The AI Effect And Its Issues: A Review Of Dell’s Earnings

Summary:

• Dell is experiencing strong demand for AI-optimized servers, with customer demand nearly doubling sequentially.
• The company has a multi-billion dollar sales pipeline for AI servers and a significant backlog, indicating high demand.
• However, Dell’s AI business presents a few operating issues, which should not be overlooked.
• In this article, we look at Dell’s Q1 FY25 earnings report to understand why the stock sold off.

Dell Is Catching Investors’ Attention

Dell (NYSE:DELL) was one of my top three picks for 2024 and among these three, it has been by far the best-performing one having returned over 100% in these few months.

To be honest, the reason why I turned bullish on Dell hasn’t materialized yet. In fact, I was convinced – and am still – that 2024 would be the starting year of a new PC replacement cycle after the Covid-related cycle. After all, PCs are an essential productivity tool – a real staple nowadays – and businesses can’t just endlessly postpone their replacement. While this trend has not picked up strength so far, there is more and more data hinting that we should see it soon. In the meantime, however, investors have pushed Dell up due to other AI-related reasons we will see in a moment. In this article, I want to go over Dell’s case. On one side, we have to understand what is happening with Dell and AI; on the other, I have reasons to believe there is still the PC replacement cycle tailwind to be unleashed and that could push the stock up even more.

Dell just released its earnings report and its shares tumbled 18% right away even though its results were in line with expectations. Dell reported $22.24 billion in revenue, beating expectations of $21.65 billion, but missed slightly on EPS, coming in two cents below the $1.29 analysts were expecting.

Why Dell Is Up This Year

To understand this report, we need to take a step back. Let’s start with a look at the recent past. With this, I mean to go over what happened with Dell as the first language models became publicly available and the AI era began.

To understand this shift, I will use Dell’s 2022 Annual Report and compare it to the 2023 Annual Report. Dell’s fiscal year ends on the Friday nearest to January 31st. As a result, each fiscal year is referred to after the year in which the month of January falls. For example, Dell has just reported its Q1 FY20245 earnings, because this fiscal year will end in January 2025.

One more thing, before we start. Dell is organized into two business segments: Infrastructure Solutions Group (ISG) and Client Solutions Group (CSG), with the former including storage solutions and AI-optimized servers together with server, storage, and virtualization software solutions, while the latter offers hardware (notebooks, desktops, workstations, various peripherals) and related services offerings.

Regarding CSG, we should be aware that Dell focuses on the most valuable segments of the industry. We see, in fact, that commercial PCs make up 49% of global sales, while they have a 75% weight on Dell’s sales mix, while only 9% of Dell’s sales come from mainstream consumer PCs versus the 22% of the industry. As a result, Dell’s total revenue per unit (TRU) is almost twice that of its competitors.

To understand why Dell’s shares went significantly up this year, let’s start by comparing the two 10-Ks, where we immediately spot a shift in Dell’s company overview.

In 2022, Dell described itself in this way:

Dell Technologies helps organizations build their digital futures and individuals transform how they work, live, and play. We provide customers with one of the industry’s broadest and most innovative solutions portfolio for the data era, including traditional infrastructure and extending to multi-cloud environments. Our differentiated and holistic IT solutions benefit our results and enable us to capture revenue growth as customer spending priorities evolve.

Take a look at what happened to the same paragraph a year later (bold is mine):

Dell Technologies helps organizations build their digital futures and individuals transform how they work, live, and play. We provide customers with a broad and innovative solutions portfolio for the data and artificial intelligence (“AI”) era, including traditional and modern infrastructure. Our differentiated and holistic information technology (“IT”) solutions enable us to capture growth as customer spending priorities evolve.

Honestly, we have seen an almost infinite number of companies rewriting their overviews to mention AI. After all, AI has been the new buzzword for the last 15 months. However, unlike other buzzwords, I believe AI, though it may be overhyped in the short term, is a development we won’t walk away from. Moreover, in Dell’s case, it is indeed quite true that the company is highly exposed to this new technology.

To see and understand how that is, I have read through the past three years of transcripts and have tracked the AI narrative as it unfolded in Dell’s conferences.

