Dell posted strong AI server order revenue of $2.6 billion with shipments of $1.7 billion, representing growth of 113% QoQ from $800 million last quarter. The backlog of $3.8 billion grew 31% QoQ, which is slower growth than we saw last quarter of 81% QoQ.
Margins contracted and this was a main focus in the Q&A. The company reported a gross margin of 21.63% down 219 basis points. This is the lowest gross margin in two years, dating back to July of 2022. The operating margin is slim at 4.14% down 254 basis points from last quarter. This is the lowest operating margin dating back to January 2021.
Revenue beat this quarter for growth of 6.2%. There was a marginal raise for next quarter revenue that also flowed through to a marginal raise for the fiscal year. GAAP EPS beat whereas adjusted EPS missed by $0.02. The guide for adjusted EPS missed at $1.65 guided versus $1.86 expected for Q2.
The AI server revenue is more than we could ask for. As long as this is the bottom for margins, we are good to go with this position. Most roads point toward Dell being a stronger 2025-2026 story due to the timing of the AI PC upgrade cycle and its core server strength being in enterprise. This is why our last write-up was called “Early AI Shoots.” With that said, we are also seeing evidence the AI story is already unfolding. With a little extra effort on technicals, we think Dell will be well worth the effort in 2024, as well.
Revenue and EPS:
Revenue of $22.3 billion beat estimates of $21.7 billion for growth of 6.22%. The company guided for revenue at the midpoint of $24 billion, representing growth of 5%. This is higher than expectations for Q2 of $23.2 billion. The company also raised fiscal year guidance to a midpoint of $95.5 billion, up from a midpoint of $93 billion. Analysts were expecting $94 billion for FY2025.
Per current estimates, we should be at the bottom for Dell.
GAAP EPS of $1.32 beat estimates of $0.77. Adjusted EPS missed by 1.55% with $1.27 EPS reported versus $1.29 expected. Looking forward, management is guiding for adjusted EPS of $1.65 +/- $0.10. This is a miss as analysts were expecting adjusted EPS of $1.86. This miss also led to the Q&A being predominately about margins.
This is the bottom for Dell on adjusted EPS with H2 expected to see over $2.00 adjusted EPS.
Margins:
The bulk of the negative price action after hours is coming from weaker margins. This is because analysts are not convinced that the AI server revenue will be accretive. Management was quite clear that the ISG segment (where AI revenue is recognized) will end the year between 11% and 14% operating margin. This quarter, the ISG segment operating margin was 8% of revenue.
Per our pre-earnings writeup: “The company is not expected to continue this trend of improving profit margins for a few reasons. First, the high-growth AI market is generating lower margins than the company’s other leading products. In addition, the company expects input costs to increase further in FY25, driven by anticipated inflation for component costs as the year progresses. Management also anticipates the pricing environment to be more competitive in FY25.”
- Gross margin of 21.6% is down 238 basis points from 23.98% in Q1 of last year and is down 219 basis points QoQ. The gross profit was $4.8 billion. Per the opening remarks: “Given inflationary input costs, the competitive environment and the higher mix of AI optimized servers, we do expect our gross margin rate to decline roughly 150 basis points.”
- Adjusted gross margin of 22.2% is down 230 basis points QoQ and is down 250 basis points YoY.
- The operating margin of 4.14% is down from 6.68% last quarter. This also marks a 97 basis points decline YoY. This led to operating profits of $920 million.
- Adjusted operating margin of 6.6% was down 300 basis points QoQ and down 100 basis points YoY. This led to adjusted operating income of $1.47 billion.
- Net margin of 4.3% was down 90 basis points QoQ yet was up 151 basis points YoY. This led to net profit of $955 million.
Key Segments:
Infrastructure Solutions grew 22% YoY yet declined (1%) QoQ to $9.2 billion. The segment reported $9.3 billion last quarter. Server and networking revenue was $5.5 billion, up 42%
AI-optimized server order revenue increased to $2.6 billion, with shipments up more than 113% to $1.7 billion. This is up from $800 million last quarter for a 40% QoQ acceleration in Q4. The AI server backlog of $3.8 billion represents growth of 31% QoQ, down from 81% QoQ growth last quarter. AI now represents 7.6% of Dell’s revenue, up from about 5% last quarter.
For FY2025, per the CFO: “We expect ISG to grow in excess of 20%, fueled by AI.”
Client Solutions was flat YoY yet increased 2% QoQ to $12 billion. This is up from $11.7 billion last quarter. Commercial rebounded to 3% growth while consumer was down 15%. For FY2025, the CFO stated she expects “CSG business to grow in the low single digits for the year.”
