TIVP036: Dell (DELL): Overlooked AI Growth Story? w/ Daniel Mahncke & Shawn O’Malley

27:17And then Dell basically goes out and manufactures it exactly to their specifications. And the large players in AI, for example, the OpenAI or the X-AIs of the world, they need that level of customization for their servers. But to get back to the company level, Dell's ISG business has two main revenue streams, So that's servers and networking and then storage. And the part that is most relevant for all things AI is servers and networking. And you can also see that in the numbers. ISG grew almost 30 % last year, but almost the entire growth came from servers and networking, which grew by 50%. And storage was basically flat.

27:58And it has been so for about the last two years. and the great thing is that we pretty much know how much growth this business will see from what i understand at least at a minimum i've heard that they have a backlog of something like 15 billion dollars of ai server shipments so if you just look at what that implies i mean that tells you they can sustain growth in the high teens for that segment for perhaps years going forward yeah i mean just for q2 they'll expect around seven billion dollars in ai server shipments And that's almost a quarter of the company's total revenue expected for that quarter.

28:35And honestly, looking at this, the guidance for the entire year seems, let's say, at least conservative. You just mentioned the$15 billion they expect for the full year. And at the same time, they expect to send about two thirds of that volume in the first half of the year already. So thinking about all the investments we see in this space, it's kind of hard to imagine growth slowing down that much already in the second half of the year. even though Teros might pull some of that demand forward let's just say I wouldn't be surprised if Dell would raise guidance in one of the next earnings calls at least on the top line but anyway what's more important for us is how long-term growth will look in this segment the PC business is kind of like the stable cash flow producer but it's not the kind of business we look for on the show it has no strong mode it's kind of cyclical and it has a relatively low margin and the ISG business seems to be a lot more attractive and potentially a great way to play these AI booms that we currently see with a company that's still reasonably priced and offers a margin of safety just due to the cash that is produced by the PC segment.

29:42So if we just take a step back, what is the best way for us to figure out what growth will look like over, say, the next five years? And I say five years just for context, because we kind of like that as a sweet spot between the short term and the long term. The long term is really, really hard to model and project with any confidence. And the short term is not really what we want to focus on as fundamental based investors. And so I don't know, it's a rule of thumb we use, but five years is kind of that golden area where we're still thinking a little bit long term, but not ridiculously far out into the future.

30:17I mean, five years in AI kind of feels like projecting 10 years in every other industry. There's so much going on. It's even those five years, it's just difficult. But still, I mean, the best way to figure out how the industry will develop in the next coming years is basically to look at industry trends, right? That's most of the time, the first thing you will start with. And we already gave some background and you don't need to be an AI engineer to know that demand is currently pretty high. Fortunately, because we certainly are far away from being an AI engineer. Very far. I am not technically minded at all.

30:51You know that, Daniel. I'm glad to have the opportunity just to cheat a little when we don't know something. And we have this wonderful community, the intrinsic value community of folks right now. We have about 60 members. And it is just such an incredible group to be able to outsource these questions to where, you know, I don't know anything about AI, but we have members in the community who work at AI companies or program large language models or are rocket scientists and be able to get input from them is incredibly valuable in filling in the gaps for us as we research these episodes. You know, I don't know how many times, but if you'll ask members in our community, they probably tell you half a dozen times where I ask them about exactly these topics, AI, rocket science, even payments, because they just tend to understand them pretty well and it just helps us whenever we research a company, a new one every single week.

31:44We cannot be experts on everything, but if we have experts, you know, pretty much a DM away. That helps a lot. And in case any listeners, you know, want to join a community where they could discuss investment ideas and perhaps meet some experts on some of these topics, you might want to apply. And you can actually do that at theinvestorspodcast.com slash intrinsic value community. We'll also put the link into the description below. So if that's interesting, just check it out. And perhaps some of our members will actually do a better job at explaining the outlook for AI servers than I will. But I promise I still give them my best.

32:18So the main difference between AI servers and the quote unquote normal servers is that they are specifically optimized to run machine learning based applications, deep learning, language processing, all that sort of stuff. And when you and I are flooding LLMs with company filings and use them kind of as a sparring partner for our company research, all of that processing is handled by Dell. Well, among some other players. But most of these servers are built around NVIDIA GPUs. Dell and NVIDIA actually have a pretty close partnership. There's even a joint venture called Dell AI Factory with NVIDIA, which is, to be honest, not the most creative name, but at least a very descriptive one.

33:02Clever name. Very original. I think that was a pretty good explanation, though, that we can all understand without going too far down the technical rabbit hole. And so I sympathize because I know how hard it is when we're doing these pitches and it's a really technical company to try to communicate the details. So I think you did a pretty good job, Daniel. And like I said, I had the same experience with my trade desk pitch. When you listen to interviews and you're reading the company filings, sometimes it's just it's so complex and there's all these platitudes and jargons. It can really be tough to sift through.

33:37And ironically, that's actually what a lot of, you know, I use ChatGPT for most is almost just translating some of these filings into plain English. So it's the same dynamic when we're trying to understand what's going on in the AI space. and if not more so, it all kind of sounds like the same thing to me who doesn't have an ear for technical hardware specs and programming jargon. And in the end, you're still asking yourself these kind of questions from 30 ,000 feet of, okay, what exactly is this business selling? And to whom are they selling it? And why can they do it better than other companies?

