Dell's Secret Earnings Engine

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Value investors often look beyond the core business to find hidden values. For instance, both Toys "R" Us (NYSE: TOY) and McDonald's (NYSE: MCD) have well-known consumer businesses. But when investors examine companies in-depth, they will stumble upon the significant value in these companies' real estate holdings.

Dell (Nasdaq: DELL) is a Motley Fool Stock Advisor pick that's been performing particularly well lately relative to competitors such as Hewlett-Packard (NYSE: HPQ), so it's especially enjoyable rooting around Dell's dusty attic. There we discover, hidden away under a pile of old Intel (Nasdaq: INTC) 386DX processors, that Dell's business is becoming almost as much about insurance as it is about computers.

"Great!" you say, "I've been looking into getting life insurance." But no, the insurance that Dell sells is warranties on computers, insuring against the computer's death, not a person's. However, it is the same kind of business as other insurers. Dell collects money now, reserves a portion to pay for future repairs under the warranty agreements, and keeps the rest as profit.

And how much profit is there? Dell's 10-K for fiscal 2003 shows that last year Dell received about $2.55 billion in revenue from warranties, or about 6% of its total revenues. Dell doesn't break out its reserves for repairs, but it has in previous years. Thus, it's possible to approximate the reserves by assuming that they are roughly the same percentage of warranty revenue -- or alternately total revenue -- that they were in 2002. This assumption might overestimate reserves slightly, since Dell's expenses servicing warranty claims as a proportion of warranty revenue and total revenue have declined slightly. Dell is becoming more efficient at servicing warranties.

This calculation yields reserves in the range of $1.55 billion to $1.6 billion, or gross profits on warranties of almost $1 billion. Looking at it another way, profits from warranties comprise roughly 13% of Dell's gross profit or about 28% of its operating profit. The operating profit number is particularly relevant when you consider that the bulk of Dell's operating expenses are likely related to computer manufacturing rather than warranties.

Thus, Dell is known as a great computer maker, but investors should also be aware of the importance of its lower-profile but much higher-margin warranty business.

Fool contributor Richard Gibbons is waiting indefatigably for your comments. He does not own shares of any of the companies in this report.