The first time AI was mentioned was when Michael Dell at Citi 2022 Global Technology Conference talked about a renaissance of computer architecture

On the data center side, again, it is multi-cloud. It’s this explosion of data. If you want to do autonomous transportation, AI drug discovery, fintech, or whatever you want to do, it involves data, right? Anything interesting in the world, data is right at the center of it. The ASPs have been going up because you have kind of this XPU phenomenon, where it’s not just the CPU, it’s the GPUs, the DPU. It’s all these specialized offload engines that are allowing a kind of renaissance computer architecture.

A few months later, Matt Baker, Dell’s SVP of Strategy and Planning, at the Barclays 2022 Global Technology, Media and Telecommunications Conference: openly talked about a new opportunity opening up for Dell:

we also have several net new opportunities that are, I would say, closely adjacent to those businesses, and those would be things like edge computing, multi-cloud, data management, security, et cetera. So, in essence, you can think of it as a twin-pillar strategy. […]

And I get a lot of questions about what is this thing called edge, and it’s caught up in the discussion of on-prem, off-prem, public cloud, all of that stuff. But the reality is, if you look at what people are trying to do with advanced data-centric workloads, what — we all use shorthand for AI and ML, they’re looking to do really interesting value-added things in the world around us.

Then, in the Q4 2022 earnings call, 9 months before ChatGPT was going to be released, Chuck Whitten, Co-COO talked about Dell’s innovation agenda:

we launched our next generation of PowerEdge servers with significantly enhanced AI and machine learning capabilities and improved energy and cost efficiency for data center, cloud, and edge environments, including new purpose-built XR servers for telecom, open RAN, and mobile edge use cases.

Few at that time would have been able to understand what was going to be released soon thereafter. But being an infrastructure company, Dell was already aware of the huge server demand that was soon to come thanks to AI.

In 2023, during the Morgan Stanley 2023 Technology, Media & Telecom Conference,

Chuck Whitten was asked to explain how Dell was positioned to benefit from growing AI workloads, and he answered in this way:

This is not a new trend. This is a long, long megatrend that we’ve long called out. There are a few allocations in our business.

One is AI is embedded into our solutions to make them better. And so whether it’s our workload optimization, the way we manage power and efficiency, the telemetry we use in our services, right, it’s part and parcel of how we build our infrastructure and our PCs.

Second, we’ve long worked with customers to develop solutions and platforms in conjunction with ecosystem partners to deliver AI solutions.

If you look at it from a shareholder standpoint it’s driving the richest growth in profit pools and infrastructure, and we’re going to benefit from that tailwind.

I think more exciting for us is the application of these models and inferencing to private data sets because if you’re going to do a medical diagnosis or you’re going to do customer service, if you’re going to do proprietary security analysis, you’re going to want to control your infrastructure, and that’s our core business, right? That’s what we’ve been working with customers on for a long time.

By now, it was becoming clear that Dell’s role would have been to offer the adequate infrastructure to make AI run and interpret the data, just like Michael Dell himself explained at the 2023 Bank of America’s Views from the Top CEO Series Conference

if you have a lot of data and you’re not using AI, you’re doing it wrong, right? So there’s so much data. The only way to interpret the data is AI. And for some time, the AI workloads have been the fastest-growing workloads that we’ve seen. And as a leader in infrastructure, we’re positioned to benefit from that growth in machine intelligence.

And look, we continue to innovate there. We recently introduced our XE PowerEdge Servers as part of our 16th-generation launch. That supports eight NVIDIA H100 Tensor Core GPUs or also the A100s. And those are the kinds of machines you need to run these large language models. […] Certainly, servers, there has been a trend toward more memory, more virtual machines, more GPUs inside these servers and that’s because of the rapid growth in AI workloads.