34:13Those are really just the basic questions that you still have to answer. It's so easy with these companies to just get lost in the detail and then also get lost in the narrative that you know some people like to tell about the company but it's exactly how i felt with dell it kind of helped me to look at the business from the customer side so i think that makes it a little bit more tangible in my opinion a customer can be pretty much any company that deals with a large set of data so new bank might be a good example i don't think it's actually a customer of dell at least not to my knowledge but as we know from your episode on them they have tons of data and that's sensitive data and new bank needs to train its algorithms as precisely as possible to figure out who is a good customer and who isn't who can we bank with who can we not get bank with and to train these algorithms you need a huge amount of computing power and those are the factories that dell builds with the help of nvidia it's kind of a build to ship business model where dell engineers co-design the racks based on the customer's use case and then they ship them out to them and install them.

35:17I appreciate you using NewBank as an example since it's one of our portfolio holding companies, but I would like to ask you just to make it more tangible. I mean, do you know who Dell's actual customers are? Is it financial institutions like NewBank that are the typical Dell customer or is it some other client? They can be. I mean, you can split the customers basically into three tiers. The first one will be, of course, the hyperscalers we already talked about, companies like Google, Amazon, and Meta, they usually build a lot of their infrastructure internally, as I mentioned, but one needs to go faster or cheaper, or they simply run into another chip bottleneck.

35:53Then they turn to outside vendors like Dell, for example. And the second group of clients, which is much more significant for Dell, is made up of AI-specific companies and projects. I guess you still remember Stargate, which by now, I think it feels like we've gotten so desensitized to hundreds of billions of dollars getting pumped into AI that now it doesn't really move us anymore. But at the beginning of the year, the Stargate announcement was a huge thing. For anybody who hasn't heard of it, Stargate is basically a joint venture between OpenAI, Oracle and SoftBank. It's a$500 billion initiative to build AI infrastructure.

36:30And a lot of that money naturally will flow into data centers. And the precise amount that will go towards these servers isn't disclosed, but considering the prices of chips, which can easily be$30 ,000 to$40 ,000 and the size of these data centers, we are most likely talking about hundreds of billions of dollars that will go to AI servers and therefore at least in part also to Dell. And another new and kind of big name customer that made headlines and that fits the category of AI companies is of course Elon Musk's xAI. And that's one that fills headlines, but it's not necessarily the one that is actually making a lot of money for Dell because it is low margin business where XAI just has a lot of leverage.

37:14where you tend to make a bit more money is with the third group of companies like, for example, NewBank. And those are basically companies that are traditional enterprises and government customers that want AI compute on-premise, large banks, healthcare system or defense contractors because they don't want their data, mostly sensitive data, to be in public clouds. The AI server business is just a lot more exciting than the PC business because growth rates seem much more attractive but and you have these tailwinds but as you mentioned the margin profile isn't looking that attractive so maybe there's some concern about how profitable this incremental growth is and i could see how scale can maybe help over the long run to bring these costs down and improve margins but generally speaking the margins on server hardware are not going to be higher than for the pc segment is that the right way to think about it yes that's true and i think it's kind of where the the bear case starts but in this segment there are some levers that dell can pull to potentially improve margins over time and scale is definitely a big part of that the more system dell ships the more they can bring down costs of integrating those racks plus despite the customization of their products they can also start standardizing some components and automating a lot of these setup tasks so you can save some money there and improve margins a bit another lever that Dell can pull here, which is missing with the PC business, is layering services on top of hardware.

38:49And that actually moves the needle. So if Dell sells ongoing management, security, or power optimization services along the server hardware, that's a boost for margins. Through its so-called Apex platform, which in my opinion is a pretty cool name, Dell sells those services and it almost works like a SaaS business. It's still a pretty small part of sales, but if you want to get bullish on AI servers and Dell in general, you would need to believe that this part will become more substantial in the future. Right now though, there's definitely margin pressure on the AI server business because the cost of GPU still weighs on those margins.

39:25NVIDIA has so much pricing power that it can sell chips at such high prices and just capture most of the value. Dell, which does not have the same pricing power, can therefore not charge markups to their customer. So it's kind of getting squeezed in between Dell and the LLMs. And that's why Dell is working on expanding their service revenue. It's pretty crazy when you compare the margins of NVIDIA with companies like Dell or Supermicro. NVIDIA boasts 75 % gross margins, whereas the infrastructure players like Dell are at only 20%. So that really is the big difference between how competition can weigh on the margins of different industries.

40:07And ISG might still be a better business than the PC business, though. And if they are successful with upselling services, perhaps AI servers can boost instead of suppress margins longer term. And one of the advantages here compared to the PC business is the higher switching costs. And again, that's more due to the services that come with the hardware than the actual hardware itself. NVIDIA really has an exceptional position in this market, but you're right. The switching costs for the ISG business are larger than for computers, where the only real switching costs were that Dell personalizes the PCs and can then offer better customer service.

40:51But let's be honest, that's not that big of a differentiator. For the ISG business, that's a bit different though. As you said, the systems they deliver are just much more complex and come with multi-year service contract. So you can see that customer lock-in in the large position of deferred revenue on Dell's balance sheet, which is more than$25 billion. And then you also have the$14 billion backlog. So in terms of top-line growth, Dell, I would say, had a pretty good run for that business. At the beginning of the last year, AI server shipments were literally$0. And in Q1 of this year, they have$12 billion in orders.

