Dell Review: Blackwell Efficiency Problems (Rating Downgrade)

Summary:

• Dell Technologies Inc.’s AI PC sales and AI server sales underperformed, raising concerns about the anticipated AI PC revolution and overall server demand.
• Nvidia’s efficient Blackwell chips may reduce the number of servers needed, impacting Dell’s future server sales and revenue growth.
• Despite Dell’s Q3 revenue miss, the Infrastructure Solutions Group slightly exceeded estimates, but server and networking revenue fell short of expectations.
• Given the uncertainties around AI server demand and valuation, I am downgrading Dell from a strong buy to a hold.

Co-Authored By Noah Cox and Brock Heilig.

Investment Thesis

Dell Technologies Inc. (NYSE:DELL) shares are down roughly 10% since Tuesday, when Q3 earnings for the PC and server giant were reported.

While this analysis is a few days later, I wanted to take some time to connect this research to an analysis I recently wrote on Nvidia (NVDA). I believe a big reason for the selloff is because AI PC sales have not taken off yet. This is calling into question the AI PC revolution that many, including myself, predicted would be immense. Unfortunately, this has not yet materialized.

The AI PC revolution has been a big focus from Wall Street analysts. So while sales here missed (and I think this was the big driver of the immediate selloff), I actually want to focus on the Infrastructure Solutions Group (ISG) numbers for this quarter.

Growth for server sales, specifically AI server sales, was slightly less than expected. I think this is a huge deal because this adds to a trend I noticed earlier this week with Nvidia’s Blackwell chip.

Nvidia’s Blackwell chip is very efficient. In fact, it’s arguably too efficient, which means companies like Dell that make money building servers around these Blackwell chips will theoretically need to sell fewer servers for customers to get the similar computing power needs. Add in the fact that Blackwell chips tend to overheat, and they will need to be spaced out. More efficient GPUs that have to be spaced out for efficiency purposes equals less Blackwell GPU servers per square foot in customer data centers.

With this comes the risk that clients chose to buy fewer, more efficient servers from Dell that have these Blackwell chips in them. This could hurt AI server sales. With AI PC sales performing below analyst expectations, this could be a major setback to the thesis.

While I have been bullish on Dell (and shares have beaten the market since then) I think now is a time to derisk until we know more about this change in GPU composition. With this, I am downgrading my view on the company from a strong buy to a hold.

Why I’m Doing Follow-Up Coverage

Back in early September, I wrote a research piece on Dell, arguing at the time that blockbuster AI growth was key to their server division growth and that investors should ignore any short-term compression in margins. In September, I thought the computer giant’s stock was a strong buy, and shares have increased nearly 20% since that article was published.

Similarly, back in September, I was bullish on Dell’s ability to benefit from the rising trend of Blackwell upgrades. Now, I think things have shifted. It’s clear that the Blackwell GPU is very efficient, and I believe this is going to start to weigh on Dell’s server sales (ironically).

Like I mentioned earlier, shares have outpaced the market since my last piece of research, but I think the company needs to be reassessed. This is why I’m doing this follow-up coverage.

Q3 Review & Blackwell Setback

Dell had a bit of a setback when the Q3 numbers were released. Beginning with EPS, Dell posted EPS of $2.15, which did beat the Q3 estimate of $2.06 by $0.09.

As for revenue, Dell missed the mark. While the company did see nearly 10% year-over-year growth, it missed the projection. Dell’s revenue estimate for Q3 was roughly $24.725 billion, but the company only brought in $24.37 billion, missing the mark by about $355.53 million.

Despite the overall revenue miss from the company as a whole, Dell’s Infrastructure Solutions Group did manage to exceed its estimates. But I think the devil is in the details here.

Dell’s Infrastructure Solutions Group delivered $11.37B in revenue for the quarter, up 34% year-over-year, and a touch above the $11.34B estimate. Included in that was a 58% rise in servers and networking revenue at $7.36B, [but this was] below the $7.53B analysts expected. AI-related servers accounted for $2.9B in revenue during the period. -Note by Seeking Alpha.

I wrote in one of my recent articles on Nvidia that the Blackwell chips are far more efficient than earlier chip models from Nvidia (H100 series). Specifically, these new GPUs are 4x more efficient in key AI tasks, according to the Nvidia earnings call.

