This is the uber-post I promised you, full of anablogger goodness: financials, strategy analysis, graphs, Oh My!

Conclusion

Starting at the end, hopefully to pique your interest as to how I arrived at my conclusion, here’s my summation of Dell:

Dell is only just beginning the turnaround from a doomed, low-margin products company to an integrated services driven company. The early signs are good, but there’s a long way to go. The change in strategy is a wise one, but it’s a bet-the-company play.

If it goes badly, Dell will remain an under-performing, middling tech-stock, peddling PCs and laptops to corporates while they waste money on distractions like storage and software. They’ll get killed in PCs and laptops by cheaper products from South-East Asia (Lenovo, ASUS, Samsung) and will have nowhere else to go. It’ll take a while to die, and there’ll be a few panicked pivots to try to arrest the fall, but it’ll be too late by then.

If it goes well, Dell will transition to an integrated company with multiple, complementary lines of business, and they will become a one-stop-shop for small to medium enterprises, positioning them well for an attack on the high end integrated enterprises. They could become the new IBM or HP.

Basic Financials

I always like to start with some basic financial analysis. It gives me a feel for what to look for. I form hypotheses based on what the numbers are telling me, and then I go digging to see if it’s true or not. I try to check my reasoning from a couple of different angles to guard against various cognitive biases (chiefly confirmation bias, but there are others), and it’s lovely when I get surprised by the data.

For those playing at home, this your basic Financial Accounting and Corporate Finance quant-y stuff. I’ve read Dell’s financial statements so you don’t have to.

A cursory look at their 2012 financials shows Dell as doing OK: Return on Equity of 39%, P/E ratio of 9.29 (so possibly underpriced), EBIT trending upwards and at $4.4bn in 2012 on sales of $62bn, and a negative cash conversion cycle (like supermarkets, Dell sells stuff before they pay their suppliers for the inventory; they get your money up front, but buy on trade credit).

Ah, but dig deeper and we start to see some worrying signs.

Danger, Wil Robinson!

Here’s a chart of Dell’s Return on Equity and Return on Assets for the past few of years:

That’s quite a dropoff in ROE, though things are recovering. Return on Assets hasn’t moved nearly as much. Why?

One of my favourites: DuPont decomposition (with a deeper explanation here), shows what’s happened: Dell have de-leveraged (they have less debt) and asset turnover has dropped.

Debt is a simple way for unscrupulous executives to increase return on equity. Basically, if you load up on debt, you can use the increased capital to generate revenue. This works really well in good times, but as we saw in 2008, too much debt means you crash and burn when you’re not making much money, because you have to spend it all on interest payments. Dell have reduced their debt since 2008, which is what everyone else has been doing.

However, asset turnover is down from 2009, and is trending downwards. This is Sales / Total Assets, and is a measure of how many sales you generate given the amount of assets you have. Dell’s main business is PCs and laptops (more on this later), so their asset turnover looks more like a manufacturer than a services company. However, having it drop like this means either sales are down on roughly the same asset level, or new purchases aren’t generating enough sales. Given the big acquisitions Dell’s made over the past five years, that’s what this trend means: Dell’s acquisitions just aren’t generating enough sales. Yet.

There are some other worrying figures in my analysis:

• Current ratio of 1.34. My rule of thumb says it should be higher than 1.5. This indicates that Dell doesn’t have a lot of buffer against short term financing pressures, and would be vulnerable in a credit crunch.
• Quick ratio, also known as the ‘acid test’, of 1.08. My rule of thumb says it should be higher than 0.75, so Dell passes the acid test.
• Dell has a lot of current liabilities (that’s all debts expected to be paid off in the next 12 months). They have quite a bit of cash on hand, but not enough to cover all current liabilities, and it looks like about $2bn of debt falls due in the next year. Expect some re-financing activity.
• Inventory related ratios (inventory turnover, receivable collection period, inventory holding period) point to issues with making sales and collecting the cash.

Enterprise Valuation

I had a quick go at a discounted cash flow model, but there are too many sensitive variables for me to use it without a lot more work. My model is particularly sensitive to Dell’s acquisition strategy. A 1-2% variance in their CapEx requirements can turn a medium-Buy recommendation to one of Sell! Sell! Sell! so it’s not a very useful model.

