DELL INC - DELL Quarterly Report (10-Q) ITEM 2. Management's Discussion and Analysis of Financial ...

ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Statements in this Report that relate to future results and events are based on the Company’s current expectations. Actual results in future periods may differ materially from those currently expected or desired because of a number of risks and uncertainties. For a discussion of factors affecting the Company’s business and prospects, see “Item 1 — Business — Factors Affecting the Company’s Business and Prospects” in the Company’s Annual Report on Form 10-K for the fiscal year ended February 2, 2001.

All percentage amounts and ratios were calculated using the underlying data in thousands. Operating results for the interim periods are not necessarily indicative of the results that may be expected for the full fiscal year.

During the second quarter and first six months of fiscal 2002, the Company continued to optimize the profitable (excluding the special charge) share growth strategy it began to execute during the fourth quarter of fiscal 2001. Overall, net unit shipments increased significantly compared to the industry, and the Company widened its lead as the world’s No. 1 supplier of computer systems. At the same time soft demand and global economic weakness has continued to result in lower overall technology spending and a highly competitive industry pricing environment. This pricing environment — together with the Company’s practice of rapidly passing component cost declines to its customers — has resulted in lower average revenue per unit, relatively flat to down net revenues on a year-over-year and sequential basis, and downward pressure on gross margins and operating margins. Management currently expects to maintain its strategy of profitable market share growth with a focus on stabilizing overall profitability relative to revenue growth.

The following table sets forth for the periods indicated the percentage of consolidated net revenue represented by certain items in the Company’s Condensed Consolidated Statement of Operations.

For the second quarter and first six months of fiscal 2002, consolidated net revenue decreased 1% and increased 5%, respectively, over the comparable periods in fiscal 2001 and decreased 5% sequentially. Overall net revenue has been adversely impacted as growth in net unit shipments has been offset by declines in average per-unit revenues.

Net unit shipments for the second quarter grew 19% year-over-year and 1% sequentially as the Company continues to profitably grow market share in all regions and product categories. Net unit shipments of the Company’s enterprise systems, which include servers, storage products and workstations, grew 33% over the same period a year ago and 1% sequentially. For the second straight quarter the Company ranked No. 1 in the United States for server shipments. Additionally, during the quarter the Company became the world’s No. 1

supplier of notebook computer systems, as shipments increased 22% compared to the prior year period and decreased 1% sequentially. Desktop shipments increased 18% year-over-year and increased 1% sequentially.

In the Americas region, net revenue declined 3% in the second quarter of fiscal 2002 compared to the same quarter of fiscal 2001, and declined 1% sequentially. Net revenue in the Europe region increased 2% during the second quarter of fiscal 2002 compared to the same period of fiscal 2001, while declining 15% sequentially. In Asia Pacific-Japan, net revenue increased 15% year-over-year and declined 13% sequentially. The market factors that affected the Americas (and the U.S. in particular) in the first quarter — rapidly softening industry unit demand and declining per-unit revenues — spread to Europe and Asia Pacific-Japan in the second quarter. Europe and Asia Pacific-Japan were also negatively impacted by seasonal demand patterns in UK/ Ireland and in Japan, respectively.

Average revenue per unit sold in the second quarter of fiscal year 2002 decreased 17% compared to the same period a year ago and 6% sequentially. This decrease was primarily due to price reductions resulting from component cost declines and the Company’s strategy of leveraging its direct-to-customer model to drive profitable market share growth. Management expects that the current pricing environment will likely continue in the near future as the Company and its competitors experience soft demand and continued uncertainty in the overall economy.

As a percentage of consolidated net revenue, gross margin decreased from 21.3% in the second quarter of fiscal 2001 to 17.5% in the same period of fiscal 2002, while declining 0.5% sequentially. On a year-to-date basis, gross margin decreased from 20.9% during the first six months of fiscal 2001 to 17.8% during the first six months of fiscal 2002. Most of the year-over-year decrease occurred as a result of intense price competition and the Company’s strategy to drive profitable market share growth. Based on the industry, economic and other factors discussed above, the Company currently expects that this gross margin environment will likely continue to be challenging, but the Company’s intent is to stabilize operating margins. Management believes that the strength of the Company’s direct-to-customer business model, as well as its strong liquidity position, result in the Company being better positioned than its competitors to profitably grow market share in the current business climate.

The following table presents certain information regarding the Company’s operating expenses during the periods indicated:

Selling, general and administrative expenses, excluding the special charge, decreased in absolute dollar amounts and as a percentage of revenue for the first six months and the second quarter of fiscal 2002 from the same periods of fiscal 2001. As revenue growth expectations were trimmed during fiscal 2001 and into 2002, management has taken steps to manage expenses relative to actual growth rates, and as a result, selling, general and administrative expenses as a percentage of net revenues have declined for five consecutive quarters, excluding special charges.

Management believes that the Company will continue to improve efficiencies and control selling, general and administrative expenses relative to revenue growth to continue to optimize overall profitability and grow market share. During the second quarter of fiscal 2002, the Company undertook a program to reduce its

workforce and to exit certain activities to further align its cost structure with current economic and industry conditions. A special charge of $482 million related to these actions was recorded in operating expenses in the second quarter. This charge included $134 million related to employee separations, $169 million related to facility consolidations, and $179 million of other asset impairments and exit costs. Other asset impairments and exit costs include $75 million to write down goodwill and intellectual property associated with the acquisition of ConvergeNet Technologies, Inc. to current fair value.

