Dell bleeds from its own price cuts

August 28, 2008: 7:27 PM ET
Click above for a Jon Fortt interview with Michael Dell.

It used to be that Dell would start PC price wars just to gain market share and punish its competitors. Sure, profit margins would suffer a little, but Dell's efficient manufacturing operation ensured it could still make money while rivals bled.

No longer.

Just look at the numbers. Dell (DELL) stock tumbled as much as 10% after hours on Thursday, as investors chewed on the news that the Round Rock, Texas-based company's net income dropped 17 percent from a year ago. One big reason: Dell is slashing prices to compete with HP (HPQ) in the hearts and minds of consumers, and in overseas markets like EMEA (shorthand for Europe, the Middle East and Africa.)

HP, meanwhile, looks fine. A week ago it too reported shrinking profits in its PC business, but investors shrugged off the bad news because of strong growth in other areas. In a call with analysts, HP CEO Mark Hurd declared himself "pleased with the continued execution" in the PC group. HP's stock has been up slightly since.

The tough truth here for Dell investors: Swings in the volatile PC market now hurt Dell more than its chief rival, HP. And because of that, it still could be quite a while before Dell's stock price marches higher. Dell may need to continue sacrificing profits as it learns to abandon its direct-only model and work with retailers and resellers around the world. If so, there will be more quarters like this one.

For Wall Street, the profit miss is hard to swallow. After all, Michael Dell has been so darn upbeat lately. He bought $100 million worth of the company's stock last quarter, and when I sat down with him last month, he pointed to Dell's unit growth in PCs as evidence that a turnaround is taking hold. "We're kind of back to our old normal Dell, where for 21 years in a row we outgrew the industry – we're feeling the love come back," he told me.  "This is what we like. This is what we're used to."

Analysts embraced the vibe, and the stock had been trading at its highest levels of the year. Industry watchers I talk to have been pointing out that as Dell ships PCs into retail stores around the world for the first time, the company is bound to see a bump. Dell is practically guaranteed to pick up market share, noted IDC analyst Richard Shim in a recent chat, if only because it will be in front of buyers in places like Staples (SPLS) and Best Buy (BBY) where it never competed before.

But as last quarter's numbers show, market share isn't everything. Sure, Dell grew faster than the overall market (and faster than HP), partly because of its new focus on the consumer business. But while HP's consumer-heavy PC group recorded operating profits of $587 million, Dell said its consumer PC operations basically broke even. Yes, Dell's business would have been more profitable if not for an $18 million legal bill – but consumers are fueling much of the world's PC buying these days, and Dell clearly has work to do if it's going to profit from the trend.

What's next for Dell? Expect investors to retreat into a bunker mentality for the rest of the year. Michael Dell and other executives lately have been positive about the company's growth outlook for the second half of 2008, but Wall Street will want some assurance that the growth includes profits, not just PC shipments.

Complicating matters, Dell no longer offers detailed financial guidance – Michael Dell calls the earnings promises a trap that "caused us to, every turn of the crank, think a little bit more short-term until ultimately we sort drove ourselves off the cliff." That approach might help him plot the company's future, but don't expect it to do much for the stock.

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