2024-01-12 04:19:09 ET
Summary
- I am reiterating my buy rating for Dell.
- Strong traction in the AI-server space, stabilization in traditional servers, and PC demand recovery will drive stronger performance in FY25.
- Assuming Dell trades at the current 7.3x forward EBITDA, I expect a 1-year total return of 14% (2% from dividends).
Investment action
I recommended a buy rating for Dell Technologies Inc. (DELL) when I wrote about it the last time , as I was bullish on DELL's focus on AI, the demand it saw despite the weak macro conditions, and its accomplishments in the storage sector. Based on my current outlook and analysis of Dell, I recommend a buy rating with a 1-year total return expectation of 14% (2% from dividend yield). I see three positive factors that will drive a stronger FY25 performance: Continuous AI-server-related growth; recovery in traditional and storage server demand; PC demand recovery.
Review
I am giving an update on my view since the stock has hit my target price. In the recent quarter , Dell revenue declined 10% to $22.3 billion. Despite the weak revenue performance, margins were stronger than expected, where gross margins saw 23.7%, beating consensus estimates of 22.7%, and EBIT margins saw 8.8%, again beating consensus estimates of 7.7%. As a result, EPS performed better than expected, coming in at $1.88 vs. the consensus of $1.46. Just to wrap up the results overview, I think the results are pretty much in line with my expectations (I modeled FY24 revenue to be down 11% and EBITDA margin to be flattish). I believe attention should be focused on FY25, where I expect Dell to benefit from continuous demand in AI servers, stabilization in traditional servers, and PC demand recovery. Below, I discuss my view on each of these factors.
Firstly, it is evident that Dell continues to see very strong traction in the AI-server space. In 3Q24, Dell generated >$500 million in AI-server revenue; this represented significant growth from the previous quarter, where 2Q24 only generated less than $100 million in AI-server revenue. I expect the strong momentum to continue through the coming years as more and more businesses rely on AI to streamline or improve their businesses. Especially for cloud service providers, they have to invest in AI-related servers to stay relevant (underlying users would demand AI-related functions). True enough, as management disclosed, AI-optimized server orders have increased to 33% of total server orders in 3Q24, driven by strong demand from cloud service providers. Looking at Dell's AI server backlog, it also points to a strong demand trend. For reference, AI-server backlog almost doubled vs. 2Q24 and has a multi-billion-dollar sales pipeline. I believe this growth has the potential to further accelerate, as management mentioned that they are seeing growing interest from customers from various industries such as higher education, financial services, healthcare, and manufacturing. Another way to frame the potential growth ahead is by looking at the size of the AI server market. Based on Foxconn's chairman , the market is set to reach $150 billion in 2027. Dell's current run-rate AI server revenue is only ~$2 billion.
Secondly, in regards to Dell's traditional server division, the company's revenue from these servers remained relatively unchanged over the last two quarters, coming in at $4.2 billion in 2Q24 and $4.15 billion in 3Q24, despite a notable change in the allocation of IT budgets towards servers optimized for AI this year. This suggests that Dell is not cannibalizing its own business, but rather that the demand for AI servers is a new form of demand that is accretive to the business. I expect traditional server revenue to grow in FY25 given that many customers have been delaying server purchases this year due to the high cost of capital environment (many businesses tightened their IT budget). My view is that these businesses can only delay their purchases for so long; they will eventually need to purchase more servers in order to grow their business, especially with more and more digital data being used. As traditional server demand (computing power) recovers, storage servers should follow through as well, which is a typical pattern that management has called out.
So let me share our current thinking. We're seeing signs of stability and inflection in parts of the portfolio, including traditional and AI-optimized Servers. We expect revenue to return to growth next year above our long-term financial framework.
we have early positive signs that there's a changing in the demand profile of traditional Servers. 3Q24 call
Finally, regarding Dell's PC segment, I acknowledge that the near-term demand was not super supportive of the PC demand recovery narrative. In the recent quarter, Dell PC business grew in August, but demand slowed in September and the slowdown accelerated in October. Large businesses becoming more selective and a decline in demand from the public sector were the main causes of the slowdown. As a result of this slowdown, market-level channel inventory accumulated, placing pressure on prices in September and October. However, my medium-term view is that PC demand is bound to recover as there is an aging installed base due for a refresh. According to the IDC , large portion of commercial PCs are reaching their 4th year mark, which necessitates a refresh, which coincides with the demand to migrate to windows 11. Also, existing PC are not able to fully facilitate AI functions, to do so, these PCs need to be upgraded.
Valuation
Author's work
I am expecting Dell to see a much stronger FY25 (12% growth, matching the decline in FY24) than I initially expected because of the stronger-than-expected AI-server revenue and its growth momentum. Adding to that momentum is that traditional server demand should recover as businesses start to invest in computing power again to grow their businesses. With the recovery of traditional servers, storage server demand would follow through, as these businesses need to store their data somewhere as they grow. Lastly, while the exact timing is hard to pinpoint, I believe the recovery in PC demand will contribute to FY25 growth. For margin, I expect margins to increase in FY25 as general compute and storage have a higher EBIT margin than AI servers.
In the past, Dell typically traded within the range of 5.8x to 8.3x forward EBITDA. I am assuming Dell will trade at its average of ~7.3x, where it is trading today. That said, I would note that there is a chance for Dell to trade up to 8x forward EBITDA if PC and traditional server demand recovers stronger than expected.
Based on my model, there is a 12% upside from share price appreciation, and if we include the dividend yield (~2%), the 1-year total return is about 14%.
Risk and final thoughts
Dell could experience weaker than expected consumer and commercial PC market demand, thereby pushing out the PC demand recovery timeline. In addition, if the Feds raise rates instead of cutting them, we could see another round of IT budget tightening, which will delay the recovery in traditional server and storage server demand.
I maintain my optimistic outlook on DELL and reiterate a buy rating. Looking ahead to FY25, I anticipate a robust performance driven by sustained growth in AI-server demand, recovery in traditional and storage server sectors, and a rebound in PC demand. In particular, I continue to see Dell's AI server business as a strong growth driver in the coming years, as evident from the growing backlog.
For further details see:
Dell Technologies: I Am Expecting A Strong FY25 Performance