Riding the ever-growing enterprise IT market

It’s hard to get excited about mature markets that grow at a steady pace unless it’s the most profitable part of the market. And when it comes to the global IT market, the part of it that is consumed by enterprises, i.e. anything smaller than a hyperscaler and a large cloud builder or outside of an HPC center or telecom provider/ services – and in this case including government agencies and educational institutions – is by far the most profitable.

It is also notoriously proactive about economic downturns and cautious about economic rebounds, reflecting the conservative nature of the top 20,000 companies worldwide and the many millions of other companies that either supply them or try to compete against them.

It’s with this in mind that we consider IT vendor Dell, which among the large original equipment manufacturers is among the few that still sells data center equipment and client equipment alike. (Lenovo does this too, but Hewlett Packard Enterprise, Inspur, Cisco Systems, and others don’t.)

As part of its financial results for the third quarter of fiscal 2023 ended in October, Dell’s direction towards the total addressable market that Dell is chasing, and therefore even offered a forecast for the datacenter TAM through 2025. This data was, to be honest, among the most interesting things Dell talked about because we don’t often get that kind of insight from major IT vendors. How Dell is running its data center business during these strange times of jittery economy and fragile supply chains and what Dell’s infrastructure customers spend on is also interesting and perhaps a good indicator of how it’s performing the company given all the uncertainties.

The thing to always remember is that IT organizations have to spend. Budgets never go to zero and things still need to be done, even if nobody feels like being extravagant. Dell certainly wasn’t in the October quarter.

Chuck Witten, who is co-COO with Jeff Clarke at the company, said on a conference call with Wall Street analysts looking at the numbers that Dell has actually seen infrastructure demand slow, but added a caveat that Storage sales “have held up quite well against servers, with growth in multiple storage types, including high-end and PowerStore.”

Witten added that with its direct selling model, Dell has immediate feedback from IT customers across geographies and industries and can see the demand environment change faster than the rest of the industry, and given this, Dell tightened its purse strings and cut operating costs by 3 percent sequentially in the fiscal second quarter and another 6 percent sequentially in the fiscal third quarter, reducing costs by $300 million and contributing to the profitability of its group of infrastructure services and its customer services group. Dell was also, Witten said, able to capitalize on component cost reductions faster than its competitors and thereby increase its profitability. This assumes that Dell has not passed on the cost savings to customers, and given the backlogs of server, storage and networking products, we believe Dell has not had to pass on these component cost savings as price reductions. Witten also said Dell has been able to reduce its server backlog, which has grown during the pandemic due to component supply issues. When all is said and done, Dell expects to grow its market share (based on data coming out of IDC next month) in both servers and storage.

And this is the patient game Dell has played to become the most dominant OEM on the planet, far outpacing HPE, Inspur and Lenovo and well ahead of Cisco Systems and a shrinking Big Blue since it exited its server business System x X86 in 2014. Dell continues to win new customers and new business, using its purchasing power of volume components across the client and server supply chains to wring whatever meager profits it can from the IT industry.

That’s not much in the way of profits for Dell, particularly a year after the VMware spin-off:

In the third quarter, Dell’s overall product sales decreased 12.1% to $18.94 billion and services sales decreased 15.6% to $5.78 billion. Overall revenues were down 12.9 percent to $24.72 billion and its net income was slashed by a stunning 93.6 percent to $245 million, but that was a very tough comparison as some profits on the VMware spinouts were registered in the period of one year ago. Since then, Dell’s profits have been declining faster than its revenues, and you can blame a lot of that on PCs, not servers, storage, and switching.

Dell reduced its debt load by eliminating VMware – it fell 43% to $27.33 billion – but sharp tightening in the PC market and slowing data center infrastructure market led to Dell burning some of cash, which is down 73.4% year-over-year to $6.44 billion.

Due to improved component supplies and declining component prices, Dell’s Infrastructure Services Group, which manufactures and sells servers, storage and switches, reported revenue of $9.63 billion, an increase of 12.4%, and it had operating income of $1.37 billion, which is 14.3 percent of revenue and that was up a great 53.7 percent.

Within ISG, server and networking hardware sales increased 14% to $5.2 billion and storage sales increased 10.6% to $4.43 billion. Overall, Witten said the third quarter was about the same as the second in terms of customer opinion and attitudes. The sales slump in China was more pronounced than expected, but spending by the energy sector, the US federal government and general midsize businesses exceeded the combined spending of all Dell customers.

“Customer feedback is very similar to what we described in the second quarter, very cautious and deliberate behavior in the face of what is a lot of macroeconomic dynamics out there,” Witten explained. “So, we’re hearing budgets reevaluated, spending re-prioritized, and customers effectively buying only for their immediate needs.”

And so, demand for new servers has been lower than expected, Dell has met a large part of its backlog and now says the server backlog is now at what it calls normal levels. And with a more predictable supply chain, that has side effects that increase profitability because goods can be bundled and shipped in volume and there’s a much lower rate of expedited shipping, both of which help the profitability of the infrastructure group. As Clarke put it, “because supply exceeds demand, we’re able to get things over the ocean and we don’t have to speed up as much” with air travel.

Where there are constraints, it’s in server power supplies, power ICs and high-performance network adapters, according to Clarke. For storage, custom ASICs and FPGAs are constrained. But the PC part of the Dell plant is on standard lead time – a slump in demand will! — and the server part of the factory is mostly on standard lead time — as will weakening server sales.

Looking forward, Dell expects ISG sales to flat sequentially, meaning they will increase approximately 4.5% year over year, and CSG sales will fall in the middle of 20% year over year, which equates to approximately a 5.5% sequential decrease. Given the current economy and the fact that people don’t want to spend on PCs because they did so in droves during the pandemic, this is about as good as you can expect from the world’s largest OEM.

Navigating the rising TAM

Since fiscal 2020, Dell has grown its PowerEdge and APEX server business at a 3% compound annual growth rate and has gained 5.3 points of market share in the mainstream server segment over the past five years, according to data. IDC data cited by Witten.

Looking forward, Dell thinks it can achieve compound annual growth of 3% to 4% (presumably through FY2025), which while less than the 8% CAGR it experienced between FY2020 and FY2025. fiscal 2023, is still growing at the pace of IT market growth overall in the industries in which Dell operates.

Here is the total addressable market Dell has been tracking in the 2021 calendar, broken down by segments:

There was a $720 billion TAM for 2021 in the core PC and data center hardware businesses Dell is seeking, which Dell expects to grow at a CAGR of 2% between 2021 and 2025. There is another TAM of $720 billion in adjacent markets where it’s starting to play out, such as infrastructure as a service (APEX utility priced machines), technology outsourcing, data management, and systems infrastructure software.

Yes, we know what you’re thinking: Dell didn’t sell all that stuff? With this second $720 billion TAM at a 10% CAGR, Dell can’t afford not to chase it. It remains to be seen how it will do it and how well it will do it.

With approximately $38 billion in sales for ISG in calendar 2022, Dell is expected to get approximately 20% share of the $189 billion of servers, storage and switching TAMs in the data center in 2022. If it only holds the share through 2025, it will have a $44.5 billion ISG business. That would be a CAGR of 5.4% for ISG between 2022 and 2025 (calendar years). And if it can grow its share by 1 point a year, as it has, that would be a $51.2 billion ISG business at a CAGR of 10.4% over the same period.

Those, we think, are the brackets between which Dell’s ISG will sit. But they are just numbers. It’s going to take a lot of work for that to happen, and a recession — a real, protracted recession, not just the defibrillator shock we’re getting from the Fed — is going to throw that model in the trash.

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