Qualiport

[ November 27, 2000 ]

Economic Profit At Dell

By Maynard Paton (TMFMayn)

Carburton Street, London -- When reviewing the financial performances of Dell Computer Corporation (Nasdaq: DELL), I've always highlighted one notable feature -- the dramatic decline of the company's incremental return on equity.

Using a two-year calculation, to smooth Dell's Y2K surge and slump, the table below (taken from this review of Dell's third quarter) clearly shows the deterioration. Pre-1999, Dell consistently generated returns on reinvested profits of over 40%.

Two years   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

So, time to worry? Certainly, the trend over Dell's last eight quarters does give some cause for concern. The obvious trouble for Dell is simple: as the company increased in size, so the opportunities for those mega 40%-plus returns on equity inevitably disappeared. But the near halving of equity reinvestment returns, from 39.2% to 22.5%, doesn't give the full story of Dell's profitability accomplishments.

Equity Risk

As an investor, you have two basic options. Either put your money into a deposit account (or similar) or put your money into a business. Sticking the money in the bank will earn a fixed and guaranteed return. However, putting your money into a business offers no such certainties. In this instance, you'll expect a greater return to offset the inherent risks involved. Enter the "equity risk premium".

Now, back to Dell. The company decides each year, as it always has up to now, to retain of all its profit (remember, shareholders' money) and reinvest it. Dell shareholders will expect that the return on their investment (i.e. their slice of corporate profits to be subsequently created by their share of the company's retained profits) to exceed what can be achieved without risk, and to adequately compensate them for the additional business perils they've taken on board too.

Let's say an investor can achieve a return of 6% risk-free. Now, the theoretical calculation of the equity risk premium is somewhat complex and is far beyond the scope of this feature. To keep things simple, let's just say that the equity risk premium is 4%. Or in other words, Dell shareholders would accept a 10% return (a 6% risk-free return plus a 4% equity risk premium) generated on their part of the company's reinvested profits. This 10% return is in turn defined as an investor's "cost of capital".

Economic Profit

Now let's introduce another concept, that of "economic profit". Economic profit is simply the "excess" profit generated over and above an investor's cost of capital. Essentially, it's this profit that creates "shareholder value". Thus, from the earlier table, we know that Dell generated an annualised 22.5% return on the $4,087m of shareholders money retained in the two years ending October 2000. So, we can now also say that Dell generated ((22.5% - 10%) * $4,087) or $509m of economic profit over that period too.

Here's how the company has performed over the last eight quarters on an economic profit basis.

Two years   Two year increase in  Excess return over  Economic
Ending        Retained Profit      cost of capital     profit
                  ($m)                 (%)              ($m)

Jan  1999        2,405                29.2               702
Apr  1999        2,641                26.2               691
July 1999        2,934                24.3               712
Oct  1999        3,169                21.6               684
Jan  2000        3,320                17.6               583
Apr  2000        3,540                15.4               545
July 2000        3,797                12.7               483
Oct  2000        4,087                12.5               509

Although the recent trend of Dell's economic profit is downwards, just like the return on incremental equity from the earlier table, the decline is less acute. Offsetting the deterioration in economic profit are the increasingly large amounts of capital being reinvested by Dell.

Here's how Dell has fared over the past five years or so. Note that the company is now generating a similar amount of economic profit compared to pre-1998, even though its reinvestment return has nearly halved over that time.

Two years   Two year increase in  Excess return over  Economic
Ending        Retained Profit     cost of capital     profit
                  ($m)                 (%)             ($m)

Jan  1997          790                36.7              290
Jan  1998        1,463                36.0              527
Jan  1999        2,405                29.2              702
Jan  2000        3,320                17.6              583
Oct  2000        4,087                12.5              509

So, as an investor, which would you prefer? Dell investing $790m at 36.7% over and above your cost of capital (equating to $290m of economic profit) or $4,087m at a 12.5% "excess" rate (equating to $509m of economic profit)? You'd go for the latter option each time. Although the rate of return is less in the second option, greater "excess" profit is still being created.

This second table really highlights that, for Dell, the focus on the incremental return on equity performance doesn't reveal the whole story. It has to be set against the rapid growth of the equity base. Dell has forgone the mega 40% returns of yesteryear to instead generate 20% returns from, very importantly, a far larger equity base. Although the absolute reinvestment performance has deteriorated over the past five years, Dell has still managed to sustain (if you take the two years to January 1999 as a blip!) its "economic profitability".

Trade-off

Businesses just can't maintain really superior return on equity performances forever. As a company grows, there inevitably becomes a trade-off between further profit growth and the declining investment returns needed to generate that profit. Economic profit puts this growth and profitability trade-off into perspective. Economic profit being maintained is a sign that any declines in returns on equity are being suitably matched by greater capital employed at those smaller returns.

Although the 10% cost of capital is a rough and ready figure, the last eight quarters have seen economic profit at Dell slip from $702m to $509m. Whilst it remains to be seen how the company fairs in the future, further declines in its return on equity ought to be matched against its creation of economic profit. A consistent amount of "shareholder value" could still be created by Dell, measured by the level of economic profit, even though some of the underlying ratios of shareholder profitability may decline.

And finally, it has to be remembered that Dell, even after the return on equity deterioration, is presently able to create a 20%-plus return on retained profits. That's well above any investor's cost of capital. And it has to be emphasised that this 20% return is still an impressive performance, given that the company is currently redeploying around $2.2b of shareholders' capital each year.

Where Next?

• Dell Hell -- Dell's Q3 2001 results reviewed