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Dell's bread-and-butter puts it in a jam

A drop in sales to its core business customers has left Dell with weak revenue and the need for a new game plan.

Michael V. Copeland, senior writer
February 27, 2009: 2:04 PM ET

NEW YORK (Fortune) -- Here's the problem Dell is facing. The second largest PC maker on the planet gets about 60% of its revenue from selling computers, and no one is buying computers. Well, that is not exactly true: No one is buying computers unless they are Apple laptops, or incredibly cheap netbooks made by Asus or Acer. So, to be more accurate, no one is buying Dell computers, especially cost-cutting-crazed business users, who drive about 80% of Dell's overall revenue.

Given that Dell can't sell PCs, it should have surprised no one that the Round Rock, Tex.-based company saw its revenue slide 16% in the fourth quarter of 2008 to $13.4 billion, compared to the $16 billion in sales it posted in the same quarter in 2007. Earnings plunged 48% in the quarter to $351 million -- or 18 cents a share -- down 48 percent from $679 million, or 31 cents a share from the year prior. "We cannot predict how deep or long this slowdown will be," said Dell CFO Brian during a conference call Thursday, "but we are predicting it to be protracted."

How did investors take the news? In after-hours trading, they bid the stock up almost 2% from the Thursday close to $8.35 and kept it on an upward climb into the following day. That suggests that a horrific fourth quarter had already been priced into the stock. Certainly a flurry of downgrades by analysts earlier this month helped get everyone ready for bad news, and drove the stock down close to 52-week lows before Dell detailed its earnings.

J.P. Morgan analyst Mark Moskowitz was among those who downgraded the stock earlier this month to "underweight" with a target price of $8.50 by the end of 2009. "A key driver to our draconian view has been that the enterprise PC replacement cycle stands to be deferred to next year," Moskowitz told clients. "Enterprise budgets are hitting the brakes, and here, we think PCs lose." Which means of course, that Dell loses, even more than competitors like Hewlett Packard that have a more diversified revenue stream.

So if you are Dell's founder and CEO, Michael Dell, what do you do? You cut costs for starters. Dell has announced $3 billion in cost-cutting measures, and on Thursday, Mr. Dell said his company had found another $1 billion it could trim. While not detailing where the cuts would come from, nothing was ruled out, including expanding the amount of work given to contract manufacturers to build Dell's computers, and additional layoffs. "We are in the midst of a review of our manufacturing capacity," Dell said. "We haven't made any decisions that are ready to go yet."

Dell is also trying to pull his company toward higher margin software and services. "Dell is the company that drove the cost of hardware down over 25 years, but for every dollar spent on hardware there are three to four dollars spent on everything else," Mr. Dell said. "That is where we are headed for future opportunities."

The question for investors is, at north of $8, is Dell's stock an opportunity now or in the future? On the positive side is Dell's approximately $9 billion cash horde, which "supports the stock" according to Moskowitz. But for that support to continue, Dell must keep its free cash flowing in positive territory. If that metric slips into the negative, Moskowitz says, investors might place less importance on the cash Dell has on its balance sheet and drive the stock down further in coming months.

Michael Dell has the right ideas to turn his company around, but the problem is that there is little evidence yet that he's having any success. And it could be a long punishing year before PC sales tick back up. If he can do for software and services what he did for hardware, that would be huge. If you bet on the stock now, you are betting that Michael Dell can pull it off. But remember, back in 1984, Dell was the innovator, and everyone else scrambled to catch up over the next two decades. Now Dell is playing catch-up, and if anything, is falling farther behind.  To top of page


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