Dell Q2: AI servers to account for 15% of revenue soon; Upgrade to “Buy Strong” (DELL)

We have initiated a “Buy” rating for Dell (NYSE:DELL) in May 2024, highlighting the growth potential of the AI-optimized server and network portfolio. Dell released its second quarter results on August 29^th after the bell, reporting a 79.5% year-over-year increase in server and networking business. The 23% growth in AI-optimized server orders underscores Dell’s growth potential in the AI ​​era. I switch to “Strong Buy” with a one-year price target of $190 per share.

Growing AI Server Business

My biggest confidence in Dell comes from the rapid growth in AI server revenue as shown in the chart below. During the quarter, server AI accounted for about 12.4% of total revenue, compared to 2.2% three quarters ago. Dell came out of the quarter with a record $3.8 billion in stock, which is remarkable.

I anticipate Dell’s AI server will continue to grow rapidly and contribute significantly to overall growth in the future for the following reasons:

• As shown in the slide below, Dell has a technology lead in the computing, networking, storage and PC markets, where it will support AI training and inference in the future. Dell’s holistic AI portfolio can provide solutions from desktop/edge to data center/cloud. In addition, Dell has expanded its partnership with key AI vendors such as Nvidia ( NVDA ), AMD ( AMD ) and Intel ( INTC ).

For example, Dell expanded its AI factory with Nvidia to include the new PowerEdge XE9680L server as well as storage, edge and workstations in May 2024. These expanded offerings can be used by enterprise customers in various industries.

• As I discussed in my previous report, Dell and Hewlett Packard Enterprise (HPE) hold a significant share of the traditional server market. I believe Dell is well positioned to leverage its existing distribution network, technology and customer base to extend its server products to AI workloads and data centers. Their rack-scale solutions can help their customers achieve high computing power and energy efficiency by utilizing the latest GPUs from Nvidia, AMD and Intel.
• As management has communicated, the current major customers for AI servers are still hyperscalers, although there is a growing number of enterprise customers. I am confident that enterprise customers will gradually expand their data center capabilities and become the main buyers of AI servers in the future. As AI enters the inference phase, there will be greater computing demands at the edge, requiring more servers and storage products.

Lead sale in SecureWorks

As reported by Reuters on August 29^thDell is trying to sell its 79.2% ownership in SecureWorks (SCWX). Dell previously explored selling the stake in 2019. At this point, I believe divesting the cybersecurity firm makes strategic sense because the cybersecurity market is not aligned with Dell’s core server and storage portfolio. As Dell shifts its strategic focus to AI solutions, SecureWorks is increasingly seen as a non-core business. SecureWorks currently has a market cap of $640 million. As such, assuming Dell sells the majority of the property at a 20% discount, Dell could get about $400 million in cash that can be deployed in AI initiatives.

Outlook and assessment

We estimate Dell’s short-term growth with the following assumptions:

• Servers and Networking: Server AI accounts for nearly 40% of Servers and Networking segment revenue. I estimate that the Servers & Networks segment will grow by 50% in FY24, mainly driven by the growth of AI servers. At the end of FY24, I estimate that server AI will account for about a mid-teens percent of Dell’s total revenue.
• Storage: As I mentioned in my kick-off report, storage growth lags behind server growth, as hyperscalers and enterprise customers typically purchase additional storage after the network goes live. As such, I do not foresee any growth in their storage business for FY24.
• Client solution for commercial clients: I assume 2% growth in FY24, in line with recent performance.
• Consumer Client Solution: The business is driven by the PC/Laptop replacement cycle. With VMware exiting Dell’s reseller business, the consumer business is likely to face growth challenges in FY24. We estimate the business to decline by 20% in FY24.

Putting it all together, I estimate that Dell will deliver 14% revenue growth for FY24, supported by strong growth in its server and networking business.

For normalized revenue growth starting in FY25, I assume Servers and Networks will grow 20% annually; storage with 5%; customer solutions by 5%. As such, normalized revenue growth is projected to be 9.3% starting in FY25.

Since the sale of AI servers to hyperscalers has a lower gross margin, I estimate that Dell will face a 10 bps gross margin in the near term, offset by a 10 bps margin improvement in SG&A operating leverage.

With these assumptions, the DCF summary is as follows:

Free cash flow from equity is calculated as follows:

The cost of equity capital is calculated to be 10% assuming: risk-free rate 3.8%; beta 0.9; equity risk premium 7%. Discounting all future FCFE, the one-year price target is calculated at $190 per share.

Negative risks

As Bloomberg reported on August 5^th In 2024, Dell plans to lay off 12,500 employees, or about 10% of its total workforce, as part of a reorganization of its sales force. Dell aims to create a business group focused on artificial intelligence and spin off some low-growth business units. Management confirmed the reorganization during earnings, indicating that the company is optimizing its sales coverage to better focus on AI starting in the second half of this year, with an estimated cost of $328 million in workforce reductions. I agree with the reorganization plan because it could accelerate Dell’s overall revenue growth going forward.

Closing thoughts

I believe the rapid growth of AI servers and networks will continue for the foreseeable future and gradually become a major growth driver for Dell’s overall financials. The stock price is significantly undervalued, based on my model; therefore, I upgrade to “Strong Buy” with a one-year price target of $190 per share.