growth and profits -- might finally be running out of steam in the cutthroat PC business. The fear: that Dell, like its rivals, is running out of customers willing to pay the prices necessary for it to increase revenues and earnings at the same time. Dell shares plummeted more than 7%, to $36.58, in after-hours trading.

While Dell executives argued that its problems were due to one-time screw-ups that could be easily fixed, some analysts are unconvinced. "They were saying the right words, but I felt they were nervous -- like they might have to change their shirts after the meeting ended," says Roger Kay, president of market researcher Endpoint Technologies Associates.

TOO AGGRESSIVE. Now the big question is whether Dell can get its revenue growth back on track. The company, based in Round Rock, Tex., has set a goal to reach $80 billion in annual revenue by the beginning of 2009, up from $49 billion in the fiscal year that ended in January, 2004. Rollins insists that Dell isn't backing off that goal. "We're reaffirming our $80 billion target," he says.

Dell does have luxuries that only a dominant market leader enjoys. With net margins far higher than its main rivals, Dell can cut prices to target market share when it wants to -- typically, during periods of fast overall PC market growth, as has been the case in recent months.

Similarly, it also has the luxury of going for profits instead. In other words, Dell can stop slashing prices, yet remain competitive with rivals' offerings. But in this past quarter, Dell, typically expert at playing that game, got too aggressive in going for market share. Indeed, Rollins adds, "Our sensitivities after the second quarter are heightened."

COSTLY PROMOTIONS. Rollins says that Dell is scrambling to once again emphasize "upselling," or steering customers toward more-expensive products, rather on the super-low-end $300 machines that helped pump up second-quarter unit volumes but undermined revenue growth.

During the second quarter, the average selling price of Dell's computers for consumers dropped a substantial 13%. While Dell will likely continue to offer these super-cheap machines, it may advertise them less and mount fewer revenue-sapping promotions, such as giving away free printers to PC customers. "We were chasing the lower-end systems for unit volume's sake," says Rollins. "We've got to get back into the mode of selling the systems that are the most profitable."

Analysts expect Dell to be able to move its PC prices north again. "Dell should be able to regain some of the revenue momentum it had," as its competitors are unlikely to try to lower their prices to undercut it, says Hamid Khorsand, an analyst at BWS Financial.

CLOUDY NOTEBOOKS. Some market conditions will keep investors nervous for now. Take notebook computers. Dell has taken more than its share of this booming market, as more customers opt for these portable models rather than desktop machines. Dell's unit volumes from notebook computers rose a hefty 47% during the second quarter, vs. just 17% for desktop machines.

Despite the overall revenue shortfall, Dell still met analysts' profit expectations during the second quarter -- in large part because notebooks carry higher profit margins. Dell's net income was $935 million, or 38 cents a share, vs. $799 million a year ago.

But the profits outlook for notebooks is looking decidedly cloudier. Given the growth, competition has been heating up, from long-time rivals including Hewlett-Packard (HPQ) and Gateway (GTW), as well as from newcomers such as Averatec. "The margins are going out of the notebook business," says Kay. "They're still better than for the desktop PC business, but they're not as high as they used to be -- and they're going to tighten up pretty quickly here."

"AN UNKNOWN HERE." At the same time, Dell is noticeably downcast about its prospects in sales to the federal government, one large factor in the gloomy third-quarter sales projection. Indeed, in the most recent quarter, sales to the federal government fell "in the double-digits," says CFO James Schneider. And federal-government sales aren't expected to pick up in the current quarter, "We've got an unknown here," says Rollins.

Another possible problem: Prices for components, such as processors, memory chips, and displays have been holding steady. Given its ultra-efficient manufacturing and logistics, Dell does well when it can quickly pass on to consumers price cuts on such parts. (A company that sells via retail stores, on the other hand, can't take advantage of lower component costs as quickly. That means its PCs fall in value for every day they sit on a store shelf or in a warehouse -- forcing the company to either try to sell them at a price higher than Dell's or to cut the price and eat the losses). On the rare occasions when prices aren't falling, Dell loses that advantage to some extent.

While component price cuts are sure to resume, "It could be a major concern going into the October and January quarters" if the current trend continues, says Charles Wolf, analyst at Needham & Co.

ANXIETY ALERT. During the conference call with analysts, Rollins tried to put a positive spin on the quarter, pointing out that Dell still reached its earnings target despite the revenue miss. Dell is expecting earnings per share for the third quarter to be 39 cents to 41 cents, up 17% to 23% from a year ago.

But until the outfit proves that all of its problems were self-inflicted, there may be more nervousness ahead. Lee is a correspondent in BusinessWeek's Silicon Valley bureau

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