Dell Q1: Low AI Server Profits Are Good
Contributor since 2023 / 1776 Followers
Summary:
- Dell’s position in the AI server market is still a key reason for optimism about the company’s future.
- Their “land and expand” strategy allows Dell to form long-term relationships and generate ongoing revenue streams.
- Despite concerns over AI server profitability, Dell’s Q1 revenue beat expectations and the Infrastructure Solutions Group saw a 22% increase in revenue.
Jerod Harris
Investment Thesis
Despite the negative market reaction to Dell’s (NYSE:DELL) FY Q1 2025 results, I remain optimistic about the company’s future. The main reason behind my optimism, as highlighted in the earnings call, is their position in the AI server market. I actually believe the call was generally positive despite analyst Toni Sacconaghi’s comments regarding the profitability and operating margins of AI servers, which I will get into later in this article.
Dell is currently taking a “land and expand” approach to the AI server space. This involves initially selling servers to clients, then participating in related client services to produce future revenue growth and profit growth. This strategy allows Dell to form long-term relationships and ongoing revenue streams. During the Q4 FY 2024 earnings call, management stated that for every dollar spent on an AI server, there is the potential of an additional $2 to $3 coming from professional services, networking, and storage around that server. This explains why their AI server division has not yet shown its full potential. The client services division has not accelerated as quickly as the initial server sales; it is a long-term strategy aimed to expand their client base and deepen their position in the AI server market.
Since my last report and the Thursday before earnings, Dell experienced a substantial increase of approximately 40%. However, after earnings, Dell fell, resulting in only a 15.27% increase in stock price since my last article in March. I believe this dip opens the door for investors to an attractive buying opportunity.
Looking at their earnings report, Dell’s Q1 revenue of $22.2 billion, up 6.2% year-over-year, beat expectations by $550 million. The Infrastructure Solutions Group (ISG) generated $9.2 billion in revenue, a 22% year-over-year increase.
Therefore, despite concerns over AI server profitability and the recent drop in stock price, I maintain an optimistic outlook on their future. I think that Dell is in the early stages of their “land and expand” strategy, where these results are expected, but will see earnings take off as it progresses. With this, I still believe Dell is a strong buy.
Why I Am Doing Follow-Up Coverage
In March, I covered Dell, labeling them as a strong buy. My reasoning for this was not only their strong financial performance, but I also believed they had a lot of potential within the AI server market, and I continue to hold this belief. Despite the drop in stock price post Q1 earnings, Dell managed to still outperform the market. Since my last publication on Dell, the stock price has increased by 15.27%, while the S&P 500 has grown by 2.32%.
During the recent earnings call, Dell’s earnings roughly matched expectations, but I think investors were looking for more. The lack of AI server profits likely raised concerns, therefore causing a drop in stock price, but I do not believe this is something to worry about. The focus of Dell’s management right now is to land and expand. What I mean by this is, Dell is focusing on selling this server to clients first, then later expanding this to make more on the client services division.
The goal of this article is to show that Dell still has plenty of potential within the AI server market, therefore remaining a strong buy.
Q1 Review
Overall, I actually think the recent earnings call was positive. Despite the market’s reaction to the earnings report, which resulted in a roughly 18% drop in Dell’s stock price, the company’s fundamentals remain strong. Dell reported a revenue of $22.2 billion, up 6.2% year-over-year, with the Infrastructure Solutions Group (ISG) generating $9.2 billion in revenue, a 22% increase. Contributing to this growth was incredible server and networking revenue, which surged 42%. Revenue of $22.2 billion beat estimates by $550 million, while EPS of $1.27/share missed by $0.02.
Jeff Clarke, Dell’s COO, emphasized that the company is still in the early stages of the server upgrade cycle. Clarke noted:
In ISG, our AI-optimized servers orders increased to $2.6 billion, with shipments up more than 100% sequentially to $1.7 billion. We have now shipped more than $3 billion of AI servers over the last three quarters.”-Q1 2025 earnings call
This demonstrates the growing AI server demand and Dell’s ability to meet it. This early phase of adoption presents an opportunity for Dell to establish a robust presence in the AI market, which is expected to expand from $30 billion in 2023 to $150 billion by 2027 by some estimates.
However, during the Q&A portion of the call, analyst Toni Sacconaghi raised concerns over Dell’s AI server profits (some analysts believe this comment is why the stock dropped so much). He asked:
AI servers went from zero to 1.7 billion, which sort of suggests that traditional servers were flat. So really the only thing that changed was you added 1.7 billion in AI servers, and operating profit was flat. So does that suggest that operating margins for AI servers were effectively zero? -Q1 2025 earnings call
The likely reasoning behind this is because, as mentioned above, Dell is still in the early stages of the server upgrade cycle.
While the lack of profit may seem concerning, considering that they are still in the beginning stages, I think Dell has lots of room to expand. In their previous call in March, Clarke stated:
[we’re] looking at an opportunity where every dollar that is for an AI server, GPU server, there’s $2 to a growing $3 of professional services around that, networking around that, storage around that -Q4 2024 earnings call.