This sensitivity makes a lot of sense in light of everything else, though, so I’ll attempt to explain after showing you a couple more interesting graphs.

How Dell Makes Money

Ok, so we’ve got some basic numbers, let’s look at them in more detail and try to figure out what’s been going on in the past five years since Dell embarked on their transformation from a hardware business into a software business.

Here’s a chart of common size income, where all the values are taken as a percentage of Sales (that’s where the ‘common size’ part comes from):

What we see here is gross margin staying above 15%, and climbing since 2010, which is when we’ve seen acquisitions like Quest software, which should have higher margins than Dell’s traditional hardware businesses of Dell. Operating income and net income slid downwards to 2010 and then recovered, which jives with gross margin going up. Dell started hanging on to more of the money they were charging.

How? Two ways: firstly, they transitioned to selling more services, and secondly, they got more efficient in general.

Here we see Services going from 7.5% of sales to over 21% in six years. That’s a lot higher than I was expecting, so Dell is making great progress on their strategy of doing more services, rather than just selling tin.

We also see Cost of Goods Sold coming down from 82.27% to 77.75% of sales, so about a 5% improvement. Not bad. Not awesome, but decent progress. Interestingly, this is due almost entirely due to a decrease in Selling, General and Administrative costs, because investments in R&D have actually increased 5% as a percentage of Sales. Dell is investing for the future.

So we see Dell is smack in the middle of transitioning from a laptop and PC company to one that sells services too. How well integrated these services are, well, that’s where the strategic analysis comes in.

Inventory

Let’s revisit the inventory ratios from earlier:

Turnover analysis	2012	2011	2010	2009	2008	2007	2006
Accounts receivable turnover	9.58	9.47	9.06	12.92	10.26	12.42	13.67
Average receivable collection period	38.08	38.54	40.27	28.26	35.59	29.38	26.71
Average inventory turnover	34.37	38.51	41.52	57.84	41.92	72.58	78.06
Average inventory holding period	10.62	9.48	8.79	6.31	8.71	5.03	4.68
Average accounts payable turnover	4.14	4.44	3.84	6.03	4.30	4.59	4.65
Average payable payment period	88.16	82.28	95.12	60.48	84.80	79.47	78.48
Cash conversion cycle	(39.46)	(34.26)	(46.06)	(25.91)	(40.51)	(45.06)	(47.09)
PP&E turnover	29.22	31.49	24.26	26.83	22.91	23.84	27.99
Intangible asset turnover	33.43	41.13	31.23	84.39	78.38	1,276.00	#DIV/0!
Goodwill turnover	10.63	14.09	12.99	35.18	37.10	522.00	#DIV/0!

 

We can see here that the average receivable collection period (this is in days) has gone from 26.7 days to 38. That’s 12 more days to collect money from people. Now, if you sell more services, that tends to be on credit, so this is somewhat expected. But, there was a big jump from 2009 to 2010, so more services sales probably isn’t the answer here. Services has been trending up gradually; there’s no sudden jump in 2010. So what happened? Probably a large acquisition with receivables collection that wasn’t as good as Dell’s.

We also see the inventory holding period going from 4.65 to 10.62 days, and inventory turnover dropping from 78 times to 34.37 times a year. The financials show that Dell has about 20% more inventory in 2012 than the average of the past 5 years, so this is just Dell holding their inventory longer. In notes to the financial statements, Dell mention making “strategic purchases of inventory, particularly HDDs”. Dell recently bought Compellent and EqualLogic, storage companies, and storage arrays have many more times the number of HDDs in them than laptops, PCs or servers. Buying a bunch of drives to keep in stock as warranty replacements, or buying them when you get a good deal, means you end up with a bunch of money tied up in inventory.

The other major figure to note is the average payable payment period, which jumped from 60.48 days in 2009 to 95.12 in 2010. Again, probably due to an acquisition, Dell went from taking 2 months to pay their bills to over 3. It’s come back in a bit, but it’s still above their historical maximum. Be warned: if you’re a supplier to Dell, they aren’t going to pay you quickly. And this is the average; some people are going to be waiting longer than this.

Dell’s Strategy

Ok, enough with the boring numbers. What does it all mean?

I disagree with Michael Ender from Information Week: Dell’s transformation isn’t complete, and I don’t remember Michael Dell saying that it was. If he did, that’s daft, because it quite plainly isn’t complete.

