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In January, after being accustomed to 40%-plus annual revenue growth, Dell warned that its sales would "only" increase by 30% this fiscal year. That target was reiterated in August, when the company published its second-quarter numbers. After those figures, the Qualiport considered that the 30% aim was going to be a tall order and sure enough, Dell revised its sales growth target to 27% in October. Two weeks ago, when Dell produced its third quarter figures, it advised that sales growth of 20% should be expected next year.
Now consider the original Dell buy report. Back in January 1999, Bruce prophetically wrote: "With the shares currently trading at a forecast January 1999 price to earnings ratio (P/E) of 78, they look very expensive". Whoops.
Third quarter Dell
But the Qualiport isn't going to throw in the Dell towel just because our investment has nearly halved in under two years. On the contrary, it could pay to remain vigilant for an investment opportunity. Pessimism often brings "great value" in the stock market. And indeed, the disappointing series of statements from Dell has created a certain amount of despondency. More on Dell's valuation later. But first, those third quarter figures.
Three months to Nine months to
27/10/00 28/10/99 27/10/00 28/10/99
($m) ($m) ($m) ($m)
Revenue 8,264 6,784 23,214 18,463
Operating
profit 818 650 2,179 1,944
Post-tax
profit 674 483 1,802 1,424
Basic EPS* $0.26 $0.18 $0.70 $0.56
(*Earnings per share)
Sales
The figures appear to validate Dell's recent "revenue guidance" (of 20% sales growth in the year to January 2002) after total sales rose 21.8% on a comparable third quarter basis. Hark back three months ago to the second quarter figures and the comparable sales growth figure was 24.9%.
Also, there continues to be the growth story of two halves at Dell, although the PC desktop side of the company made a surprising resurgence during the latest quarter.
Three months to Third Quarter Second Quarter
27/10/00 28/10/99 Yr-on-yr Change Yr-on-yr Change
Revenues ($m) ($m) (%) (%)
Desktops 4,297 4,003 7.3 6.1
Enterprise 1,570 1,153 36.2 48.2
Portables 2,397 1,628 47.2 56.1
Whereas I was concerned about the lacklustre PC division (it recorded 6% year-on-year growth) three months ago, it now seems that it's the turn of Dell's corporate server ("enterprise systems") and laptop ("portables") operations to cause the unease. Although this third quarter is being compared to a pre-Millennium surge, both of these two divisions have seen their year-on-year growth rates decline materially of late.
Another worry is the sequential quarter-on-quarter growth. Whereas the desktop operation managed to record a very creditable third quarter sales increase of 9.8% over the second quarter, Dell's servers and laptops, underpinning the company's longer-term growth, faired less well. Disappointingly, the server division managed 7.8% sequential growth and the laptop division produced just a 4.2% sequential improvement. Nevertheless, Dell did declare that the company's "worldwide shipments of servers and notebooks grew significantly faster than the overall industry rate".
Dell also looks set to meet its 27% growth target for this fiscal year. The company requires sales of $8,873m for the fourth quarter, a figure that entails a 7.4% increase over this third quarter performance. That requirement comes after these results recorded a 7.7% overall revenue increase over the second quarter numbers.
Profits
There was better news further down the third quarter income statement. Operating margins rose from the 9.6% recorded in the second quarter to 9.9%. The performance in cost reduction stemmed four straight quarters of margin decline and helped operating profits jump 25.8% on the year.
At the bottom line, third quarter post-tax profits jumped 40%, aided primarily by "financing and other" income soaring from $40m to $145m. Profit from non-operating activities now contributes 15% of Dell's pre-tax income.
Incremental return on equity
In this feature, I reviewed Dell's incremental return on equity performance. But one difficulty I found when using the equity base for Dell's incremental return calculations was that the valuation of the company's investments distorted the results.
The latest quarter figures further highlight the complications. At the end of the third quarter, Dell had $3,146m of investments compared to the $3,982m of three months earlier. And although the company retained $674m in profit during this quarter, Dell reported a decrease in stockholders' equity (from $6,462m to $6,057m) mostly due to the decline in the valuation of its investments.
So whilst Dell took shareholders' money (in the form of retained profits) to reinvest during the quarter, purely looking at Dell's latest balance sheet could suggest otherwise. Overall, with fluctuating investments comprising a large part of Dell's equity base, it perhaps makes sense to concentrate on the incremental return on Dell's retained (or net) profits, profits that essentially form the company's equity base anyway.
The following tables show the increase in annualised net profit over the last eight quarters, set against the amount of net profit retained by Dell to generate that increase. The second table, showing a two-year incremental return, is used to smooth out Dell's Y2K surge and slump. For the record, Dell's incremental return over the five years to October 2000 is 30%, although it's clear from the tables that this performance is unlikely to be sustained in the future.
Year One year increase in Net Profit Incremental
Ending Net Profit retained ROE
($m) ($m) (%)
Jan 1999 515 1,460 35.3
Apr 1999 537 1,589 33.8
July 1999 566 1,750 32.3
Oct 1999 529 1,849 28.6
Jan 2000 400 1,860 21.5
Apr 2000 362 1,951 18.6
July 2000 297 2,047 14.5
Oct 2000 389 2,238 17.4
Year Two year increase in Net Profit Incremental
Ending Net Profit retained ROE
($m) ($m) (%)
Jan 1999 942 2,405 39.2
Apr 1999 955 2,641 36.2
July 1999 1,005 2,934 34.3
Oct 1999 1,001 3.169 31.6
Jan 2000 915 3,320 27.6
Apr 2000 899 3.540 25.4
July 2000 863 3,797 22.7
Oct 2000 918 4,087 22.5
The results are slightly different to those previously calculated, but not by very much. The conclusions are the same as before -- the dramatic falling off of Dell's reinvestment performance in recent quarters to a still-not-to-be-sniffed-at 20% level.
Summary
From the analysis, I regard Dell's 20% sales growth target for fiscal 2002 as being realistic. I don't really see it as a low hurdle, purposely set so Dell can avoid downgrading investors' expectations next year. My biggest concern at the moment is the apparent sharp slowdown in the server and laptop divisions, although it has to be borne in mind that this is just a three-month performance under scrutiny. It remains to be seen whether this quarter's trend will continue.
That concern, however, is offset by a revival in the group's PC operation and, more importantly, a long-awaited rise in operating margins. This margin improvement is notable, since it wasn't anything to do Dell selling a greater proportion of higher margin servers and laptops (low margin desktops increased their percentage of overall sales). Significantly, the margin improvement also helped to ease the precipitous decline in Dell's incremental return on equity performance, another good sign.
Overall, Dell still exhibits some impressive financial characteristics and potential, factors that still merits inclusion within the portfolio. Indeed, with the stock price falling to $24, is it time for a top-up? At this stage, I would say no. At $24, Dell stands on a prospective price to earnings (P/E) ratio of 21.8 for the twelve months to January 2002, assuming no further hiccups occur in this current fiscal year. For a company growing at 20%, there could be a top-up temptation should Dell's prospective P/E for fiscal 2002 fall below 20.
Where Next?
Read these recent Qualiport features on Dell:
• Delving into Dell -- Full Year 2000 and Q1 2001 results reviewed.
• Unwell Dell -- Q2 2001 results reviewed.
• Sell Dell? -- Dell's deteriorating return on equity highlighted.
• Right On The Fence -- TMFGoogly defers a Dell decision.