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Dell Q3 1997
November 24, 1997

by Randy Befumo (TMF Templr)

All eyes were on Dell Computer (Nasdaq: DELL) as it reported third quarter earnings today to great fanfare. Although conventional estimates sat at $0.65 per share, super-charged, high-powered whisper numbers were $0.66 to $0.67 per share according to a number of media sources. Luckily for Dell, the company came through like a champ earning $0.69 per share, one-upping the whisper numbers yet again. Unfortunately for Dell, this happened after the market closed, leaving the company open to a $3 5/8 drop to $79 3/4 before the market closed. The entire decline came in the last two hours of trading, indicating that some speculative types did not like the odds going into the close or heard rumors that the numbers simply would not be good enough.

Overall: In the third quarter ended November 2, revenues for Dell exploded 57.9% to $3.19 billion, up 13.3% sequentially. Earnings per share grew even faster, rising 76.9% year-over-year from $0.39 per share and 16.9% sequentially from $0.59 per share last quarter. The additional growth in EPS came from the magnifying effects of a rising operating margin and a lower number of outstanding shares. Year-over-year operating margins increased nearly a full percentage point to 10.9% from 10.0% a year ago, while shares outstanding dropped to 360 million weighted average shares from 382 million last year. During this quarter, the company repurchased nine million shares at a cost of approximately $300 million, or $33 a share. The company purchased the shares by exercising some of the put contracts it has been selling over the past two years.

Revenues: Strong revenue growth was almost 2.5 times the industry growth rate, as measured by IDC and Dataquest. According to Dell, this revenue growth came without a drop in average selling prices for computer systems. Revenues per unit remained stable despite the company's aggressive price cuts, indicating that many are trading up to more powerful systems and that sales of enterprise class servers and workstations are making up for any revenue loss on the desktop side. Revenues from servers and workstations were 10% of sales in the quarter, up from 8% last quarter and 4% a year ago. The velocity of the business in these much higher-margin products is in excess of the overall company, a fact that helps margins quite a bit. The company is currently generating $3 million in low-cost sales a day from the Internet, a rate that would be $1 billion over a full year. Although growth in Asia ticked down relative to last quarter, an uptick in growth in North America more than made up for this.

Cost Structure: Dell's continuing ability to hold the line on average pricing and increase revenues is the reason why it continues to increase operating margins despite assumptions by almost every analyst on the Street that it will end. Sequential operating margins grew by 0.3% due to flat operating expenses as a portion of sales and a gain in gross margins. The slight decrease in sales, general and administrative expenses relative to sales came even though the company increased headcount by 1,600 to 14,900 sequentially, a 10.7% increase. The company stated that declines in key component pricing as well as processor speed gains should allow sales to continue to accelerate while allowing it to continue to bring more operating dollars to the bottom line.

Balance Sheet: The company generated $395 million in cash from operations, allowing it to pad the balance sheet with approximately $100 million even after repurchasing shares. The company now has $1.62 billion in cash and marketable securities, meaning a full 41.2% of its working capital is represented by cold, hard cash. Dell managed to eke its days of inventory down to 11 in the quarter, giving it 33 inventory turns per year. The only black mark on the balance sheet was that days sales outstanding, a measure of how efficiently a company manages accounts receivable, increased by one day to 38 days. The pop in accounts receivable may be due to the delicate nature of the balance sheet, as it essentially freezes one day in time. As a result, the balance sheet from any one quarter can often be muddied by factors that are not transparent to the investor, indicating that long-term trends are much more important to analyze.

Capital Allocation: As stated, Dell repurchased 9 million shares of stock in the quarter. Since February of 1996, Dell has repurchased 68 million shares and has outstanding put obligations to purchase another 27 million. Eventually its ability to repurchase a significant amount of stock will slow if the share price continues to rise, but for now it appears that Dell can reduce outstanding shares by about 7.5% to 10% over the next year, a reduction that should continue to help it to accelerate EPS growth. Overall, the company has been incredibly good at allocating capital, generating a 176% return on invested capital this quarter. Dell continues to demonstrate its skill in capital management, a factor that sets it apart from most of its peers in the "box"-making business.

Looking Forward: With $0.69 EPS in this third quarter, forward earnings estimates may be clicking up over the next few days. Dell should exit fiscal 1998 with around $2.60 EPS and could do as much as $3.60 EPS in fiscal 1999 if it can maintain this revenue velocity. Given that the valuation still is rich relative to historical standards, Dell will need to increase revenues at more than two times the industry's growth rate, climb up the value chain with servers and workstations even further, and maintain or improve its cost structure to get to these kind of earnings numbers. Thankfully for shareholders, Dell has done nothing to indicate that this is not possible, and the company's shift in emphasis in this quarter's press release away from asset management to growth will probably set off another round of "follow-the-leader" type announcements from competition.

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