Dell only just completed their purchase of Quest Software for $2.4bn in September this year. In three months, they’ll have barely had time to figure out where the senior execs fit into the broader Dell hierarchy, let alone cascaded the restructuring any deeper than that.

Restructure? Won’t they just keep Quest as a “bolt-on” acquisition? No, they won’t because that would be stupid, and Michael Dell is not stupid. I’ll explain:

Corporate Strategy

Dell is changing from a multi-market business into a corporate entity with multiple businesses. It’s looking a lot more like a conglomerate than it used to, though Dell is more at the Sharp end of the spectrum (a tightly coupled grouping of businesses that share resources that looks a lot like a single business) than at the KKR end (a restructuring strategy; buy it, fix it, sell it).

The espoused strategy at Dell World 2012 is that Dell wants to become a full-service provider. They want to be able to sell you a “solution”, not just the “ingredients”. They’re far from the first to attempt this, and they won’t be the last. In some ways, I think Dell has a shot at succeeding, but to be honest, the more I’ve researched this, and the more I write, the more I think they’re in serious trouble.

Dell has historically been a box-dropper: they sell PCs and laptops to consumers and businesses. That’s what most people know them for. More recently, they bought Compellant and EqualLogic storage, and Force10 for networking devices. They appeal to mid-market businesses and some smaller enterprise and public entities. Large enterprises mostly use Dell for fleets of PCs and rack-mounted servers. Some probably buy their storage and a few other bits and pieces, too, but here in Australia, you won’t find any Dell stuff outside of PCs, laptops and blade servers.

However, Dell knows how to sell to the enterprise, and has been doing is successfully for a long time. Sure, it’s PCs and servers, but all the stuff that goes with it: the sales cycle, customer service, logistics, asset management, Dell knows how to do this at serious scale. Unlike some other tech companies with a real R&D, techo/engineering company background (that shall remain nameless), Dell actually understands what enterprise is. So unlike other companies that have to simultaneously learn how to do solutions selling and how to service the enterprise, Dell already has part of the puzzle sorted.

However, there’s a key difference with Dell: they’re in the Consumer segment. PCs is where they started, and they still sell a lot of PCs and laptops. They just don’t make much money at it.

The trouble with being in the hardware business is that Samsung is better at it. They produce consumer and SMB stuff that’s every bit as good as Dell or Lenovo (I have many Samsung devices), and it’s better gear than HP quite frankly. And Samsung (or ASUS, or Lenovo for that matter) can make it a lot cheaper than Dell can. Samsung is also doing a much better job of branding than Dell are. Dell’s marketing is a mess (something I’ll go into more on later), but Samsung are doing a great job of out-cooling Apple in phones, and unlike Apple, Dell or Lenovo, are making great money in TVs. Samsung gets consumer electronics.

Looking at Dell’s 2012 financials again (note 15 if you’re interested): the Consumer segment makes up 19.17% of revenue, but only 5.9% of profits. Consumer is only one fifth as profitable any other segment: about 2.72% profit on $11.9bn in sales. Why bother? That’s one reason IBM got out of the laptop business and sold it to Lenovo.

The Kind View

Here’s what I think Michael Dell has in his head as the strategy. He hasn’t got the division/business unit presidents to really grok the idea yet, because they’re not saying the right things yet, just mouthing platitudes about customer value and solutions and not being in the ingredient business.

I think Michael wants to have a full set of components that they can bring together as a whole-of-stack “solution” for customer business problems. Nothing earth shattering here, but that’s actually a good thing. If people can easily recognise the goal, then they have a much better chance of understanding it, and therefore doing the right things to achieve it. I think the idea is that Dell can supply you with all your PCs, laptops and tablets, plus all the software to manage them, securely. They can also supply you with racks full of storage, compute and networking that you then run VMs on. And they can supply all the manageware to go with that too. And all the consulting/professional services you need to figure out what to buy, buy it, install it, and even run it for you. Ideally, a bundle of both as a managed service where you can seamless move workloads between your own datacentres and Dell’s.

Consumer devices are important for this, because people are far more tech-savvy these days than they used to, and the lines between work and play have never been more blurred. Being in Consumer gives you a great way to find out customer information about how they want to use devices for play, and for work. You get more and better insight into your customers than other companies who are focussed only on “work”.

