Yesterday after the markets closed, Dell reported results from its most recent quarter that caused its stock price to fall 8% in after-hours trading. While we can never really know why a stock falls (as it is the result of the choices of tens of thousands of decision-makers that mostly remain anonymous), the media widely reports that the stock fell because of Dell's lowered revenue guidance. The market's infatuation with revenue growth can create excellent opportunities for value investors.
While Dell expects its revenue growth for the year to be closer to 3% instead of its previously anticipated 7%, the company actually increased its expectations for operating income growth for the year from 15% to 20%! Surely, operating income is more important than revenue, right?
Not according to the market it seems, nor the media. In this article from CNBC, for example, nowhere is it even mentioned that profit guidance was raised. Instead, the focus is only on the lower revenue growth.
But foregoing low return, low margin revenue is exactly what companies should be doing. Dell may lose some business, but it's business that's not worth having. As per management's comments:
"Based on...the continued management of lower-margin business...Dell is raising its non-GAAP operating income growth expectation for FY 2012 to 17-23 percent year-over-year from 12-18 percent."
The CFO commented that Dell is "maintaining our focus on developing higher-value solutions and services to drive stronger profitability and smartly manage a balance of growth, increased operating income and cash flow."
This is what shareholders should want, in contrast to a company that expands recklessly, diverting company assets and resources and starting price wars with competitors that are ultimately harmful to the business. Nevertheless, the company received pushback on the conference call (e.g. from one analyst: "Help me understand why you're seeing slowing year-on-year growth, yet characterize the business as being healthy?"), but had the following to say. The statements may be repetitive, but they drive the point home for those who can't take a subtle hint:
"As part of our strategy, we continue to make deliberate decisions to eliminate low value-added revenue...There's no question that our revenue growth is being impacted by our strategy, but that's a trade-off we're willing to make."
"We continue to eliminate lower margin business that's not strategic to the company long term. Specific examples of this include exiting lower value reseller business in both Storage and Software, as well as unfavorable retail and reverse option deals in our client business."
"We're seeing similar profitability improvement in our Software and Peripherals business, where gross margins have improved over 400 basis points year-over-year and 80 basis points sequentially. S&P grew 1% to $2.6 billion as we focus on significant pruning activities and now represent 16% of our revenue. This is a good example of an area where we're exiting portions of the business where margin rates and returns are low and products are not strategic to our solutions focus."
"We're actively managing this business and moving our product portfolio to higher value products while exiting lower margin products in Retail business."
"Again, we say it all the time; we're focused on operating income. You're going to see a change in the shape of the P&L as we mix more and more to higher value solutions and services."
These are exactly the "long-term thinking" kinds of statements you want to hear from management. Yet it seems clear that the market is overly focused on revenue growth. As we've seen in retail, the market appears to pay too much attention to same-store sales even though profitability is far more important.
This overemphasis on revenue is not unique to Mr. Market. In Manage For Profit, professor and consultant Herman Simon argues that management quests for market share and revenue growth are destroying value. Dell (and value play Lexmark, which has taken similar steps) should be applauded for its discipline in not chasing revenue growth at the expense of profitability.
Disclosure: No position
This article was written by Saj Karsan of Barel Karsan. If you enjoyed this article, please consider subscribing to the feed.
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