To The Moon

Summary

• Weak PC shipments are a concern heading into Dell's fiscal Q4 report, but premiumization and lower component costs should help, but enterprise could be the bigger risk.
• Multiple sources are pointing to declining server and storage demand, threatening a weaker outlook for Dell over the next couple of quarters.
• Dell has leverage to edge cloud and AI spending on servers on storage, and opportunities in software, outsourcing, and IaaS, but has to prove it can achieve meaningful revenue growth.
• Dell looks undervalued on low single-digit growth assumptions, but low-growth tech value plays can take a long time to work.

mesh cube

The post-pandemic deceleration in the PC market has been a painful one for$Dell Technologies Inc.(DELL)$ , as the shares have lagged peers like$HP Inc(HPQ)$ ,$Hewlett Packard Enterprise(HPE)$ $IBM(IBM)$ and $NetApp(NTAP)$ over the past two years. While there has been progress in building up offerings on the enterprise side, including infrastructure-as-a-service, software, and product solutions relevant to cloud migration to the edge and AI, it hasn’t been enough to offset Street concerns about slowing PC demand.

Going into the fiscal Q4 earnings report, Dell shares do look undervalued on what I believe to be conservative assumptions (long-term revenue growth of 2% to 3% and even less growth in FCF), but the reality is that low-growth tech is usually a tough place to generate substantial alpha. What’s more, I do think that worries about the PC cycle will linger a bit longer, with newworries about enterprise adding to the mix. I see value here, but it will take at least a few months for the market to come back around to these names.

PCs Still Weak, And Now Enterprise Is Softening

The market expected weak PC results for the calendar fourth quarter of 2022, but the roughly 28%-29% year-over-year and 7% quarter-over-quarter decline (different sources report slightly different numbers) was still worse than expected. Making matters worse, Dell underperformed a weaker market, seeing a 37% year-over-year decline and losing about two points of share, while$Apple(AAPL)$ and ASUS gained share (Lenovo maintained global leadership at around 23%).

While that’s not a strong backdrop for a business that still generates more than half of the company’s revenue and over 40% of operating earnings, actual results may not be quite as bad as those numbers would imply. Dell has been prioritized higher-value systems (including high-end gaming), and that should drive revenue results above the underlying volume numbers. Likewise, Dell should continue to benefit from easing component costs, which will be good for margins.

On the other hand, enterprise (the ISG segment and the commercial side of CSG) could be a source of downside risk in this quarter and with guidance. Multiple reports (third-party research, sell-side VAR surveys, company reports/guidance) have pointed to weakening server and storage demand as enterprise customers batten down the hatches into growing uncertainty about the state of the economy in 2023.

While I expect Dell to maintain leadership in its core markets, I expect year-over-year declines in the end-markets for at least a couple of quarters. As is typically the case, a nervous market has suddenly started to care about cash flow again, and that is leading server and storage customers to cut back on spending, and that will likely drive a relatively brief downturn.

Fiscal Q4 Is Likely Dialed-In, But I See Some Risk To Guidance

Dell management has usually been decent about short-term guidance, so I’m not too concerned about the upcoming reported quarterly numbers. I expect revenue in the $23.4B-$23.5B range, down about 16% year over year and 4% to 5% quarter over quarter, with a mid-20%’s decline in the CSG segment (Lenovo’s comparable business was down 34%, but has less high-end leverage and less overall leverage to the U.S. market).

While the average sell-side estimate for FQ4 gross margin is 23.65 (versus 23.7% in Q3), I think a little upside could be possible here given declines in component costs and improving supply chain/logistics costs. Likewise, I think there could be some upside to the $1.65 EPS target, although probably not a lot of upside.

I’m more concerned about guidance at this point. Looking at all the data out there, I think the bottom in the PC market could slide back another quarter, leading to downside risk to April quarter guidance. Likewise, I’m concerned that the enterprise slowdown is picking up steam, and that will just add to the pressures on guidance for the next couple of quarters.

The Outlook

Dell management has a challenge familiar to many mature tech companies – convincing investors that the company has a next act that includes worthwhile growth. There are some opportunities for growth in PCs (more hybrid work, more Infrastructure-as-a-Service), but nobody really thinks this is more than a low-single-digit growth market at best.

Management has opportunities in areas like servers, storage, and software, but the first two are also seen as mature markets and Dell’s ability to effectively grow software and services is still a “we’ll see” proposition for the Street (Lenovo faces the same skepticism). I do see attractive opportunities as the cloud pushes out to the edge and enterprises embrace AI, both of which should drive server and storage demand (including higher-value all-flash systems), but Dell has to prove that offerings like APEX can drive meaningful added value, as there won’t be much credit given for basic hardware offerings (even if they skew higher end).

I expect Dell’s revenue to bottom out in FY’24 as the hangover from pandemic-driven PC growth works itself out and enterprise hardware demand corrects ahead of a rebound next year. From that lowered starting point, I believe Dell can generate around 3% growth, but the company clearly has to execute on opportunities in software, outsourcing, and infrastructure-as-a-service (multi-cloud infrastructures, hybrid and private clouds, et al) to drive more investor interest.

A richer mix of services and software could be good for margins, as could growth from edge and telco market opportunities, but I’m taking a conservative approach and modeling a modest long-term decline in FCF margins toward 5% that will drive minimal annualized free cash flow growth from FY’24 onward.

The Bottom Line

Dell does look undervalued on the basis of what I think should prove to be conservative cash flow assumptions, as well as on forward-looking multiples (EV/EBITDA, et al), but the reality is that low-growth tech is a tough place. I do think that Dell is undervalued now and should rerate once the Street is comfortable looking past the enterprise hardware downcycle (probably three to six months from now), but investors looking to play the potential value here will need some patience.Source :  Dell: Undemanding Valuation Into Earnings; Weakening Enterprise A Threat | Seeking Alpha