FOOL ON THE HILL
For Whom Dell Still Tolls

Sure, it's been a tough year for boxmakers. But Dell remains the low-cost provider in the business, earns higher returns on capital than almost any company around, has had success expanding into the higher-margin server and storage markets, continues to grow faster than the market, and has less than 12% worldwide market share.

Format for Printing

Format for printing

Request Reprints

Reuse/Reprint

By Richard McCaffery (TMF Gibson)
January 18, 2001

As the personal computer business seems to slide into the ocean, investors have to wonder about the boxmakers.

Indeed, it's been a rough year -- and a rougher couple of months. Gateway (NYSE: GTW), Apple (Nasdaq: AAPL), and Compaq (NYSE: CPQ) all warned about a weak fourth quarter. You can't open a newspaper without reading that PC growth rates are slowing, the worldwide economy is slowing, and personal data assistants like the Palm Pilot are pushing the PC off center stage.

In a recent article, I tried to put that slowing growth in perspective, given how much PC growth soared in 1999 and based on estimates from International Data Corp. It's important to remember that PC growth rates have been all over the chart during the last seven years, and you shouldn't expect that to change in the future. Fast-growing industries don't grow evenly; there's just too much noise in the economy. In a nutshell, growth in worldwide PC shipments is expected to come in at around 18.8% in 2000 and 16.6% next year. Here's a look at the numbers:

Worldwide PC Shipment Growth*
Year    Shipments(millions)   %Growth
1994       47.3                 --
1995       59.5                25.8%
1996       70.2                18.1%
1997       81.4                15.9%
1998       91.9                12.8%       
1999       113.5               23.6% 
2000       134.8               18.8%
2001(est.) 157.2               16.6%

*Source: International Data Corp. (IDC)

My take is that the PC industry will remain a growth business for the ablest players -- not that it isn't slowing, just that it's still a growth business. That's where Dell (Nasdaq: DELL) comes in. I bought shares of Dell in October when they dipped below $25 -- on their way to $17. My reasoning went like this: Dell is the low-cost provider in the business, earns higher returns on capital than almost any company around, has had success expanding into the higher-margin server and storage markets, continues to grow faster than the market, and has less than 12% worldwide market share. In short, I believed the market overreacted when it dragged Dell below $25 and it traded at less than 30 times trailing free cash flow. I'm looking for Dell to double its free cash flow in six years -- 12% annual growth.

Clearly, PC growth rates are slowing. And Dell, which will finish the year with more than $30 billion in annual revenues, won't grow sales at 30% annually anymore. But it doesn't have to if it continues earning high returns. Dell expects to grow sales 20% annually in 2001 and 2002 (unless we hear differently in the fourth-quarter conference call) and plans to grow operating profits even faster.

Because of my focus on cash flow and returns, I took a look at Dell's cash from operations and free cash flow for the last nine quarters. Free cash flow, which equals cash from operations minus tax benefits from stock options and capital expenditures, is a useful measure of a company's earnings power. We use it at The Motley Fool all the time since it isn't as subject to accounting distortions as net income. I found the results a little surprising:

Dell            CFO      FCF 
Q3 2000        2,993    1,879 
Q2             1,951    1,245
Q1               762      596
Full Year 99   3,926    2,489
Q3             3,091    1,919               
Q2             1,999    1,128
Q1             1,069      639 
Full Year 98   2,436    1,696
Q3             1,684    1,446

That's a lot of numbers to throw at you, but hang in there. The good news for Dell is that, based on these cash flow figures, the company routinely generates more cash than it reports on the bottom line. It's a nice indication of the company's profitability and financial health. Nothing new there.

What's a little alarming is where free cash flow stood at the end of Q3. As of the end of the third quarter, Dell had generated $1.87 billion in free cash flow. That's down from last year, when the company reported Q3 1999 FCF of $1.91 billion. What gives? Over this time period, Dell increased sales 25.7% and net income 46.5%. Shareholders can't be too happy to see free cash flow dip 2.1% while sales and income soar, especially since cash management is Dell's specialty.

The biggest difference between the cash flow statements from the two periods is changes in working capital, a line item that includes accounts such as receivables and inventories. Last year, Dell got a $614 million boost to FCF as a result of this line item, while this year working capital changes added just $173 million to the pot.

It's not unusual to see fluctuations in Dell's working capital accounts during the course of the year, and I'm not sure we see anything like a trend of declining cash production ability at this point, though growth is slowing. (We called the company for a further explanation, but didn't get one in time for publication. When we hear back, we'll update the story.) Go back to the second quarter, isolate that one period, and you'll see that FCF jumped almost 33% over the previous year. Go back to the first quarter and, again, you see lower free cash flow year-over-year.

Having examined Dell's days sales outstanding, days inventory, and payables, I don't see any reason to get nervous about Dell's cash management at this point. Dell's cash conversion cycle, which measures how quickly it turns raw materials into cash, stood at a negative 15 days at the end of Q3, slightly higher than a negative 17 days a year ago. Either way, Dell gets paid for its products and services 15 days in advance, a very sweet arrangement. PCs might not be a great business, but it becomes a great business the way Dell runs it. (For more on computer hardware sector, check out our InDepth page on the subject.)

I also took a look at Dell's annualized return on invested capital as of the third quarter. This sounds like nasty stuff, but it's used to determine how much money Dell earns for each dollar in invested capital. In its Q3 earnings report, the company said ROIC increased to 316%, up from 164% a year ago.

The bad news about ROIC is that applying it requires estimates and adjustments. For example, one analyst may include more cash as invested capital than another. Anyway, I couldn't get my numbers to match Dell's. By my estimates, the company's returns are down from a year ago, at about 200% compared with 265% a year ago -- and this is after making a large adjustment to the company's most recent balance sheet. See, Dell now has more than $3 billion in long-term investments that weren't there a year ago, probably the result of Dell stepping up its incubator business. Therefore the company has a much larger capital base to earn a return on. Counting these investments, Dell's annualized Q3 ROIC is about 49%.

What does all this mean? As with any business, Dell can be probably be expected to earn a lower ROIC over time. That's what competition and slower growth does to returns. The key is that the company remains very profitable. Most companies in the S&P 500 are lucky to earn a return on invested capital in the 10% to 12% range.

Historically Dell has sold at a premium to the market, not just because it's growing fast but because management converted the company into a cash machine by boosting its return on capital. That hasn't changed. It still deserves a premium, yet it sells at about the same earnings multiple as the overall market.

It's a mistake to think of Dell as just another boxmaker. Due to its capital management -- skills that are very hard to copy -- Dell earns higher returns than some software companies, and returns are the name of the game. Once panic over the latest PC slowdown has worked its way through the system, we could see Dell trade higher. I'm willing to wait and see.

Have a great day.