Qualiport

[ August 11, 2000 ]

Unwell Dell

By Maynard Paton (TMFMayn)

Carburton Street, London -- Qualiport constituent Dell Computer Corporation (Nasdaq: DELL) unveiled its second quarter results last night. Given the current valuation of Dell, there are still one or two doubts lingering over the company's financial statements.

Here are the figures presented by the US computer giant.

                Three months to          Six months to
              28/07/00    30/07/99    28/07/00    30/07/99
               ($m)         ($m)        ($m)        ($m)

Revenue       7,670        6,142       14,950      11,679

Operating
 profit         736          694        1,361       1,294

Post-tax
 profit         603          507        1,128         941

Basic EPS*    $0.22        $0.19        $0.41       $0.34

(*Earnings per share)

Sales

Total sales rose by 25% on a comparable second-quarter basis and by 28% on a comparable half-year basis. However, there continues to be a growth story of two halves within Dell.

               Three months to
              28/07/00    30/07/99      Change
Revenues       ($m)         ($m)          (%)

Desktops      3,911        3,685          6.1
Enterprise    1,457          983         48.2
Notebooks     2,301        1,474         56.1

Worryingly, the latest quarter saw the core desktop division grow at just 6% year-on-year. In the three months ended April 2000, the desktop division witnessed revenue growth of 12%. Is the PC game effectively up for Dell? The latest single-digit growth accomplishment certainly gives that impression. Of course, PCs are only half of the turnover story at Dell. Enterprise servers and laptops now drive the top line, with impressive 50%-ish growth now being attained at both divisions.

Company Chairman Michael Dell commented that "the second-quarter results and expectations for strong industry demand in the second half of the year keeps us on track toward our goal of 30% full-year sales growth".

The 30% target looks a tall order. With sales of $25,265m recorded in the year to January 2000 and first half fiscal 2001 sales of $14,950m, the stated goal requires Dell to generate revenues of $17,895m in the next six months.

If we assume that sequential sales growth in the forthcoming two quarters will be equal, then third and fourth quarter revenues of $8,492 and $9,403 respectively can be expected. Or in other words, near-term sequential quarter-on-quarter growth is forecast (by Dell) to be around 10.7%.

Achieving that 10.7% figure will be quite a feat, especially when the previous four quarters had recorded sequential sales growth of 10.4%, 0.2%, 7.0% and 5.4%. Given the latest Dell results, I suspect the current 25%-28% annual growth rate target is a more realistic ambition.

Profits

Hefty revenue increases at Dell haven't been fully converted into profits of late. Over the four most recent quarters, Dell's profit margins have slumped from 11.3% to 9.6%. The causes have been increases in component costs, staff wages and infrastructure expenditure. On both a comparable second-quarter and half-year basis, operating profits at Dell edged a paltry 5-6% upwards.

The pressure on margins combined with the ambitious ongoing revenue targets gives me the jitters. When I revisited Dell last month, I wrote:

"A hint of the pricing pressure Dell looks to be suffering was given in the "management's discussion" of the (fiscal) 2000 numbers: 'Notebook computer unit sales increased 61%, primarily as the result of pricing actions... Desktop computer systems unit sales increased 46% during fiscal 2000. This increase was primarily attributable to the Company's aggressive market penetration of new and high-end products.' "

Will Dell slash margins at the expense of keeping their 30% sales growth promise? The phrase "turnover is vanity, profit is sanity" comes to mind...

At the bottom line, second-quarter post-tax profits jumped 19%, aided primarily by "financing and other" income soaring from $30m to $125m. Profit from non-operating activities now contributes 15% of Dell's pre-tax income.

Incremental return on equity

Another concerning part of the Dell financials is the latest incremental return on equity calculation. Although I've deduced the five-year incremental return on equity to be 32.2% in the past, it's apparent that recent returns have sharply declined.

In the year ended July 2000, Dell's equity base had swollen by $3,092m to $6,462m. In that time, annualised profits have risen from $1,750m to $2,047m, an increase of just $297m. The incremental shareholder return over those twelve months therefore equates to only 9.6% ($297m / $3,092m). Similar calculations for the year ended January 2000 gave a 7% figure.

There are two factors to consider here. Firstly, recent reinvested equity returns include the Y2K-depressed final quarter of fiscal 2000. But more significantly is the relatively low fixed asset requirement of Dell to generate profit improvements, coupled with the company retaining far more of its earnings than necessary. This combination leads to large slugs of underperforming cash and investments appearing on the balance sheet. Indeed, cash and investments have soared from $4,715m to $8,298m in the twelve months ended July 2000.

Although improved market values of the company's investments may impact the latest equity reinvestment calculation, question marks are starting to appear over Dell's decision to persistently retain all of its profits. Suffice to say, further investigation is required on this subject.

Valuation

Prior to yesterday's results, brokers were forecasting earnings per share (EPS) of $0.92 for the current year. At the current share price of $38 3/4, the prospective price to earnings (P/E) ratio is 42.1. The shares aren't cheap, especially when doubts hang over company-declared revenue target and reinvested profit productivity.

I ended my previous look at Dell by remarking:

"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' ".

Apart from the operating cash flow, a feature that was not disclosed in Dell's press release, nothing in the second-quarter results has really put to bed the bearish first-quarter observations.

Dell offers the Qualiport exposure to healthy market growth potential. That's great. But the company has its work cut out to justify its lofty valuation.

Where Next?

• The Qualiport revisits 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 Dell discussion board (US Fool) | website