So far, all of what we have seen caters to ISG. But then, Sam Burd, President of CSG, at Bank of America 2023 Global Technology Conference started also speaking about the impact of AI on Dell’s client solutions:

in the PC space, think about that workstation kind of environment coming to more mainstream PCs, where we see the advent of offload engines and NPUs or VPUs that add AI processing capability on CPUs that will be available on the architecture in the future. And the ability to then take task I’m doing on a PC and have what — Microsoft talked about a build of a copilot-type experience where it’s augmented by artificial intelligence. And I’m not searching on how to do settings on my device. We’ve had multiple years where we’ve built — we have something we call Dell Optimizer. We built — before everyone wanted to talk about AI, we’ve had intelligence on our devices for multiple years of optimizing, automatically setting, and configuring that device so you can think about better performance of the same power. So, greener PCs perform better for users done automatically.

After these events, we have the Q2 2024 Earnings Call. Here Dell switched gears as AI was mentioned 50+ times. In fact, Dell approached this earnings report with some caution, due to softening hardware demand. However, it had to present to the market a faster-than-anticipated recovery thanks to significant strength in AI-enabled servers and software-defined storage solutions. The PowerEdge XE9680 was seeing “unprecedented strength”. In addition, Dell gave for the first time an estimate of the AI TAM, projecting it to grow at a 19% CAGR for a few years to around $90 billion. During this quarter, AI services made up 20% of Dell’s server order revenue and the company reported an XE9680 backlog of almost $2 billion.

As a result, Dell repeatedly stated that demand was way ahead of supply, with a 39-week lead time.

The Q3 2024 earnings call was even more AI-centric, with over 60 mentions of the word. Dell confirmed AI server demand continued to be strong and announced it had shipped over $500 million of AI-optimized servers “including our XE9680, XE9640, XE8640, and the R750 and R760xa servers”. Customer demand for these AI servers nearly doubled sequentially, and demand remains well ahead of supply. Dell used this call to give a new estimate of the TAM and its CAGR for the next 4 years. Now it started talking about a final market value of $120 billion, growing 18% per year. Moreover, it explained this growth wasn’t cannibalizing traditional servers.

Another important piece of news was that the pipeline for AI-optimized servers tripled QoQ with a lead time remaining 39 weeks.

What I think was extremely interesting for us investors is the words that were spent on the current AI hype, which Dell is likely well aware of. Using its multi-decade experience in technology infrastructure, during the earnings call, I believe the following words were used to make investors mitigate their short-term expectations and understand what the process is that’s going on (bold is mine):

AI hype is everywhere, and we need to be measured in our expectations. We are still in the early innings with AI as customers continue to work through their AI strategies. Experience over multiple technology cycles tells us that progress won’t always be linear, but we are excited about the opportunity in front of us. We believe Dell is uniquely positioned with our broad portfolio to help customers size, characterize, and build GenAI solutions that meet their performance, cost, and security requirements. Our AI strategy, AI in our products, AI built on our solutions, AI for our business, and AI for our ecosystem partners are the foundation for our actions, priorities, roadmaps, and partnerships.

Momentum picked up even more when, just three months ago, during the Q4 2024 Earnings Call Jeff Clarke said Dell was increasing its view of the TAM to $152 billion and a 20% CAGR going forward to 2027. Admittedly, he said this was “probably a lagging indicator that is still catching up”.

In favor of this view, we have the recently announced partnership of Dell with Nvidia (NVDA) to sport in Dell’s new PowerEdge XE9680L servers Nvidia’s GPUs. Nvidia announced in its last earnings call that Dell will be taking its Spectrum-X for Ethernet to market and reported strong and sustained growth, which makes us expect good results down the road for Dell, as well.

From one earnings call to the next, Dell stock kept soaring and is now among the best-performing stocks in the market, with a 250% growth over the past year. With such a massive run, we should not be surprised that normalizing earnings could lead to a meaningful sell-off, with many locking in significant gains.

The Issue of Dell’s AI Server Margins

There is something that some investors started to watch more thoroughly, though, until now, it has not been the cause of fear. First of all, Dell’s revenues have hovered between $85 to $102 billion in the past few years. As fast as AI-optimized server demand is growing, we are still before a market opportunity worth $2 to $4 billion for Dell. Surely, not peanuts, but neither a game changer. At least, not yet.

Moreover, this additional revenue seems to hurt the company’s margins because AI server margins are really low due to the high manufacturing costs which can’t be passed completely onto the customers to keep prices reasonable.