41:27And as I said, another$14 billion in the backlog. We just saw the margins of Supermicro, HP, and Dell compared to NVIDIA. And I have to ask, are those the two main competitors for Dell and the AI server space? Is that the right way for us to be thinking about it and who to compare them with? Yes, I mean, it's a competitive space, so there are many companies, but both of them and Lenovo are in the top five based on market share. So the two biggest players are obviously Dell and Supermicro. For Supermicro stock, this entire AI hype was also a pretty big tailwind. It doubled year-to-date, well, at least before the latest earnings report.

42:08But I guess the main reason for the difference is that Supermicro is almost a pure play in AI. More than 70 % of its revenue comes from AI servers. And for Dell, as you can see with us two, it still has the reputation of being more of an old-school hardware company and with half of its top line still coming from PCs, I think that's not even an invalid point. And I can't be an overall margin concern because Supermicro has the worst margins in the industry and they have no PC business that they can fall back on just like Dell, HP, or even Lenovo have. So I think margins are not what concern the market, at least right now.

42:46I think we both know in the short term, Mr. Market's perceptions can matter a whole lot more than the actual facts. And I know the other day we were talking about the different perceptions of Adobe, which is one of our portfolio companies, and then Figma, which had this recent IPO. And it's the same industry facing the same AI threats. And still, Adobe just can't catch a break because it's seen as this kind of more boring value play. And people are more keen to draw concerns about how AI will disrupt this giant business, whereas you have Figma tripled on the day after its IPO. And so Figma is a shiny new entrant and it's got a fresh story and it's more of a disruptor.

43:30And all of that is just much more exciting, which leads to more favorable market treatment in the short term. I think it's kind of typical for a podcast to not pitch Figma, but to pitch Adobe and to not pitch Supermicro, but to pitch Dell. But I would say that's because the good news for investors who want to look past the headlines. A structural advantage, for example, that Dell has compared to Supermicro, and one of the reasons why Dell could gain the number one spot so quickly, is its go-to market model in the enterprise space. So Dell has decades of experience in that space, while Supermicro and also most of the other players in that industry without the PC market background lack that completely.

44:14Roughly half of Dell's revenue still comes from direct sales, particularly to large corporate, government, and education customers. So Dell's account teams manage relationships directly, which allows for more customized deals, lighter feedback loops, and just more predictable renewal cycles. And it's a supply chain and sales network advantage that we talked about in the beginning. And it's not only helping them in PCs, but now currently it's also playing out in the server market. Part of Dell's distribution strength also comes from the way it's structured to reach different types. of customers they build a pretty broad partner network ranging from large it firms to regional integrators and these companies that resell dell's hardware alongside their own services and that allows them to cover both ends of the market you might say you have these big enterprise clients that usually work with dell directly and then you have these smaller and mid-sized businesses that are often served through these partners kind of reminds me of our discussion of dtc and retail business just on a much larger scale and Dell seems to have the best of both worlds somewhat super micro doesn't really have that same enterprise facing service layer and when you're trying to land eight or nine figure infrastructure deals not having a direct relationship to your customers can be a real limitation on that point and building out those direct sales channels and support teams something that Dell actually developed over the years in the PC market So yeah, the legacy PC business, at least in this point, has its advantages.

45:47Of course, there are also disadvantages. But in this case, it really helped them building the number one spot in servers. Maybe we should talk more about the outlook of the PC market before we dive deeper into the competitive landscape of AI servers. And in the end, I would say this is still just half of Dell's sales. And you already mentioned that the PC market is currently going through a tough period where a lot of demand was brought forward during the COVID pandemic. And there's just this unusually high demand for new PCs and laptops at the same time when we were all stuck at home. And that certainly makes sense.

46:22And when we just think about all the people who suddenly started to work from home, who had previously worked out of an office or all the school kids that were staying home too, instead of going to school. I mean, it makes a lot of sense that this was a time ripe for people buying computers, buying desktops, upgrading old systems, and even corporations have used that time to upgrade some of their PCs. And so, I mean, I'm just pulling up Dell's numbers here. And it does look like the CSG segment reached its peak in 2022, corresponding to really the end of the pandemic. And the segment was growing at a stunning 27 % at the time.

47:00And since then, though, it's been a different story and has actually been contracting. Yeah, this has pretty much been going down since then. The headwinds of PCs are why Dell saw pretty much no growth in revenues over the last three years. And the good news is that the business is now stabilizing. It's still flat year over year, but that's because the retail demand for PCs is still kind of lagging. Commercial customers, they are buying again. And since commercial customers make up 85 % of sales, seeing an acceleration there is a lot more important than you know you and me the average customer the commercial side is also where ai pcs are expected to have a significant impact michael dale seems to be pretty excited about this new cycle of pcs you mentioned it a lot and if they do cause a new upgrade cycle the csg business or the computer business might actually become a tailwind at some point in the next few years and i should clarify though that ai pcs is a pretty wide term and the current market is already valued at around 50 billion dollars and it's expected to grow at a cake of about 20 per year in the years ahead the problem is at least to me it doesn't seem that there's like a clear definition of what an AI PC even is technically an AI PC is any computer that can run AI workloads locally so on the device itself without needing to offload the task to a cloud data center but that sounds great especially if you're a company that works with sensitive data that doesn't want to upload to a cloud.

