In a July 2000 interview in SmartMoney magazine, Miller praised direct sales computer company Gateway (NYSE: GTW), which, as of June 30, was his second-largest holding, constituting 6.43% of Value Trust's assets, just behind America Online (NYSE: AOL).
Gateway overtook rival Dell (Nasdaq: DELL) as Value Trust's second-largest holding earlier this year, when Miller added to his Gateway position after a fourth-quarter earnings scare related to a chip shortage. At the same time, Miller has pared back his stake in Dell, believing the days of outsized returns for the Round Rock, Texas company are finally over.
In the article Miller said, "The Dell P/E multiple is two times the Gateway multiple even though Gateway is earning more than Dell."
Since Miller made that statement, Dell's price has declined, so it now has a forward P/E of 41.2, compared to Gateway's 34.3. While it's clear that the multiples of these two great companies are converging, what interests me is Miller's contention that Gateway earns more than Dell. I'll run you through a few quick calculations to show you where I think the companies stand. I'd really like input from Bore readers on this topic, since many of you probably know the companies better than I do.
Annualizing the Q2 numbers, I have Dell earning higher return on average equity (ROE), return on invested capital (ROIC), and free cash flow relative to tangible assets.* If Gateway is earning more than Dell, I can't see it. [I calculated ROIC using the following formula: NOPAT (Net operating profit after taxes)/ total assets minus non-interest-bearing current liabilities and excess cash.] Here's the comparison:
ROE ROIC FCF/Tangible assets Dell 39.9% 63.0% 22.3% Gateway 21.4% 26.5% 14.7%* Free cash flow and balance sheet numbers taken from 1999 annual reports. Excess cash is backed out, as are tax benefits from Dell's stock options.
As you can see from my numbers, while both box makers are excellent companies -- far above the norm in terms of profitability -- Dell outshines Gateway in every category and seems to deserve its higher multiple.
Of course, my calculations are backward-looking. It's possible that Miller thinks Gateway will generate greater free cash flow in the future, though it's very hard for me to see how, considering Dell's commanding lead and leaner structure (i.e., lower asset base relative to earnings power).
It's also possible Gateway has a wider spread between its return on invested capital and cost of capital, but that's also very hard for me to believe considering that Dell's ROIC greatly exceeds Gateway's.
On the other hand, in terms of multiple expansion, I could see Gateway having more room to grow than Dell, so perhaps it makes sense that Gateway is Value Trust's second-largest holding.
Still, I have to ask, is it possible at this late stage that the market isn't properly valuing Gateway given all the time it's had to see Gateway's efficiencies, and see the success of its country stores and its beyond-the-box expansion program? It's possible. We'll find out.
Your Turn:
What do you think, Bore readers? Is Gateway earning better returns than Dell? How so? Post your thoughts on the Bore discussion board.
Related Links:
Dell discussion board
Gateway discussion board
Gateway Meets Growing Demand, Fool News, 7/14/00
Dell's No Rule Maker, Rule Maker, 6/28/00
Dell Is a Lean, Rule Making Machine, Rule Maker, 6/29/00
