The bull case for value trap Dell (Nasdaq: DELL) includes expectations that the company can boost operating margins to its long-term goal of greater than 7%, compared with 5.6% for the past year. All else being equal, such an increase would boost operating income -- and probably earnings per share -- by 25%.

Dell enjoyed 8%-plus operating margins from fiscal 2003 to fiscal 2006, so 7% doesn't seem like a big stretch. What's more, in recent years the company has dropped billions on acquisitions of high-margin businesses such as Perot Systems. The addition of high-margin revenues should make it even easier to expand margins.

Should be an easy layup, right?

Well, maybe not. Somehow the bulls don't seem to have figured in the impact of "rebates" from Intel (Nasdaq: INTC) to Dell. The rebates were never a secret. The size of the rebates was. As it turns out, the secret was a big one ... $4.3 billion big from 2003 through 2007, according to the SEC. That's 23% of Dell's operating income during its closest matching fiscal years, fiscal 2004 through fiscal 2008.

Doing the math
From fiscal '04 through fiscal '08, Dell’s revenue totaled $264 million. Its operating income totaled $18.9 million, so operating margin for the combined period was 7.2%. But if you back out the $4.3 billion of rebates from Intel, operating margin falls to 5.5%. That's not much different from Dell's operating margins since then.  

Dell Fiscal Year

Closest Calendar Year

Dell Operating Margin

FY 2003 CY 2002 8.0%
FY 2004 CY 2003 8.6%
FY 2005 CY 2004 8.6%
FY 2006 CY 2005 8.0%
FY 2007 CY 2006 5.3%
FY 2008 CY 2007 6.0%
FY 2009 CY 2008 5.9%
FY 2010 CY 2009 5.1%
FY 2011 CY 2010 5.3%

*Dell's fiscal year ends about one month into the calendar year. 
Sources: Capital IQ, a division of Standard & Poor's, and The Motley Fool.

Blame it on HP
Dell's margins collapsed about a year after Hewlett-Packard (NYSE: HPQ) hired Mark Hurd as its new CEO. Hurd, who joined HP in April 2005, had a reputation as a cost-cutter. HP quickly began delivering better earnings. In 2006, the easy explanation for HP's improving earnings and Dell's deteriorating margins was that HP's new CEO was making it more competitive.

Case closed? Not quite. Another significant event in 2006 was Dell's decision to add AMD (NYSE: AMD) as a supplier of microprocessors. Until then, Intel had been Dell's exclusive supplier. Moreover, Dell was alone among brand-name PC makers in not offering AMD-based PCs. While Intel gave rebates to many, if not most, PC makers for marketing "Intel inside," many in the industry believed Dell was getting extra-large rebates from Intel in exchange for keeping AMD outside.

In 2006, Intel was badly lagging AMD in server-processor performance. Dell's exclusive relationship with Intel was becoming a drag on its sales of high-margin servers and add-ons. In May of that year, Dell announced that it would begin using AMD as a supplier. According to the SEC, Intel immediately cut its rebates to Dell by about $250 million -- three-fourths of the drop in Dell's operating profits for the period.

Hmmm … do you think that was more than a coincidence? Let's look at Dell's margins before and after the May 2006 announcement of its new relationship with AMD.

Quarter Ended

Dell Operating Margin

May 2005 8.5%
August 2005 8.3%
November 2005 6.3%
February 2006 8.8%
May 2006 6.7%
August 2006 3.8%
November 2006 5.1%
February 2007 5.7%
May 2007 6.2%

Sources: Capital IQ, a division of Standard & Poor's, and The Motley Fool.

The illusionist
Dell's fairly steady 8%-plus operating margins from fiscal 2003 through fiscal 2006 (see the first table) were an illusion, based on information in an SEC complaint against Dell. The SEC states that Intel's rebates steadily grew as a percentage of Dell's operating income, climbing from 10% in fiscal 2003 to 38% in fiscal 2006. In the first quarter of fiscal 2007, which ended just weeks after Dell announced its new relationship with AMD, the Intel rebate amounted to a whopping 76% of Dell's operating income. It seems that a resurgent HP was pressuring Dell, but HP was only part of Dell's problem. The huge decline in Intel rebates was another big problem.

The SEC complaint claims that Dell misled investors about the reason for the dramatic drop in profits, attributing the drop to aggressive pricing and higher-than-forecasted component prices. In July 2010, Dell settled with the SEC for $100 million, neither admitting nor denying guilt. Chairman Michael Dell and then-CEO Kevin Rollins paid another $4 million each to settle, also neither admitting or denying wrongdoing. Dell settled the SEC

Foolish takeaway
Dell led the charge in taking costs out of the PC business model and making PCs more affordable. For a time, it was rewarded with fat margins. Then HP got its act together. Without a return of juicy rebates from Intel, investors need to question Dell's ability to improve its margins and regain its former glory.

Trying to keep up on Dell's efforts to increase its margins or any other companies mentioned in this story? Add them to our free new feature, My Watchlist, today!

Fool contributor Cindy Johnson owns no Dell products and no shares in any of the companies in this story. Intel is a Motley Fool Inside Value selection, the Fool owns shares of and has bought calls on Intel, and Motley Fool Options has recommended a diagonal call position on Intel. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.