The flat YoY and 2% QoQ may seem nominal but it’s quite important to see this segment bottom finally as it’s been declining for two years (!). Here is what management stated about what to look forward to in this segment: “We remain optimistic about the coming PC refresh cycle driven by multiple factors. The PC installed base continues to age, Windows 10 will reach end of life later next year, and the industry is making significant advancements in AI-enabled architectures and applications. We will continue to focus on commercial PCs, high end of consumer, and gaming, driving a strong attach motion, a strategy that has served us well across various economic cycles.”
For the full year, the company expects: “the combined ISG and CSG business to grow 11% at the midpoint, and our other business to decline, as previously discussed on the Q4 call.”
Cash and Debt:
Dell has operating cash flow of $1.04 billion for a margin of 4.69% in the most recent quarter. Free cash flow of $457 million represents a margin of 2%. This is slim margins for Dell, which can report a FCF margin >10%.
The company has $7.12 billion on the balance sheet with $25.4 billion in debt.
Dell returned $1.1 billion to shareholders through share repurchases and dividends.
Earnings Call:
Margins:
The Q&A was essentially analysts attempting to come up with creative ways to ask how much AI servers are impacting the margins. To cut to the chase, this is what analysts are concerned about:
Question
Toni Sacconaghi (Analysts)
Yes. If I just look year-over-year at the ISG business, storage was perfectly flat. AI servers went from 0 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 0? And if that's not the case, how do you square the circle with what I just outlined?
Answer
Yvonne McGill (CFO):
Toni, I'll take that one. So when I look at the overall ISG performance from an operating income standpoint, storage — I'll start with storage, right? Operating income was low in storage. You know that Q1 is seasonally our lowest revenue quarter from a storage perspective. When the revenue declines, the business de-scales. And so we saw that evidenced in the Q1 results. And while OpEx remains unchanged, to the point you're making, the OpInc rates decline.
In traditional servers, we saw strength in large enterprise and large bid mix. So a shift there a bit, which, as you know, that drives lower margin rates. When I look into Q2 and FY '25 though, I'd tell you that we expect ISG OpInc rates to improve as we talked about in the guide over the year, and really deliver against our long-term framework that 11% to 14%. So I think what we saw in the first quarter was multifaceted, but we do continue to expect recovery as the year goes on. And those AI-optimized servers, we've talked about being margin rate dilutive, but margin dollar accretive. And so you'll continue to see that evidenced in the results also.
–End Quote
Since this is a such an important topic, I’m going to copy and paste another part of the Q&A on this topic that goes over the same question. I’m cutting down the response to the most succinct answer from the CFO.
Question
Erik Woodring (Analysts)
I'm going to kind of hit on a similar topic that everyone has. But Yvonne, you're talking about improving ISG operating margins through the year. Obviously, it seems like the strength and momentum you have in AI servers means that will continue to become an increasing mix of revenue. You also have commodity cost headwinds to contend with.
And so again, I know we've kind of talked about this topic, but maybe on a bit more detailed level, can you just help us understand what are the most significant factors that we should be thinking about that would support ISG operating margin expansion as we work through the year? Is that pricing? Is that mix? Is that storage mix? Just help us understand what are the most important factors there, again, as we look through the year.
[…]
Answer
Yvonne McGill (Executives)
Yes. And the one thing, I don't think I called out specifically, the storage margins will continue to improve also because we will scale, right? We talked about the OpEx, we talked about that level of spend that we have. But as we scale that business, we will get that. And I'll reiterate that we do expect ISG Op Inc [operating income] to finish FY '25 within our long-term framework, so 11% to 14%.
–End Quote
The read-through is there could be a 0% operating margin on servers but storage will make up for it. Per previous comments: “for every $1 of AI server, there's $2 of services, storage and other higher-margin things that come.”
Conclusion:
Dell’s management is confident they will exit the year at a higher margin. Typically, we do close positions with contracting margins. We are making an exception to this rule because Dell is at a bottom both on revenue and earnings. That is key to understanding why we stick with a company or not, which is that a bottom is meant to mark an inflection point.
There are a few irons in the fire: AI servers for cloud service providers and enterprises which includes networking and storage, and then separately, the new upgrade cycle coming for PCs.
Per the trading plan, key levels have to hold for Dell. However, Knox was expecting this pullback and he has a buy plan in mind depending on how the price action plays out. You can reference the webinar from earlier today or the upcoming Positions Report due out early next week to learn more. Technicals are important especially for this position because Dell has rivaled Nvidia on YTD returns. Thus, we want to stay diligent in the event this is a breather before the next leg higher.
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