Qualiport

[ July 14, 2000 ]

Delving into Dell

By Maynard Paton (TMFMayn)

Carburton Street, London -- On Wednesday, I revisited Dell Computer Corporation (Nasdaq: DELL), a company your Qualiport managers have been unduly indifferent to in the past. Our lack of attention has been a little odd, especially when you consider the current $130b market value of Dell is double that of the other six Qualiport companies put together. Anyway, I'll carry on from Wednesday's feature.

Return on capital

Dell reports the return on invested capital (ROIC) calculation when detailing its annual performances. For fiscal 2000, a figure of 243% was recorded, up from 120% on the previous year. Dell boasts that the most recent ROIC accomplishment is twice as high as its nearest competitor. Although the ROIC method has its merits, I'm more from the school of owner equity returns, rather than the returns generated from specific assets.

Year ended Jan     2000     1999     1998     1997     1996
                    (£m)     (£m)     (£m)     (£m)     (£m)

Reported earnings  1,666    1,460     944      518      272

Shareholders'
 equity            5,308    2,321   1,293      806      973

Incremental return
 on equity (96-00)    32.2%

Since the end of January 1996, the company has required an additional $4,335m of shareholders' equity to increase post-tax profits by $1,394m. On an incremental return on equity basis, Dell produces a figure of 32.2%. Although just shaded by MMT Computing (LSE: MMT), by far the smallest company held in the Qualiport, Dell's equity reinvestment performance puts the efforts from the rest of the portfolio's constituents firmly in the shade. No problems here.

Stock Options

Time to throw in a Buffett quote:

"It seems to me that the realities of stock options can be summarised quite simply: If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?"

Ever since the dawn of stock options, there have been arguments for and against the current accounting practice concerning these investment devices. At the moment, the employee gains to be had from options are not incorporated in a company's main profit and loss statement. Thus, there's no knock-on effect with earnings. Instead, the gains are hidden away from a company's profits within an obscure accounting note, usually dealing with a company's share capital or reserves.

So, as hefty stock options are normally associated with hi-tech US companies, it's worth taking at look at how Dell is affected.

According to Dell: "Had the Company accounted for its Incentive Plan and employee stock purchase plan by recording compensation expense based on the fair value at the grant date on a straight-line basis over the vesting period, stock-based compensation costs would have reduced pretax income by $329m ($224m, net of taxes), $194m ($136m, net of taxes) and $100m ($69m, net of taxes) in fiscal years 2000, 1999 and 1998 respectively."

In other words, had Dell employees been working for a private company and been given cash instead of exercising their options, post-tax profits would have decreased by 13%, 30% and 7% in the fiscal years 2000, 1999 and 1998 respectively. I'm not going to dwell too much further on the subject of stock options at the moment, mostly because I've only considered Dell on this thorny topic. In the future, I'll muse over stock options and the effect on the Qualiport seven in more detail. But for now, like the accountants and most shareholders, I'll simply ignore them. (Sorry Warren).

The future

Michael Dell isn't too reticent when it comes to outlining the opportunities for his company: "The potential for Dell is enormous. Even as the second-largest company (in the industry), we accounted for only 11% of the computer systems sold worldwide last year. And industry growth remains strong. Globally, we expect companies to spend $370b annually on their infrastructures by 2003, a substantial portion of which will be for server and storage products, and related services. That trend plays directly to our strength as the Number 2 and fastest-growing major supplier of servers in the world."

Dell continues: "This year, the total computing market... is projected to reach $1 trillion, and our current share is less than 3%. We believe that our... capabilities position Dell extremely well to continue to grow at a multiple of the industry rate."

Valuation

I know Bruce is a fan of cash flow valuations, and it's tempting to value Dell on the favourable cash flow figures rather than earnings. But I'm always a bit wary of valuing companies based on "surplus" working capital cash that effectively isn't profit, but instead is cash still owed to suppliers. Stock options aside, I'll stick to earnings.

At $53 a share, consensus earnings-per-share (EPS) figures place Dell on a prospective price-to-earnings ratio (P/E) of 57 for the year ended January 2001. The P/E falls to 44 for the year after. So, there's a fair bit of expectation in the current price.

How about this for a further valuation attempt? Re-using the stab at valuation Bruce proposed eighteen months ago, the then anticipated 2009 (split-adjusted) share price of $155 equates to a compound average annual return of 12.7% at Dell's current $53 share value. Dell would have to fall to $44 to clear the Qualiport's 15% annual return hurdle. But knowing that the Qualiport has had its fingers burned on long-term optimistic projections before, and we're talking about 20%-plus annual growth rates here, I'm rather cagey at declaring any suitable "fair price" valuation.

Q1 and Summary

As I mentioned in Wednesday's feature, I admit to not knowing a great deal about the future of the computer manufacturing industry. It's fast-changing and suffers from intense competition, which doesn't, on the face of it, make for much long-term predictability. But in the last ten years, the Dell management have steered the company from being the number 25 computer systems company to become the US number 1. So, there's obvious talent at Dell that we can place some of our investing faith on.

If I was wanting a piece of the forthcoming sector growth, I would prefer to ride with the current winners, rather than those who are have slid down the ranks and are adapting to the new industry ways. In fact, rather than looking at today's winners, perhaps investors should be considering the upcoming industry players that could turn Dell's business into a bygone legacy. Unfortunately, I can't offer any suggestions on this count.

I've got no real complaints about the Dell financials. For a company of Dell's size, the growth rate and equity reinvestment performance are exemplary. Dell is simply a great company that offers the Qualiport exposure to huge market growth potential.

However, I'll finish off on a slightly downbeat note. I'm a little uneasy after reading the excellent Motley Fool Research Report on Dell's first quarter. Penned by US Fool Zeke Ashton (TMFCentaur), the report contains such bearish comments as "sales growth has definitely begun to slow", "operating expenses are growing faster than sales", "net income was heavily weighted by investment gains" and "a decline in operating cash flow".

Okay, so that was just one quarter. But it's worth the Qualiport bearing in mind Zeke's remarks before Dell's interim results, due early August.

Where Next?

• Review Wednesday's Qualiport feature on Dell.
• Pop across to the US Fool for the Motley Fool's Stock Research
• Learn about Return on Invested Capital and Incremental Return on Equity
• Visit the busy Dell discussion board (US Fool) | and website