Dell: What happens when component cost rise?

Dell's most recent quarter benefited from falling component costs. The rub: It isn't passing those benefits on to you.

A few months ago, Apple got a huge bump on cheap component prices. It pocketed most of the gain. And it can because it's a premium brand.

Dell, however, may be a different story. For the second quarter, Dell reported net income of $733 million, or 32 cents a share, on revenue of $14.8 billion.

Not passing those cheaper costs to you may become an issue. Component costs, which are on the rise, are one of the main reasons analysts are skeptical about Dell's future quarters. Of course some audited results and comparisons to the restated historical results would be nice too.

Dell's gross margin last quarter was 19.9 percent and Merrill Lynch analyst Richard Farmer sees something more like 18.5 percent in the long run.

Friedman Billings Ramsey analyst Clay Sumner details the environment in a research note:

"Revenue was modestly ahead of the consensus, but gross margins were once again higher than any since mid 2000...We believe that margins were so high because of an unusually favorable component cost environment and because of changes in Dell's behavior on two fronts. First, we believe Dell is no longer smoothing its EPS results with accruals, so we expect margins to be more volatile in relation to changing component costs. Second, Dell appears to have changed its pricing strategy toward capturing more of the benefits from falling costs, rather than passing them on to customers in an attempt to stimulate demand. We hope that the first change is lasting, but we suspect that the second could prove more temporary. Whether or not Dell gets more price aggressive, however, we expect 3Q margins to fall due to rising costs for displays, batteries, and, to a lesser extent, memory. Heading into 2008, we expect margins to continue falling as Dell ramps its retail PC distribution."

Sumner raises a host of issues. Let's break them out:

• The component landscape. Prices are going up so Dell won't have the wind at its back in the second half. Meanwhile, Dell's effort to bolster its retail presence will negate some of its supply chain prowess.
• What happens when component prices go up? Dell has two choices when component prices increase: Pass on increases to preserve profit margins or eat a bit of the costs. If it passes on increases perhaps it reflects a bit of a truce between Hewlett-Packard and Dell, the two largest PC players. A lot will depend on HP, which is the stronger company. If HP decides to squeeze Dell on pricing it can. Meanwhile, the bulked up Acer may limit the ability of Dell and HP to pass on cost increases.
• Dell's retail adventure. Since Dell hasn't held quarterly conference calls with Wall Street color on its retail partnership with Wal-Mart isn't available. Sumner is on target though when he writes that Dell's retail moves won't come cheap.