48:28In practice though, I think the line is pretty blurry. Some of these machines have dedicated neural processing units, which are called NPUs. So they're basically designed for AI tasks like voice recognition, image generation, or language translation. Others just rely on your CPU or GPU with just a few extra instructions tagged on. So I don't know, there's not, that doesn't seem to be a big difference, at least in what they can do right now. Just so I'm following what you're saying here, it sounds like computers don't need to have a neural processing unit or NPU to necessarily be considered an AI PC.

49:07Exactly. It's only 5 % of that$50 billion AI PC market actually has NPUs in it. And part of the reason is that NPUs just don't add that much value yet. You can run applications like Microsoft's CoPilot a bit faster or you get smoother background blur on a zoom call but let's be honest you don't spend another thousand dollars on a new computer because it takes less power to blur your background on zoom plus many of the tasks that involve ai are not even done by npus even if the pc or laptop has one classical gpus often do a better job at performing them and npus pretty much only have the benefit of being more efficient when they do it which is where they make more sense in smaller or in mobile devices they can run the background use less power that makes more sense for these smaller devices.

49:55So I don't know if you have an Apple Watch or anything like that, Sean, but one of the tasks that would be perfect for an NPU is measuring your heart rate, for example. That's a simple task that permanently runs in the background and you don't want to use the CPU or the GPU for that. So pretty much to summarize, what sounds like this huge innovation for PC or in the PC space is more of a marketing thing right now, at least that's how it sounds to me. I'm not saying this won't change in the next years or in the next one or two years, especially for commercial clients, since they care a lot more about these incremental efficiency gains, but it doesn't seem like this will soon start a new cycle that completely changes Dell's PC trajectory.

50:40All right, so the AI growth story for Dell is still mainly about these AI servers and not really in the PC space. I think that is a good way to recap everything we just talked about. And maybe we should pull a thread a little further around competition and the moat that Dell has around these business segments, if any. And the PC space is mostly commoditized. And from what you told me, the AI server space is also crowded and maybe getting more crowded. And so is there any way on the server side of things for Dell to differentiate itself from the super micros of the world and these other competitors?

51:19well once again it's it's a hardware business right so generally there are few modes in hardware especially if you're not a consumer facing brand like as we discussed apple is for example where brand power is just much more powerful and important to sell your product to consumers and dell is a market leader in the ai server space with a market share of a little over seven percent and of course that is because they have just you know superior products more precisely dell claims to have multiple advantages, such as better high performance computing, security features, but also cooling. Yes, cooling.

51:54I've looked into it a bit and it seems like they do have some extra fancy cooling tech, but let's be honest, if you're a company and you have to list cooling as one of your advantages, how much differentiation can there really be? I mean, one of the most clear competitive advantages in this space is the management software. where AI servers are deployed at scale, and they need to be remotely managed, secured, patched, and monitored. And Dell's tools seem to do a better job at that than, for example, Supermicro, but also other competitors. At least that's what a third-party market report suggests, and I also link to that report in the show notes in case you want to check it out.

52:30To make it tangible, when tested, Dell's tools save nearly two hours of admin time for every 100 servers deployed. And multiply that across a full data center, and you would literally save days of high value and pretty expensive IT labor. That is some very serious operating leverage when you're deploying thousands of AI servers and even more so when you think about the different real-world constraints, like tight timelines and power limits and limited headcount. I mean, that is a huge value add. And a strong service portfolio is not only important to gain customers, they are also incredibly important for Dell themselves and for their margins.

53:09The bare argument about this entire AI growth story is that AI servers have incredibly slim margins. We are once again talking about 5-7 % gross margin. So they will only have a meaningful impact on Dell's overall profits if the services and the entire ecosystem that Dell bundles together can at least double that margin profile. based on Dell's guidance it looks like they can sell AI servers plus services at gross margins somewhere in the low teens perhaps with more scale and the close partnerships that Dell definitely has they can negotiate better terms for purchasing chips over time as well but I don't know that's not something I would I would count on NVIDIA wouldn't partner with them as closely as they do if it weren't mutually beneficial I haven't yet deep dived into NVIDIA but I came across many Jensen Huang interviews for my TSMC research and now again for Dell.

54:05And he's the type of person, at least it seems like that to me, who is very vocal about the great work his partners are doing. It has been that way with TSMC and now it has also been that way with Dell. Although when you compare his margins to his partners, I think I can guess why he's happy with the partnership. But for the other companies, it doesn't look that great. And besides the management software, Security is another big factor. Dell supports many different security features like multi-factor authentication, external key management, and all of that will not really tell you anything if you have no idea of storage.

54:38But still, those are like the small little things that make Dell products a bit better than competition. Some part of that is even sustainability functions. I mean, Dell offers energy consumption reports to help enterprises and their customers to reach ESG goals. And like I said, all of those things they don't move the needle on their own. Perhaps they can if they are added on to Dell's generally superior product, kind of move the needle. But you and me, I think we would agree this is not a mode and it doesn't give Dell any pricing power. At most, it will help with retention and scale. And what about players like Hewlett-Packard or Lenovo?