Now, there is an added detail: Blackwell chips are rumored to overheat if they are placed within too close of a proximity of other Blackwell chips.

Because the chip is so efficient, you don’t need as many Blackwell GPUs within a hyperscaler’s data center to get the same inference output (compared to Nvidia’s previous products).

And, since they are now overheating if they are too tightly packed together, hyperscalers have a carrot and stick incentive to space out these servers.

This, in turn, means that the new AI servers Dell is building will need fewer Nvidia GPUs in them to produce the same level of efficiency.

During a recent earnings call, Dell Vice Chairman and Chief Operating Officer Jeff Clarke spoke on the backlog of Blackwell chips that they currently have.

…as the order shift in Q3 shifted dramatically towards Blackwell, that product is in its ramp and production, and obviously, our backlog reflects when we believe we’re going to get the parts and be able to ship them, and we’ve translated that into our Q4 guidance…

Keep in mind that Q4 guidance slightly missed expectations.

From a GPU standpoint, I am seriously concerned not as many of them are needed. Given that forward revenue growth for the company overall is expected to be just 0.68% YoY, the company’s valuation is really dependent on strong AI server sales. There are no guarantees this will continue over the long term.

I Am Unsure About Valuation

While Dell shares do trade discounted to the sector median, their forward P/E may not be low enough to account for the near 0 revenue growth. Dell’s forward Non-GAAP P/E is currently at 15.91, while the sector median sits at 25.27. While this is a 37.04% difference to the sector median.

Like I mentioned before, Dell’s forward revenue growth is currently below 1% YoY on a forward basis (0.68%). Compared to the sector median for forward revenue growth of 5.62%, this means Dell’s difference to the sector median is 87.83%.

Unfortunately for Dell, what were supposed to be tailwinds at the beginning of the year are now seemingly turning into headwinds. The company is not going to benefit as much from the AI PC revolution. Nvidia’s GPUs are now more efficient, which means that servers and networking equipment will be roughly the same price, but customers will need less than what they had in the past.

With this, it’s difficult to figure out what shares are worth right now. This is why I am a hold on the stock. If we saw evidence that AI PC sales pick up, I would be inclined to upgrade the stock.

Bull Thesis

Besides AI PC sales turning around, I think the biggest bull thesis could be that more hyperscalers start purchasing more Blackwell servers to offset the fact that the newer ones are more efficient.

Dell management did note that most of the customer orders this quarter did switch over from Nvidia technology to Blackwell. While this is an indication that the market is starting to consume these more high-powered servers, there is unfortunately no indication showing that they will need more orders of server equipment than they did with older GPU technology.

In my recent article on Nvidia, I noted that Nvidia would need four times as much demand for server equipment because the Blackwell chip is so much more efficient. Dell is in a similar position because this means less server demand.

Just 64 Blackwell GPUs are required to run the GPT-3 benchmark compared to 256 H100s or a 4 times reduction in cost, Nvidia Executive Vice President and Chief Financial Officer Colette Kress said on a recent Nvidia earnings call.

NVIDIA Blackwell architecture with NVLINK Switch enables up to 30 times faster inference performance and a new level of inference scaling throughput and response time that is excellent for running new reasoning inference applications like OpenAI’s o1 model, Nvidia’s CFO added on the earnings call.

While initial demand for Dell Technologies Inc. servers is strong (according to data from Wall Street analysts), this doesn’t mean this will hold up as we get past FY Q4 and FY Q1 next year. It was expected there would be preorder demand. Once this is satisfied, there is no guarantee this rate of demand will hold up. This is my primary concern.

Takeaway

Looking at Q3 holistically, Dell is in an interesting position. Blackwell chips are really efficient. The question is if they are too efficient, which puts Dell in a very tough position because this could reduce server demand.

Nvidia has produced a really powerful product. However, we’re not quite seeing higher levels of large language models (“LLMs”) from the foundation model producers like Open AI. I am still bullish on Open AI’s o1 model (and the AI trend as a whole). However, larger, more sophisticated models need to come out in order for companies to buy a proportional amount of Blackwell chips. I am not sure if AI models are advancing enough to need more orders. That is the essential question.

With this, I think shares are a hold for now.

---

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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 (main 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.

---