What's in Store for Dell?

Over the last few years, Dell (Nasdaq: DELL) has been on a quest to lower its expenses, exit low-margin businesses, and move up the value chain. Despite trading higher than the $13 the stock occasionally saw in 2011, the company still has a lot more upside ahead if it can execute its refocused business strategy without facing too many roadblocks.

Company snapshot:

Source: S&P Capital IQ.

Ongoing efficiency improvements
For a while now, Dell has been focusing on increasing its services segment, increasing efficiency, and working to improve customer relationships. While revenue of $15.4 billion in the third quarter of fiscal 2012 was actually lower than revenue of $15.5 billion in the second quarter of fiscal 2011, operating income was actually up from $785 million in the previous quarter to almost $1.2 billion in the most recent quarter, an improvement of more than 50%.

This operational improvement is a thoughtful and deliberate shift in strategy away from low-value, low-margin products. The company is on track to achieve more than its previously forecast non-GAAP operating income growth of 17%-23%. Over the last three quarters, operating margin has clocked in at 7.7%-8.6%, much higher than the comparable quarters from fiscal 2011, which clocked in at the 4%-7% range. The company's long-term GAAP operating income target is 7%, which will most likely be reached unless the fourth quarter is a disaster.

Despite the company's improvements thus far, there's more work to do. The company mentioned that it has some third-party software business that carries unattractive profit margins. The company plans to work through that in the next several quarters, which could mean temporarily depressed revenue as it refocuses or exits the lowest margin areas.

Also, Dell is still dealing with the tragic flooding in Thailand, which has affected its hard drive supply chain. The company expects difficulty in this area until at least the first quarter of fiscal 2013. In fact, the trouble could extend even further.

Moving up the value chain
One of the main drivers of the company's increased operating margin has been its decreased emphasis on volume-driven products, which often occupy the lower ends of product lines. This shows maturity on Dell's part, since it's no longer chasing growth at any cost. Volume obviously increases sales but is not necessarily value added.

One of the increased areas of focus is its services segment. The backlog for this segment ran at about $5 billion a few years ago, but it was $13.5 billion at the end of the last quarter. A growing service business is likely to keep the momentum going in terms of operating margins. At 14% of revenue and still growing, the services segment is doing nicely.

Another higher tier offering is the company's XPS 14z laptop, an ultraportable laptop that weighs as little as 4.36 pounds. The laptop, which started selling in November, is priced at $999.

While increased operating profits are nice, the company needs to now focus on growth going forward. If the company can generate revenue growth while still meeting its long-term operating margin target, the results should be very strong.

Foolish bottom line
All told, Dell is still a cheap stock, but investors have yet to embrace the shares, as evidenced by the forward earnings multiple of eight. The company itself believes shares are cheap, having purchased 142 million shares year to date for $2.2 billion. Over the past four quarters alone, the company has reduced outstanding shares by 7%. If the company can execute on its strategy, the earnings multiple should creep up.

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