55:18In contrast to Supermicro, I know they also come from the PC space. So I guess they'd have some experience with some of the same advantages in terms of sales, ecosystems, and supply chains and all of that. So how does Dell differentiate from them? And just when you look at the numbers here, I've got FinChat pulled up. Lenovo trades at a Ford PE of 10 times in Hong Kong. And so that's even lower than Dell, or at least their valuation. And it's the same for Hewlett-Packard. Well, Lenovo and HP are structurally similar to Dell. I would say the main differentiator right now is scale and the fact that Dell's products simply seem to be better if you just compare them to competition and what their customers say.

55:58I mean, NVIDIA also partners with Lenovo and HP, but they focus on Dell because their servers are the highest quality, faster computing, higher levels of customization, and also, at least shown in the reports, they are the most reliable. Lenovo's and HP servers are less complex and also at cheaper price points, which is why they sell more of their server products to smaller or medium-sized companies with lower budgets and also less complex operations. And that also obviously comes with less potential for upselling services and even more struggles, therefore, with margins. So I don't know. You just said it.

56:35Lenovo trades at a multiple of 10 in Hong Kong and has a significantly higher share of China sales. And usually the market discounts that quite heavily. Most Asian companies traded a much steeper discount to American peers. So I wouldn't even say that they're necessarily cheaper valued than Dell. I think it's not necessarily a great comp, but Lenovo's AI server backlog is about$9 billion and HP's backlog is$3 billion. So Lenovo also has the same advantage of being the number one in the PC space. And actually they are the only company that more or less successfully launched its AI PC product. So I think currently it's fair to say that Lenovo seems to be the company winning the PC business and Dell seems to be the company winning AI service.

57:20But of course, that story is not yet written. So it could change in a year or two. How does it look on the capital allocation side? You know, sometimes a below average industry in terms of returns and favorability for shareholders can be redeemed with really great management teams that are excellent capital allocators. And I would recommend reading the book, Outsiders, anybody who wants to learn more about how capital allocation can really shape outcomes. And a great industry doesn't always deliver great shareholder returns because of poor capital allocation. And so even if Dell's margins are not software-like, the point being is that the company is still profitable.

58:03And if handled properly, management should be able to drive attractive returns to investors, especially if you're getting the stock at the right price. And it seems like, you know, Dell is pretty close to what you might call a reasonable or potentially attractive price. And so it's still, though, the thing that I'm trying to wrap my head around is when I look at the company, the cash flows from operations are so volatile. In 2021 and 2022, Dell's operating cash flow jumped over$10 billion. And then if you look at just last year, that same number is only 4.5 billion. So I wasn't expecting it to be so cyclical, but it is a really cyclical business, it seems.

58:45It is. I wasn't expecting that level of cyclicality too when I first looked at it, but cash flows seem a bit more lumpy than the business actually is. I would say the business itself is not as volatile as the cash flows make it seem. A lot of that volatility actually comes from swings in working capital, and that's mostly due to how Dell manages supply chains, inventories and payment terms. If you layer operating profits over the chart of operating cash flows, you can see that it's a much more stable and fortunately upward trending line. So management didn't really communicate what was happening in detail, but I would assume the chip shortage during COVID led to some disruptions in accounts payable where perhaps longer payment schedules were negotiated, would pull billions into the years of 2021 and 2022.

59:30And then when the bottlenecks eased, Dell paid back suppliers and saw these huge outflows of capital at once. And you can see all those movements in the accounts payables numbers. In 2022, it was a tailwind worth almost$6 billion. And that turned into a huge headwind only a year later when Dell paid$8.5 billion. So I think the big lurches in cash flows were primarily balance sheet related. But as you said, there is enough cash flow to think about. allocate how well do they allocate capital and with michael dale holding 40 of the company he would benefit most himself if they are actually good capital allocators and that's a great point yeah it's always nice when we have founders and ceos who really have skin in the game and have incentive structures that are aligned with shareholders and i just want to mention inventories too i mean we've looked at a few companies by now that have intentionally built up their inventories in the last few years in response to not just tariff concerns, but also the bottlenecks that the world saw because of the COVID pandemic and also how the war in Ukraine has just totally disrupted global supply chains, or at least it did for a time back in 2022.

1:00:44So a lot of companies' takeaway has been, I need to have more inventory on hand than we previously would have modeled for. And that does come at a capital cost. And so I think it's to to say the chip industry was more affected than most by some of these disruptions. I mean, when we look at Dell's inventories, there was a clear spike in 2022 and then again last year. And I wonder if it's an intentional buildup of inventory. I mean, we saw a huge spike in demand for AI service last year. And then again, with the tariff situation, Dell probably just thinks that now is a good time to build up inventories and it might be cheaper to do so and also reduce the risk of these potential bottlenecks in the future that can really materially hurt the business.

1:01:27And so just to get back to capital allocation, as we're talking about inventory, and that is part of that in a way, I mean, what is Dell's strategy there? The company pays a dividend. And if I'm not mistaken, it's also buying back shares. But what do you think of it in aggregate, what they're doing on the capital allocation side? Yeah, so the general policy is that they will use 80 % of free cash flow to either pay back or buy back shares and pay a dividend to shareholders. And in recent years, that has actually been a lot higher. Almost all the free cash flow was spent on either buying back shares or paying a dividend.