But there’s no money in Consumer: it’s a low-margin, high-volume play. The margins are in business and enterprise, but they’re quite different. They still use PCs, though, and it’s a rare company that could completely ditch PCs or laptops for their entire workforce and replace them with tablets (though Dell make those, too). Dell is smart to grab enterprise software like Quest, because there’s real money to be made there. Plus, the screen in front of you is a much better way of getting your brand into the mind of a customer than a server in a lights-out data-centre 30 miles away.

Dell could become the branded ecosystem for some businesses the way IBM is for some very large corporates.

Expect Problems

There are several big gaps in the strategy, and maybe this is where future acquisitions will come from.

Dell doesn’t have anything serious in the networking space. Cisco had years of experience in networks before they came up with UCS, and a router is just a specialised server. They already know a lot about building ASICs, and actually succeeded where Sun failed in making the network the computer.

Dell also lacks in the services space. HP used to be a great engineering company (it’s now called Agilent), but now they’re a printer ink company that has a sideline in servers and switches. Oh, and they have what used to be EDS. IBM has been 60%+ services for years now (though IBM GSA is an in-joke for those who remember it). Building it organically will take a long time.

But most importantly, Dell doesn’t know how to sell bundles yet. Solutions is one step up from that, so they need to get that sorted, and soon.

Bundles of Goodness

Dell’s sales force is used to selling components. Servers. Storage. PCs. They have a whole range of skills and experience centred on this focussed approach, and there’s absolutely nothing wrong with it. Except that that’s not what Dell does any more.

Selling a combination of components as a ready-made solution is a completely different approach, which requires different skills and knowledge. For example, your sales force now need to know about a lot more pieces so they can advise the customer on which bits they should buy. That’s a lot harder, so you need better sales people, so you need to pay them more. That’s ok, because you should be making more margin on the bundles, because they have more value to the customer than individual components on their own.

A way to simplify this approach is to provide either pre-built bundles, or a base chassis that you can customise a little bit, just like… say a website where you can order a PC or laptop, and add or subtract bits that you want. More memory here, base level Windows there. It’s almost like Dell has done this before!

And that’s where Dell needs to head: mass-customisation of bundles of pre-built solutions. Here’s a rack full of storage, network and compute. How many do you want? Bigger drives? Maybe SSDs instead? 1Gb or 10Gb? Fully HA?

Long Way to Go

Dell have a long way to go to reach this level of sophistication.

I spoke to a bunch of people on the Solutions Showcase floor at Dell World 2012, testing out how they approached solutions selling. I was careful to always pose a business related technical problem, hoping for a solution type sale, but I kept getting ingredient answers.

Don’t get me wrong, these people know their product inside and out. I learned more about ducted rack cooling than I ever wanted to, and the cloud folks were dead keen to tell me all about the server configuration I’d need to build my own.

But that’s not what I wanted. A Solution to my cloud question would have been: here’s how you can use our cloud service, how you order it, what the purchasing model looks like. Here’s how you can transfer the workload from your gear to ours. Need gear? Sure, here’s a 2 page glossy on the 3 sizes of cloud rack we supply, with the config options (like I was buying a car). If you want more detail, we have a full bill-of-materials glossy that has all the speeds and feeds, if you’re a rev head who likes that sort of thing.

Because the people buying Solutions are the people I talk to in my day job. They don’t care about gigabytes per second. They care about how soon they can have it, how much it costs, how long it’ll last before they buy a new one, and how much better it is than the competitor’s one. You’ve got to get higher up the value ladder, away from what it does to how it makes me feel. I need to feel that Dell is the best choice for people like me, and that I’d be mad to choose someone else.

That takes Marketing, in the true sense of the word. And we’re back to how Dell’s brand doesn’t really stand for Solutions. It stands for PCs and laptops. Dell have, first and foremost, a branding issue. They need to fix that, and it needs to flow through to everything else they do.

The Windows Elephant

Dell is welded to Windows for the operating system. They’re very dependent on Windows 8 succeeding to drive sales of PCs, laptops and tablets, but mostly PCs and laptops. If enterprises go to Windows 7 and then wait it out for Microsoft to figure out whether they’re in the phone or PC business, that will hurt Dell quite a bit. Michael Dell was effusive in his exhortations of how much he loves Windows 8 and how awesome it is, and isn’t it just simply the best? You know? Like totally the way of the future, and isn’t it exciting?

