Dell and the margin

Computer maker Dell (DELL) released 2009 year end and quarterly earnings yesterday. Cash flow from operations increased 106% YOY (that's year-over-year) and the cash conversion cycle improved from -25 days last year to -36 days. On top of that, free cash flow and cash on hand are both on the rise.

So why did the stock price drop 6.65% right after the release?


To keep his employees working through the recession, Michael Dell had to keep throughput (how much stuff comes through a particular node, person, or process) near pre-recession levels. To do this, the firm delivered “cost and performance leadership” (quote from the earnings presentation). That is, Dell cut prices to keep market share.

The market recognized this and reduced the price of Dell according to the reduced near-term earnings expectations.

The technology space is well-known for continually falling prices and continually increasing performance. To be a cost and performance leader, Dell reduced its margin. As prices continue to fall in the marketplace, competitors' prices will eventually fall to Dell's levels and pricing parity will return. By that point, the recession will be ending (it will be ending, right?) and the renewed opening of wallets will drive the next sales increase.

Dell likely anticipated the short-term drop in stock price, but made the calculation that there was cover to do so in the current recessionary environment.  Since the firm still posted outsized revenue gains and sits on a pile of cash, this might be seen as a buying opportunity for investors.  Some quick back-of-the-napkin cash flow analysis might be helpful before pulling that trigger, along with some consideration of what the recent Perot acquisition means for the strategic direction of the firm.

While the revenue-over-margin strategy works for Dell in the medium term, it doesn't work for every company. Firms that offer a non-commodity product or service have much more difficulty growing margin once a price cut is instituted. The reason is simple: there is less competition to drive other competitors' prices lower. On top of that, once your customers become accustomed to paying the new, lower price...the expectations are set. The new price increase changes the value proposition in the mind of the purchaser – the “give” is now greater and the “get” is the same.

-Bryan