Thoughts on Dell

Yesterday was D-Day—Dell reported earnings. At this point, Dell’s image among the financial media is somewhere between Kim Jong-il and thyroid cancer.
If you recall, on Halloween Dell said it was going to report earnings of 39 cents a share, which was at the “low-end of expectations.” The media went into gleeful outrage and fell beneath the low-end of my expectations, which—let’s face it—is already pretty darn low. As for Dell’s stock, it promptly dropped 8% on volume of 105 million shares. Apparently, the low-end of expectations was…well, not expected.
Speaking of low-end, that’s the rap against Dell. The company can’t compete in the market for cheap PCs. Plus, their sales growth is slowing, their customer service is horrible and they’re pursuing nuclear weapons. No wait, that last one I think is Kim Jong-il. But you get the idea.
Over the last few days, I’ve gotten about 20 gabillion e-mails asking me why I’m not panicking over Dell. The easy answer is that panicking won’t make me any money. (I’ve tried it.) The other reason I’m not panicking is that there’s no reason to panic.
The Major Concern right now is Dell’s slowing sales growth. For the last several quarters Dell’s sales growth has slowed down (or “decelerated” if you’re an analyst, or maybe a Vulcan). But slowing sales growth is not necessarily a problem.
Here’s your investing lesson for today. When you’re looking at a company, the single-most important number is return-on-equity. Forget head-and-shoulders, forget bear traps and double bottoms, forget volume, forget stochastics. Return-on-equity tells you more than anything else about how well a company is performing. It’s the best measure of efficiency, bar none. In short, ROE tells us how much we get for how much we got.
ROE can be deconstucted down into three parts (warning, math ahead). Profits margins, asset turnover and leverage. Think of it this way:
Profit margin is profits divided by sales.
Asset turnover is sales divided by assets.
Leverage is assets (stuff you have) divided by equity (stuff you own).
If we multiply them it will look like this:
(Profits) (Sales) (Assets)
———- X ——-X——– = ROE
(Sales) (Assets) (Equity)
I pass the graphics savings on to you.
The mathematically inclined will see that the two “sales” and two “assets” cancel each other out. And we’re left with profits divided by equity, or return-on-equity. See, easy.
The beauty of ROE is that it works for every company. You can compare General Electric to a lemonade stand. A company like Wal-Mart may have a teeny profit margin (around 3%), but incredible asset turnover. Wal-Mart is really just one big inventory control machine. A financial company like Citigroup might have 15 or 20 times more assets than equity, but it generates only a few pennies of revenue for each dollar of assets.
Everything here balances out. If you want to borrow more to increase your leverage, your interest costs will hurt your profit margin. Or, you can increase your asset turnover by lowering your margins. Doesn’t this just scream for its own School House Rock? (R-O-E for you and me!)
Return-on-equity doesn’t lie, and it can’t be tricked. Earlier this year, General Motors generated huge sales growth with its employee discount. But it sacrificed its profit margins. The ROE never changed. GM just rearranged the equation. It turns out, GM still sucks.
The other great thing about ROE is that it’s stable. Almost all financial stats can bounce around, but the ROE of a company tends not to change much from year-to-year. The only true way to improve your ROE is to become more efficient.
The ROE of your average company is about 10%. The good ones are around 15%. Really good is 18%-20%. Yesterday, I talked about Patterson Companies. Patterson has had nine straight years of over 20% ROE. It could be longer—that’s as far back as my records go. For the last six years, Dell has averaged 40% return-on-equity.
Now do you see why I give Dell the benefit of the doubt?
For the third quarter, Dell increased its revenues by 11.3%. But thanks to a shift to higher-margin products, the company was able to increase its net margins. Dell isn’t getting beaten on the low-end. It’s changing its strategy so it’s not so reliant on the low-end. The ROE for was over 18% for last quarter alone. (I haven’t dug through the details, but it looks like Dell’s equity was hurt by a bad investment, which lowers the equity base.)
So let’s look at the scoreboard. Dell’s stock is $13 off its high. Yet, if it hard earned two more pennies a share this quarter, no one would be complaining. Two pennies versus $13? So those marginal pennies had a P/E ratio of 650! Yes, I have no problem taking the other side of that bet.
By the way, Dell grew its earnings-per-share by nearly 17% last quarter. This is the disaster we’re looking at? Now look at any old story from the last two weeks. We have “It’s Bad to Worse at Dell” from, where else, Business Week. This comes a few weeks after the magazine ran two anti-Dell pieces simultaneously. Every blackheart’s favorite story is: The King Is Dead.
Maybe Dell is done for, but they have a funny way of showing it. My theory is that bad news sticks to them. And for now, I’m sticking with ’em too.

Posted by on November 11th, 2005 at 6:15 am


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.