Dell’s strategy means that they’re trying to offer more than a hardware product because they know these can be one time revenue opportunities vs. recurring. Rather, Dell is trying to offer a life cycle service for their customer’s servers, which means that not only do they work with clients on the original application of the server, but they also support them through add-on storage, and other continued services.
I think that investors were looking for Dell to handily beat earnings projections, but they reported pretty much in line with expectations. I think this is right on track. With their land and expand approach, Dell is still in the early stages, so we won’t really see revenue take off until a little farther down the road.
Valuation
Although Dell’s earnings call led to a nearly 18% decrease in stock price, I still believe Dell has a promising future ahead.
When looking at Dell’s valuation metrics, their forward Non-GAAP P/E (FWD) is 18.10, sitting 22.56% below the sector median of 23.37. If Dell were to have its forward P/E converge on the sector median, this would imply Dell has an upside potential of roughly 29.11%. Keep in mind, the company is still set to record strong growth in areas like GAAP EPS growth over the next 12 months (25.30%). And while revenue estimates only have revenue growing at 0.27% over the next 12 months, I think this is conservative. As I have been saying, client services revenue from AI server optimizations has not ramped up yet (in my opinion). This will be a strong catalyst, I believe.
How This Affects My Previous Valuation Estimate
In my previous coverage, I stated that their upside potential was 50.6%. While Dell is far from this post-earnings ($140.04 per share as of the time of this writing), pre-earnings the market actually captured a decent amount of this, with their peak price per share hitting $179.21 on May 29th.
In March, I estimated that the price could reach up to $183.40/share. Despite the recent drop in share price, I still have a similar price target ($180.81/share based on the non-GAAP EPS reaching sector median). I cut my target slightly due to questions about the AI servers profitability, but I think overall the story is still the same. I still believe this is an excellent way to play the AI wave while not paying the same earnings multiples we might see with Nvidia.
Risks To Thesis
I previously discussed in my coverage of Nvidia (NVDA) in May that a significant risk of that investment is that some firms may not achieve the necessary return on investment (ROI) from these AI servers & GPUs, making the math difficult to justify the expenditures. In the case of Nvidia, the high cost of their AI chips poses a substantial challenge. According to the Wall Street Journal, the industry has put $50 billion into Nvidia’s chips to train large language models, but generative AI startups had only made $3 billion in revenue. Nvidia’s CFO, Colette Kress, stated that they believe that for every $1 spent on AI infrastructure provided by Nvidia, there is a 4-year opportunity for cloud providers to earn $5 in GPU instant hosting revenue. While this metric seems promising, it may end up being overly optimistic given the rapidly declining costs of AI models. The cost per token for AI models has fallen significantly over the past year, making it cheaper to deploy AI technology. As AI model prices continue to fall, the pressure on Nvidia to ensure their GPUs remain efficient enough to maintain the promised ROI will increase. From Chat-GPT 4.0 to Chat-GPT 4o, the API costs have dropped by 12 times. Assuming this decrease in cost is consistent across the market, this would mean that Nvidia needs to increase the productivity of their GPUs by a multiple of 12 for them to be the same net-costs per API call. But, they have not met this, as the new Llama 3 model’s efficiency only increased by a multiple of three.
Shifting focus, I think there is a similar risk to investing in Dell. If the prices for LLMs continue to drop, the cost of Dell’s servers will outweigh the return on the investment. If this were to occur, consumers will no longer purchase these servers, therefore decreasing revenue.
However, this is where the client services division could come in to help. Part of what Dell is good at (besides making powerful servers with Nvidia and AMD (AMD) technology inside) is telling clients how to optimize and make the most of their servers. Most companies have not initiated the initial round of AI server upgrades (most enterprise servers are not equipped to run LLMs, even if Dell helps them optimize their technology). With this, the initial upgrade cycle opportunity is still here.
From this point, Dell may have an issue getting some of these clients to upgrade their servers on a normal cadence we would see with normal server products (due to the longer timeframe it will take to generate an ROI) but this is where client services come in. Client services can help these clients make the most of what they have. In my opinion, it’s a win-win with Dell’s clients getting valuable insights to make the most of their technology, and Dell getting revenue from their hardware products for years to come.
Bottom Line
Despite the market’s immediate negative reaction to Dell’s Q1 earnings, my outlook remains optimistic due to the company’s strategic factors and long-term growth potentials. I fully believe Dell’s “land and expand” strategy is central to this optimism, as the company aims to initially sell servers with the expectation of generating significant future revenue from related services.
At the core of it, I believe the recent earnings highlighted solid fundamentals, with a 6.2% year-over-year revenue increase to $22.2 billion and a 22% rise in the Infrastructure Solutions Group’s revenue.
While concerns about the profitability of AI servers were raised during the earnings call, it’s important to view these in the broader context. The early stage of the server upgrade cycle means that current financial returns are just the beginning. As Jeff Clarke noted, Dell has shipped over $3 billion of AI servers in recent quarters, demonstrating strong market penetration and potential for future growth. With this, I still believe Dell is a strong buy.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of AMD, DELL either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Noah Cox (account author) is the managing partner of Noah’s Arc Capital Management. His views in this article are not necessarily reflective of the firms. Nothing contained in this note is intended as investment advice. It is solely for informational purposes. Invest at your own risk.
Seeking Alpha’s Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.