When Dell addressed the 2024 Morgan Stanley Technology, Media & Telecom Conference its management admitted that “AI servers are margin dollar accretive, but rate dilutive”. This means that selling AI servers generates more profitable revenue, but the profit margin rate is lower than Dell’s overall rate.

This caused Michael Dell to be asked during the Bernstein Conference whether we may be seeing some temporary overbuild in capacity which could lead to what happened in the past 20 years, where the technology infrastructure market didn’t grow but stayed bound within the $50 to $70 billion range for 15 years. This is how Mr. Dell replied.

We see a big TAM growing for hardware and services, which is the place that we tend to play in […]. There will be a new wave of kind of AI-enabled PCs that can run these models, just like there’ll be new phones that could run these models and then you’ve got all the inference activity that’s going to occur. Once you’ve trained your model, you have to put the data through it, so you get a better outcome, you make a prediction, and you have something occur more effectively. That’s going to require an enormous amount of computing power.

So, what should we make of all these words? Here are my takeaways:

1. AI-related infrastructure will see growing demand for at least 4 years
2. Dell’s product portfolio services will capture this demand and will generate additional revenues, though it is not yet clear if they will be large enough to sensibly impact Dell’s huge top-line
3. In this growth stage, profitability will be sacrificed to keep up with the market demand. However, investors should be aware that, sooner or later, Mr. Market will demand margin accretive operations rather than margin dilutive ones. After all, Dell’s long-term financial model targets a 3 to 4% revenue growth and EPS growth in the high-single-digits, which are not exactly the numbers a fast-growing business posts.

With this, we have caught up with today’s and Dell’s Q1 2025 earnings call.

But, before we move on to Dell’s financials and its latest report, we should spend a few words on another topic.

The PC Refreshment Cycle Is Coming

Back to where we started. I said at the beginning of the article that the main reason I was bullish on Dell was because a new PC replacement cycle was coming. At the Bernstein Conference, Michael Dell confirmed that “we are bullish on the coming PC refresh cycle, where we are well-positioned”. After all, businesses can’t endlessly postpone the purchases of productivity tools such as PCs. On average, PCs and tablets have a lifespan between 3 and 5 years. As a result, since in 2020 and 2021, we witnessed strong spending in the category, and we should see the new cycle start by the end of this year. Moreover, we are seeing the first AI PCs coming to market and Dell will be a big player here. While investors are focusing on AI-server demand, we are probably going to see a surge in CSG sales starting in the second half of the year. This should bump up Dell’s revenues and margins. In a context where the excitement is on AI while we still are not seeing a meaningful financial impact, we could see the market celebrate Dell’s renewed strength thanks to its legacy business.

Dell’s Financials

Let’s take a quick look at Dell’s overall financials before we move on to the quarterly report.

First of all, Dell is not a growth stock. At least, not for now. Its long-term revenue CAGR is 3.6% and is not expected to come above 4%. As a matter of fact, Dell’s top-line does reflect some volatility, with revenues breaking the $100 billion barrier right after the pandemic, to then retrace back to around $90 billion.

At the same time, Dell is a profitable company, with EBITDA margins around 10% and net income margins above 3.5%. True, a net income of just $3.2 to $3.5 billion from a $90+ billion revenue is not exciting, but we have to consider Dell is a manufacturer and, as such, it has a very high cost of revenues ($67 billion over the last 12 months) and high SG&A of more than $12 billion. What matters more, however, is that Dell’s capex is not that high, rarely coming in above $3 billion. At the same time, the company’s cash from operations is usually between $8.5 to $10 billion. This means the company usually generates over $5 billion of FCF, as we can see below.

As we can see, this created a situation where Dell’s FCF conversion rate is usually above 100%, which is a very good achievement. Free cash flow also matters because Dell commits to return over 80% of adj. FCF to shareholders via buybacks and dividends (Dell initiated a quarterly dividend just two years ago and has increased it aggressively in the past two years). The remaining FCF is committed to an IG rating and a 1.5x leverage target or tuck-in M&A activity. And this leads us to Dell’s balance sheet.