1:02:01But 80 % is obviously the more sustainable long-term goal. And it's kind of similar to what PayPal is doing with the difference that PayPal is not paying a dividend. They simply buy back shares for, you know, 80 % of cash flows. And there was a bit more room for paying back shareholders since Dell used COVID and the years after to pay down debt from the EMC acquisition. It's almost$70 billion was spent on reducing debt just from 2020 to 2023. So I would generally say they do quite a good job of capital allocation. If I would be a shareholder, the first thing I want to see is them paying down these huge amounts of debt and then paying back shareholders through either dividends and buybacks.

1:02:39What I wouldn't like to see is any other acquisition, even remotely as big as they used to be back then with emc i mean 67 billion dollars i don't think that's um an acquisition i would want to see from dell but i haven't heard anything that would indicate that they try to find any acquisition target so i think they're mostly focused now on paying dividends and buying back shares and the expected dividend for this fiscal year is two dollars and ten cents which at current prices would mean a dividend yield of about 1.5 1.6 percent and the buybacks are also at record levels right now just in q1 of this year dell actually bought back shares with two billion and that's almost as much as the entire last year.

1:03:19So another$8 billion is authorized in buybacks. And if you combine the dividend yield and the buyback yield of close to 5%, that gives you 6 % to 7 % shareholder's yield, which I think is quite reasonable for a company like Dell. That's a very reasonable starting point for an investment thesis. If you know that you have these returns of capital that are basically supporting the direct forward returns you can expect with the investment. And so, I mean, it does seem like management, maybe rightfully so, sees a good opportunity to buy back shares. And as we know, it makes such a difference to do buybacks at prices that are value accretive.

1:03:59I mean, last week we looked at Ferrari and we both felt like them buying back shares at current prices, when you have a stock trading at a very, very premium market multiple, it's just not going to be the best use of their capital, right? I mean, if you pay a higher price, you can retire fewer shares. And so you're just, you're not getting as much bang for your buck. And so the stock price, even after the latest earnings drop was so high for Ferrari that these billion dollar buyback programs just really didn't even move the needle. So it just felt like they were throwing money into the oblivion and was really accomplishing nothing.

1:04:32And I would say the same for their dividend, honestly. And that's why I'm kind of glad to see that the situation is different with Dell. Yeah, it's totally different in Dell's case. And I mean, the$10 billion would currently mean a reduction of about 10 % of its market cap, which is quite meaningful. And honestly, this might be one of the most positive points for Dell. First of all, you have a CEO who owns 40 % of the company. So he's highly aligned with shareholders. And then you see them doubling down on buybacks at a time where there's still reasonable doubts about the margin profile of the overall business and especially how value-equative AI servers can be.

1:05:09And the company definitely seems to think they can make this work with selling services on top of these AI servers and therefore improving the margin. If they buy back$2 billion of shares just in that quarter, I think they would bet on themselves. I think it's really easy to forget. And we talked about in our episodes on Ulta in AutoZone, but you can compound earnings per share in two different ways, right? You can grow the numerator. You can grow the amount of profit you're generating each year over time. But you can also just as validly grow earnings per share by shrinking the denominator, reducing the number of shares.

1:05:46Yet you're dividing those profits across so that ongoing shareholders get a bigger and bigger slice of that pie. So when you say something like shrinking, buying back 10 percent of Dell's market cap, I mean, that is if you can shrink the share count 10 percent. I mean, you have basically increased my ownership over the business very, very dramatically. But not to linger on buybacks too much, I do think we've focused a good bit on the potential upside with Dell, that the backlog growth, the hyperscaler wins, the NVIDIA partnership, the operational scale, and then also some of the capital allocation and the buybacks and the dividends.

1:06:25And I think we've discussed some of the shortcomings of the business in terms of margins and slower growth structurally and also kind of the intense competition. But to really round out the investment case before we get to everybody's favorite part, the valuation, I do think we should linger on just exploring whether there are any other risks that the audience should be aware of that maybe we haven't yet mentioned that could threaten Dell's profitability in the years to come and disrupt this huge tailwind they've had in their AI service business. So how exposed generally is Dell to macroeconomic cycles?

1:07:03And then how good is the investment opportunity here if the AI narrative proves to be a little bit overhyped at the current moment? And then are there any other risks on the horizon that are worth exploring for us? Well, compared to the PC side of the company, which is extremely cyclical, The ISG segment looks more or less stable because a large portion of Dell's ISG revenues comes from pretty much mission-critical infrastructure. That's enterprise servers, storage systems, and data center networks, all of which tend to be tied to long-term IT budgets. But of course, that doesn't mean that Dell or the server business is recession-proof.

1:07:42If we hit a true CapEx recession, especially in the AI space, you will see an impact. and the servers are expensive. And when budgets tighten, spending three to five million dollars, which is required to build an AI training cluster, becomes a much harder sale for any company. And I think Dell currently has about two to three thousand different customers. So you can imagine how many of those will be smaller companies for whom an investment like this is a pretty big thing. The good news is that Dell's AI backlog gives them some forward visibility and a lot of their backlog comes from the big players in the space.