About here is when I usually smile, nod, and back slowly away, trying not to make eye-contact.

Dell’s insistence that Windows 8 definitely does not suck felt like desperation. In fact, I’ve tried Windows 8, and it’s much worse than that. It doesn’t suck. It’s just… meh.

It looks great for a tablet, but would suck on a desktop PC or a laptop without touch. Why Microsoft has decided to become a bad copy of Apple is beyond me, and they’re going to get killed in the mobile phone market. The new Lumia is nice, but Samsung and Android are going to overtake Apple in the mass-market. Apple won’t care, because they make a gazillion in margin every time someone buys another charger dongle, and they’ve never been about volume. Microsoft bought Nokia when they were on fire because, I dunno. They’re scared witless of people using iPads and smartphones instead of laptops? Have you tried writing anything substantial on a phone?

So if Windows 8 is just a non-event, Dell’s sales will suffer, and as we saw earlier, sales is very important to Dell in order to justify all these purchases they’ve just made.

Windows 8 is also a problem for Dell’s desire to serve businesses with Solutions, because it means that their solutions will, necessarily, be Windows based. There were a couple of token Ubuntu and SuSe booths at Dell World 2012, but like all the other minor partners, they were buried up in the back corners where no foot traffic would pass. That’s a bit crap if you’re a small partner of Dell, hey, it’s called Dell World, not Dell’s Partner’s World.

This means that Dell’s strategy, to a large extent, is contingent on Microsoft’s strategy, which seems to be the exact opposite of Dell’s: moving from PCs and Enterprise/business software into phones and tablets. These two strategies aren’t that well aligned, so how Dell manages that will be interesting to watch.

Summing Up

Dell got very good at an economy of scale play with mass-customisation of PCs and laptops, then used that to break into the data centre with servers. That’s a low-margin, high-volume business. Solutions is a high-margin, lower-volume business, and requires a completely different set of skills, processes, and activities.

Dell has a mammoth task to integrate all the different businesses they’ve bought. Their cultures are different, and they’re used to doing their own thing. They have to all be converted across to the Dell way of doing things. That’s a substantial task on its own. From the purely financial viewpoint above, we know that at least the larger acquisitions aren’t as good at operations as Dell, as evidenced by Dell having worse asset turnover and operating efficiency since the big purchases.

Dell doesn’t have a track record of integrating other businesses, and they’ve just bought a lot in a short space of time. They need to get their revenues back up to justify these purchases before going out an buying a bunch more. Maybe some small things there and there to fill in small gaps, but that’s about it. They need the cash to spend on the integration and cultural transformation that needs to take place.

Because Dell’s culture will have to change to support their change in value proposition from ingredients to solutions. Maybe they can import that culture, at least in part, from one or more of the acquisitions, but however they do it, it’ll take a long time and cost a lot of money. Transformations of this scale just do, so they may as well be serious about it.

But if it succeeds, this is what it’ll look like:

• Your sales person will know a lot more about business than most tech sales people. She’ll talk to you about the ROI of your investment in Dell solutions, and have some handy case studies or customer references to back it up. There’ll be independently commissioned reports from the likes of PwC, Deloitte, Gartner and friends backing them up with data.
• People inside Dell will move around a lot more. They’ll get cross-skilled in the different areas a lot more than they do now, because the best people at Dell are integrative generalists now, not technical specialists with narrow but deep knowledge of one technology.
• There will be a lot more customer and partner events where people come together to share stories on how different Dell ingredients were used to solve business problems. It’ll be about how great combinations of Dell kit worked, not how fast the storage arrays is.
• You’ll see more emphasis on things like the time it takes from order to install, a Dell managed service capability (not just “cloud” infrastructure), solutions leasing
• Dell’s advertising will start to look a lot more like IBM’s, or Deloitte’s, or PwC’s. If they’re smart (or hire smart branding people), it’ll be similar, but different in a uniquely Dell way.

I think Dell could do it, but let’s not kid ourselves about how hard this will be. They’ll need plenty of money for it, and it has to be sponsored and well supported by Dell and his division presidents. And while this is going on they have to get sales up while keeping margins up so they don’t run out of cash or get distracted by crises spawned by an unhappy Wall Street.

I wish them luck.