Historically, Dell had been a bit over-leveraged. But in the past three years, Dell has paid down its debt aggressively, reducing its core leverage to just 1.5x, making it a very healthy company with little need to take on new debt at higher rates.

As a result, we see Dell’s LT debt moving down quarter after quarter, thanks to steady quarterly payments. In the most recent quarter, for example, Debt paid down another $3.48 billion.

Overall, we have a company whose main product so far can be considered a staple and whose new frontier is to expand its dominance in the staple of the next era: AI servers and AI PCs.

Let’s then look at its results, coupled with the guidance.

Dell’s Q1 FY2025 Report

Here we are, Dell reported quarterly revenue of $22.2 billion, up 6% YoY. As we have noted, this is fast growth for Dell. Moreover, there was a massive difference between Dell’s two divisions: ISG reported $9.2 billion in revenue, a 22% increase YoY, with record servers and networking revenue of $5.5 billion (+42% YoY) while storage revenue was flat; CSG, on the other hand, reported $12 billion in revenue (flat YoY) with commercial client revenue up 3%, but consumer revenue down 15%. Diluted EPS were up 67% YoY to $1.32, but non-GAAP diluted EPS came in lower than expected at $1.27, down 3% YoY.

Seeking Alpha just released a few useful charts where we see the segment revenues in the last ten quarters, showing what we have outlined through this article: ISG is growing, while CSG is suffering.

Seeing the difference between revenue growth and earnings decline, we can immediately understand where the issue could be. When we check Dell’s operating income, we find the company reported $920 million for the quarter, a 14% decline YoY.

So, the picture is quite clear: had Dell not been involved in AI due to its optimized servers, the company would have posted a very weak report. However, strong growth across its infrastructure business, mainly led by AI demand, kept the company more or less afloat. This was not enough for Mr. Market. At the same time, Dell reported AI-server orders increasing to $2.6 billion and a backlog growth of 30% to $3.8 billion, a $900 million growth. We are still before a small portion of the company, but this fast growth in its order book makes me expect we could soon see an $8 to $10 billion business segment.

However, let’s take a look at the operating segment results.

Even though ISG posted a 42% revenue increase in servers and a 22% total increase, its operating income decreased by 1% to $736 million. CSG was overall flat revenue-wise, while its operating income fell by 18%.

If we zoom out, we see that this has been going on for a while, with DELL’s CSG constantly reporting decreasing revenues, while ISG has been mainly flat, though AI-related demand is soaring.

After all, its total cost of net revenues increased 10% YoY. Why is this so important? Because, so far, Dell sees revenue growth with little impact on margins. This leads to decreasing operating cash, which is the starting point used to calculate a company’s free cash flow. We can see how Dell’s cash flow from operations has trended downwards for the past few quarters.

Dell’s Valuation After FY25 Guidance

Dell guided for a Q2 revenue range of $23.5 billion to $24.5 billion, thanks to ISG expected to report growth in the mid-twenties. For the full fiscal year, Dell expects revenues around $95 billion, which is still below the highs seen a couple of years ago, and non-GAAP diluted EPS around $7.65. This immediately leads to a fwd PE of 22.9. While this may be a very reasonable multiple for software stocks, in this case, we are before a company with a strong manufacturing activity, which also affects its productivity and its cost structure.

From the cash flow perspective, Dell is expensive, trading at a fwd P/FCF of 23.2. Its FCF yield is now around 4%, which is decent, though not extremely cheap. Were Dell a fast-growing company across its main segments, I would be more at ease with this valuation, but seeing that Dell is none of this, it’s no wonder investors move in and out of the stock quarterly, as a consequence of notable earnings calls. In this case, Dell’s profitability is being damaged.

As much as I appreciate the company and its business, I would not buy it at today’s price because of the still high multiples reflected in Dell’s current stock price of $170. Dell is poised to benefit from AI server demand and will be among the AI-infrastructure winners. But the AI-frenzy has the risk of inflating many stocks’ valuations, baking in the price unrealistic expectations that have little to do with a real and successful business.

As a result, I rate the stock as a hold right now.

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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.

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