In addition to the $482 million charge, the Company also recorded an impairment charge of $260 million during the second quarter reflecting other than temporary declines in fair value of certain investments. This charge is reflected in investment and other income (loss), net.

The Company announced plans to eliminate approximately 4,000 employee positions (5,700 including the fiscal 2001 special charge) worldwide from various business functions and job classes. Substantially all of the employees have been separated from the Company. These actions, together with those undertaken in the fourth quarter of the prior fiscal year, are expected to result in annual savings of nearly $500 million. These savings are expected to be partially reinvested via pricing, selling incentives, and research and development activities to support continued unit growth in the Company’s enterprise systems. The Company will continue to manage its operating expenses relative to expected revenue growth, and will undertake additional cost-cutting actions if necessary to enable it to continue to optimize profitability and grow market share.

The Company continues to invest in research, development and engineering activities to develop and introduce new products and to support its continued goal of improving and developing efficient procurement, manufacturing and distribution processes. For the three- and six-months ended August 3, 2001, research, development and engineering expenses decreased in absolute dollars and as a percent of revenue as compared to the prior year periods as the Company managed its spending in light of current industry conditions. The Company expects to continue to invest in research, development and engineering activity, with an increasing emphasis on enterprise products, including servers and storage.

Investment and other income (loss), net primarily includes interest income and expense, gains (losses) from the sale of investments, impairment charges for other than temporary declines in fair value of investments and foreign exchange transaction gains and losses. For the three- and six-months ended August 3, 2001, investment and other income (loss), net, was ($207) million and ($149) million, respectively, including the previously mentioned impairment charges of $260 million to write down the carrying value of certain investments.

The Company’s effective tax rate was 28% for six-months ended August 3, 2001 as compared to 30% for the second quarter and first six months of fiscal 2001. The differences in the effective tax rates result primarily from changes in the geographical distribution of taxable income. The effective tax rate of 30% for the second quarter of fiscal 2002 results from revising the expected full year fiscal 2002 effective tax rate to 28%. The Company’s effective tax rate is lower than the U.S. federal statutory rate of 35%, principally because of the Company’s geographical distribution of taxable income.

The following table presents selected financial statistics and information (dollars in millions):

At August 3, 2001, the Company had approximately $7.8 billion of cash and investments. Of that amount, investments in equity securities totaled approximately $456 million with cost approximating fair value. The principal source of the Company’s cash is from its operations. During the first half of fiscal 2002, the Company generated $1.8 billion in cash flows from operating activities, resulting primarily from the Company’s net income, efficient asset management evidenced by a Company record cash conversion cycle of negative 30 days (an improvement of 9 days from the beginning of the fiscal year), and income tax benefits that resulted from the exercise of employee stock options. Capital expenditures during the first six months of fiscal 2002 were $145 million. For all of fiscal year 2002, similar capital expenditures are currently expected to be in the range of $300 to $350 million.

The Company maintains master lease facilities providing the capacity to fund up to $1.2 billion. The combined facilities provide for the ability of the Company to lease certain real property, buildings and equipment to be constructed or acquired. At August 3, 2001, $634 million of the combined facilities had been utilized.

The Company has a share repurchase program that it uses primarily to manage the dilution resulting from shares issued under the Company’s employee stock plans. As of the end of the first quarter of fiscal 2002, the Company had cumulatively repurchased 905 million shares out of its authorized one billion share repurchase program, for an aggregate cost of $8.3 billion. During the second quarter of fiscal 2002, the Company repurchased 17 million shares of common stock for an aggregate cost of $739 million. The Company utilizes equity instrument contracts to facilitate its repurchase of common stock. At August 3, 2001, the Company held equity options and forwards that allow for the purchase of 56 million shares of common stock at an average price of $51 per share. At August 3, 2001, the Company also had outstanding put obligations covering 81 million shares with an average exercise price of $44 per share. The equity instruments are exercisable only at the date of expiration and expire at various dates through the first quarter of fiscal 2004. The outstanding put obligations and forwards at August 3, 2001 permitted net share settlement at the Company’s option and, therefore, did not result in a put obligation liability on the accompanying Condensed Consolidated Statement of Financial Position.

Management believes that the Company’s cash provided from operations will continue to be sufficient to support its operations and capital requirements. The Company anticipates that it will continue to utilize its strong liquidity and cash flows to expand the Company’s presence in high-end systems (servers, storage, notebooks, and complimentary products), expand geographically, improve the efficiency and effectiveness of its direct-to-customer model, and repurchase its common stock.

There are numerous factors that affect the Company’s business and the results of its operations. These factors include general economic and business conditions; the level of demand for the Company’s products and services; the level and intensity of competition in the technology industry and the pricing pressures that have resulted; the ability of the Company to timely and effectively manage periodic product transitions, as well as component availability and cost; the ability of the Company to develop new products based on new or evolving technology and the market’s acceptance of those products; the ability of the Company to manage its inventory levels to minimize excess inventory, declining inventory values and obsolescence; the product, customer and geographic sales mix of any particular period; the Company’s ability to recover its investments in venture capital activities; and the Company’s ability to effectively manage its operating costs. For a discussion of these and other factors affecting the Company’s business and prospects, see “Item 1 — Business — Factors

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