1:08:17they are less likely to go bankrupt in a recession. But that dependency on a few large customers, of course, also comes with more concentration risks. And then you have Dell's position in the AI value chain. We already talked about it. They're not building the chips. They're not building the models. And being the infrastructure layer is somewhat of a double-edged sword. So on the one hand, it's a great position to be in to get a lot of volume quickly. And on the other hand, the companies around you just capture most of the value. technically it does it's in the part of the stack that could be outsourced or squeezed out in a slowdown and it's difficult given the complexity and scale required in the business but it's definitely possible especially when you look at the competitive landscape i would think the the risk of hyperscalers insourcing is is a serious one i mean they have the money they have the scale and the know-how to do it and as you said before there's a trend toward vertical integration whenever possible.

1:09:14And that brings the risk of commoditization. If more OEMs scale up, figure out how to do cooling, and then rack building becomes more plug and play, that would pressure margins long-term, I would think. That looks to be in somewhat of a good competitive position if you just compare to the AI server companies. But I would say the chances of them improving that positioning and therefore also the business economics are just as high as the chances is that competitive pressures increase and the market share and the margins come under even more pressure than they somewhat already are. And the long-term contracts with clients and close partnerships with NVIDIA, Intel, and AMD, and they give some stability to Dell's business.

1:09:57I guess another risk though, is that we all realize in just two or three years that AI might not keep improving as fast as everyone hoped for. And investments overall just get scaled back massively. Currently, everybody is counting on that backlog of 15,$15 billion. That's not supposed to come. Those numbers look way worse than we are currently expecting. I would be surprised if that happens. It's not like the dot-com bubble, at least I don't think of it as that. The big money is coming from companies that are either already highly profitable or they have billions in funding. And many of the AI business models are already proven.

1:10:34That doesn't mean that most of today's AI companies will be successful, but the overall industry, in my opinion, should have a good chance of getting better instead of getting worse in the next years. Okay, well, so I think we know the investment thesis is going to be mainly based on the growth in AI servers. And so the question is, how much can that actually move the needle in a conglomerate like Dell? And really, I guess the question is, what did your valuation tell you about whether Dell is fairly valued and then also just the prospects going forward based on your expectations of what can happen with the AI server business.

1:11:11So I wanted to see what fair value we would get if we assume that Dell is, quote unquote, only growing the AI server segment in line with the market. And that would mean a CAGR of 35%. Management said it expects$15 billion, as we often said today, in AI server revenue for the current fiscal year. And since overall sales will be about$100 billion, we're actually only talking about 15 % of the entire business. That's kind of the problem there is with Dell. I would assume that the rest of the business will just keep growing at a cake of about 5 % going forward. It might be a bit higher in an up cycle and a bit lower in a down cycle.

1:11:47But I don't see AI PCs boost this segment sustainably and significantly. And that would leave us with an overall revenue cake of about 10 % for the next five years. It's even slightly lower in my model since there were some divestments in recent years, which still added some volume to revenue back then, but they're not going to in the future. And that's why I have revenue at a cake of about 9%. And that's not necessarily a lot. If you could get the margin profile that some people are hoping for, it might be enough, but that's a different question. No, I mean, it's not what you would expect when you hear AI thrown around, right?

1:12:26And AI play, we're so used to these ridiculous growth numbers. But at the same time, it is still more growth than actually what I think most analysts are expecting with the company. I think the consensus on Wall Street is about 8 % to 9 % revenue growth for this year, followed by a slowdown in the next few years. So it seems like what implicitly is being said there is that Wall Street doesn't believe that this can be a longer-term tailwind for the business. Surprisingly, analysts are not expecting much from Dell. Usually they're the first jumping on the bandwagon if there's an AI play here, but it doesn't look like that for Dell.

1:13:00It's not even that they expect the current demand being put forward by tariffs. Otherwise, growth estimates for the next year should be significantly lower, which they aren't. They're just expecting a steady slowdown of growth in the few years ahead. And I don't really see that. ISG share is growing quite fast. And I like the creativity to see how Dell is not growing the AI server segment at at least 30 % per year. the overall market is just growing so fast that you could even lose share and the servers are still growing that fast and that should lead to growth around about 10 per year overall however and that's kind of the important part my model also shows that at a pretty moderate discount rate of 8 and at the current multiple of 12 to 13 this would get us to a fair value of around 120 and compared to dell's current price in the high 120s the market pretty much agrees that dell will grow its top line in the high single digits or low double digits but it's not necessarily enough to achieve good returns with this stock and in the end Dell seems pretty much fairly valued right now and this even assumes stable margins if we see more pressure on that end the value could be much lower than 120 overall honestly I must admit I've been quite disappointed in Dell I when I first went through or read the pitch I thought we would see a company or I was expecting a company that is on the brink of becoming structurally more profitable.

1:14:25But it appears that while growth might accelerate, the pressure on margins for this business will likely continue and they will continue for a while. I mean, I think I'm glad to hear you say that because I've certainly had mixed feelings as we've gone through the conversation here. And this is one of those times where I'm not sure personally I'd put a lot of weight into any model we developed, even if it said the stock was very cheap, which it sounds like your model doesn't. I mean, tech hardware is this notoriously bad industry to invest in, right? And so we shouldn't conflate it with software, which is a great industry by most measures, broadly speaking.

