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The latest figures are a far cry from the 42% ROE calculated on the traditional basis. Pre-1999, Dell's equity reinvestment accomplishments were in the 50%-plus bracket. From the table above, it's obvious that earnings retained by Dell post-1999 are now failing to live up to the achievements of prior years.
Investments and acquisitions
The plunge in performances has been reduced, but not to any level that totally removes the doubts. An incremental return on equity of 13.5% isn't inspiring.
Having a "smoothed" pre- and post-Y2K performance and adjusting for acquisitions and investments finally gives investors some reassurance. A 20%-plus incremental reinvestment achievement is not to be sniffed at.
I stated: "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."
At the time, I believed three factors influenced this seemingly mediocre performance:
• the Y2K-despressed final quarter of fiscal 2000 (the three months to 31st January 2000);
• the low fixed asset requirements of Dell that have led to ever-increasing mountains of underperfoming cash, and;
• the rising market value of Dell's investments
Another factor I'd now like to add is the deteriorating operating margins that have been witnessed over the last eighteen months.
Unlike its profits, Dell could still be generating a commensurate increase in revenues from its expanding asset base. Thus, increases in operational costs could be causing the underperforming reinvestment performance. If so, future margin improvements, already appearing in the latest second-quarter results, would subsequently jack up the incremental return to suitable levels.
But on the other hand, a declining "sales to equity" performance alongside an incremental return on equity deterioration spells an all-round corporate slowdown. And this situation would suggest a fair degree of shareholder danger.
Enquiring into the equity base
Having now perused the Dell accounts in further detail, improved market values of the company's investments have indeed impacted on the original calculation. And to a lesser extent, Dell's acquisition of ConvergeNet in October 1999 has influenced the result too.
First of all, let's determine Dell's "traditional" return on equity (ROE) for the twelve months ending July 2000. The company generated post-tax profits of $2,047m in that period whilst employing average shareholders' equity of $4,916m. Dell's ROE thus equates to 42% ($2,047 / $4,916). At first glance, a fantastic figure.
But what counts for the investor is how recently employed equity is being utilised. Using the incremental return on equity calculation, we can determine if Dell's ROE figure is disguising recent sub-standard reinvestment achievements.
Quarterly summary
The table below summarises Dell's latest seven quarters and the resulting 1-year incremental return on equity figure.
Year One year increase in Incremental
Ending Annualised profit Equity ROE
($m) ($m) (%)
Jan 1999 515 1,028 50.1
Apr 1999 537 1,391 38.6
July 1999 566 1,771 32.0
Oct 1999 529 2,362 22.4
Jan 2000 400 2,987 13.4
Apr 2000 362 2,808 12.9
July 2000 297 3,092 9.6
But is this just to do with Dell's operating margin decline over the past year or so? The table below suggests that Dell's fast-expanding equity base isn't generating a commensurate increase in sales either.
Year One year increase in Incremental
Ending Annualised Sales Equity Sales/Equity
($m) ($m)
Jan 1999 5,915 1,028 5.75
Apr 1999 6,200 1,391 4.46
July 1999 6,494 1,771 3.67
Oct 1999 6,830 2,362 2.89
Jan 2000 7,022 2,987 2.35
Apr 2000 7,148 2,808 2.55
July 2000 6,865 3,092 2.22
The precipitous decline in the rate of additional profits and sales being generated by Dell's expanding equity base gives me cause for concern. But as mentioned earlier, increases in the market values of investments and acquisitions do affect the equity denominator within the calculations.
The market value of Dell's investments increased by $559m during the year ended January 2000. Removing this figure, and $332m of assets acquired from the purchase of the revenue-less ConvergeNet, produces these revised numbers.
Year One year increase in Incremental
Ending Annualised profit Equity ROE
($m) ($m) (%)
Jan 2000 400 2,096 19.1
Apr 2000 362 1,917 18.9
July 2000 297 2,201 13.5
Year One year increase in Incremental
Ending Annualised Sales Equity Sales/Equity
($m) ($m)
Jan 2000 7,022 2,096 3.35
Apr 2000 7,148 1,917 3.72
July 2000 6,865 2,201 3.12
Now consider Y2K
Of course, account has to be taken of the Millennium slowdown. Perhaps a better guide to Dell's ongoing reinvestment performance would be to take a two-year incremental outlook. Of course, this now brings the pre-Y2K surge of orders into account. Equity analysis has never been easy!
Two Years Two year increase in Incremental
Ending Annualised profit Equity ROE
($m) ($m) (%)
Jan 2000 915 3,124 29.3
Apr 2000 899 3,308 27.2
July 2000 863 3,972 21.8
But having said that, the 2-year table and all the other tables before each have a common characteristic -- the dramatic falling off of Dell's financial performance in the recent quarters.
Summary
The dilemma for the Qualiport is to obviously decide whether this deterioration is a Y2K "glitch" or whether it's the beginning of the end for the corporate shooting star.
Dell has given a 30% sales growth target for this current financial year. As reported in the previous Dell review, this would result in some serious profit increases. Meeting the declared target would no doubt turn around the profit reinvestment performances. Even so, I feel Dell's current incremental return on equity (excluding the Y2K effect) is somewhere within the 13%-21% range, a performance that still merits inclusion within this portfolio.
At a share price of $37, Dell stands on a price to earnings (P/E) ratio of 40 times the profits expected for the year ending January 2001. So no room for error, should the company slip up. At the moment, the Qualiport jury on Dell is out.
The company's upcoming third quarter could be make-or-break for the company. Will Dell be on route for its declared 30% sales growth target? As I rounded off my previous feature on Dell by saying, "the company has its work cut out to justify its lofty valuation".
MMT Computing
After a little deliberation, I'm announcing a Qualiport top-up in our holding of MMT Computing (LSE: MMT). The company hasn't drastically changed since it was first proposed for the portfolio, and after meeting Tony Grellier, its Managing Director, my opinion still hasn't altered. At a current share price of 540p, MMT stands on a forward P/E ratio of 10 for the year to August 2001.
So, sometime in the next 5 trading days, and in accordance with the Fool's Trading Rules, the Qualiport will buy £1,677-worth (all the portfolio's cash reserves!) of MMT Computing.
Where Next?
• Review Dell's annual and second quarter results
• Visit the Dell discussion board (US Fool) | website