1:15:02The hardware side of things, the actual physical computers and products, again, unless you're Apple, it's just really hard to make good money on this stuff. And there's just very stiff competition. And the competitive dynamics and the product features, I mean, it's as fast changing as anything out there. And what that means is that advantages that can get quickly swept away. If you have a competitive advantage, it's more likely to get disrupted in a fast paced technological industry than elsewhere. And so it also just takes a lot of technical know-how to even be able to recognize what types of advantages are meaningful and what are just more illusory.

1:15:39And so the company's margins are very, very low relative to the S &P 500. The growth isn't inspiring. and there's no track record of generating excess returns on capital. So by all measures, nothing about the screams that it's a compounder I'd want to own long term. And the point being, my guess is that Dell doesn't have a moat. But even if it did, again, I'm not sure I'd feel comfortable underwriting it. And that is to say nothing about all the uncertainty around AI right now. And maybe that sounds like a cop out and kind of obvious to say, but it's so true that not every industry's future is equally uncertain.

1:16:16And the classic example that Buffett always uses is Coca-Cola, and it really does make the point well. And I know with almost absolute certainty that for the next 100 years, folks will continue to enjoy carbonated, sugary, caffeinated drinks. And that is just a reality of our human biology, right? Coke is designed to appeal to everything that gives our taste buds pleasure. And so the range of outcomes for a company like Coke over the next decade is probably going to be much narrower than with a company like Dell. And it's just so much easier to look at Coke and decide whether the stock is fairly valued relative to the expectations for the future and what you think is a reasonable price to pay.

1:16:56But yeah, with Dell, I feel like I have no idea what could happen. And the reality is that I'm not sure anyone does. These are such sweeping trends that are changing so quickly. I don't know if I could sleep at night if we had a big bet on Dell. And that's kind of the gut feeling of an investment that we sometimes talk about. And even if the valuation is seemingly cheap, if it doesn't feel right, it doesn't feel right. And again, I should mention that it actually compared to some of its peers like HB and Lenovo, Dell trades at a slight premium. And so I appreciate that you tried to push us out of our comfort zone today, Daniel.

1:17:31and I have a number of friends tell me to take a look at the stock but personally I'm happy to pass on it and based on your valuation it doesn't really seem like you're recommending it for our intrinsic value portfolio either. I think the person that got pushed most out of their confidence on is probably myself. I mean you summarized it pretty well Dallas is a conglomerate of what I would call pretty complex businesses and guessing where those businesses will be in five years is incredibly hard it. If you buy a business with low margins and no history of high returns of capital, you either need a bargain price or you need high conviction that the business is at a transition point that makes it much better.

1:18:11And I was looking for exactly this in Dell when I started my research. But just like you, I had a lot of people say that Dell is this exact point. But honestly, I just couldn't see it. The AI server business is growing rapidly, but it comes with similar margin and also return problems as the PC business. And the stock is just not cheap enough to make an argument for a value play here. So yeah, I'm not recommending to add it to the intrinsic value portfolio. And perhaps this might be the last company that I looked into, which is clearly a hardware play with not a great margin profile at all. It's kind of a cliche, but I do think it is fair to mention and maybe accurate.

1:18:49And we say it a lot, but the great thing about investing is you get to decide which pitches to swing on. And you only get struck out when you do swing. And like in real baseball, where you can sit there and take a strike and you kind of have to swing at things. In investing, we don't have to swing. There's no penalty for inaction in the short term. I mean, of course, if you never swing, the opportunity cost will compound over time. But I just said to emphasize that we don't need to force ourselves into any investment that we don't feel very confident in. And it's safe to say neither of us are all that excited personally about owning Dell at current prices.

1:19:22But other reasonable minds can differ on that decision for their own portfolios. And we're looking for those rare fat pitches that are so easy to hit, we can just knock them right out of the park. And I don't think Dell is one of those. There were a lot of reasonable minds that made me think Dell could be one of those, but looking into it, I just don't think it is. But all right, enough of that talk. How about you give us your hints for the next episode, which hopefully for you is not payments and hopefully for me is not a hardware company well i guess next week i'll be kind of making another dangerous pitch that could also be a value trap of sorts where the stock is really a battleground with competing narratives about its future and it's kind of interesting in a relatively short period of time the company went from being a market darling to being a beaten down value play kind of like a dell but actually really unlike dell the margins are much better and it's a cash flow machine, honestly.

1:20:21So that's pretty vague. I don't think anybody could get it just from that. So I should also say that this company is in the business of love and relationships, if you want to put it that way. They're the biggest player in their industry. And really what they try to do is connect people together digitally and in the real world. So I worry I gave away too much with that, but let us know in the comments if you know which company I'm talking about. I think I have an idea and I'm just glad it's a high margin business, honestly. So today I will leave you with a quote by, well, of course, Michael Dell.

1:20:52And he said, ideas are a commodity, execution is not. And I couldn't really identify a moat in Dell, but they have executed better than competitors for decades now. And if they can continue to do the same in the AI space, I wouldn't be surprised if they remain on top, but it's just not an investment we would currently want to take. And with that, don't forget that you can currently apply to our intrinsic value community to potentially discuss more attractive value plays than Dell. And I guess if you made it until the end of this episode, that says something about your interest in learning about investing.

1:21:28So again, you can find the link in the show notes below. And with that, have a great Sunday. Until next time.