Tuesday, March 17, 1998

Cash-King Portfolio Report
by Al Levit

TOWACO, NJ (Mar. 17, 1998) --Today's column is about a stock that has been unusually good to me and all of its other shareholders over the last 10 months (and 10 years!). Over those last ten months, it has split twice, and I've purchased more shares on three separate occasions. I was originally led to this stock because it was included in both of Tom Gardner's original Cash-King portfolios (see Step 1 for those). And yet, ironically, in spite of a truly outstanding earnings release last month, I am here to tell you today why I don't think Dell Computer (Nasdaq: DELL) is a true Cash-King, and why I can't recommend it at the present time for this Portfolio.

What does it take to be a Cash-King? Well, most of what we look for is summarized in Step 6; it includes high gross margins, high net margins, a strong Flow Ratio, consumer products sold 'round the world, lots of cash and negligible amounts of long-term debt, et al. Dell seems to leap most of these bars quite easily. Let's tick them off, one by one:

1. Consumer Mindshare: Dell's computers are very well thought of in the PC industry. They're consistently rated "Best Buys" by PC World and other industry magazines. In terms of sales, Dell is currently the #3 PC-maker in the country. Its most recent earnings release was a blowout, as well.

2. Repeat Purchasing Business: In this category, Dell is in the same boat as Intel and Microsoft. Most of us won't buy a new computer every year, but many of us do use computers every day and will methodically upgrade and/or purchase new systems in the years ahead. These qualities illustrate many of the advantages of a repeat-purchase product -- free marketing because of use and repeat purchasing, among them.

3. Size: Dell Computer is capitalized at $46.6 billion.

4. Financial Items

Cash (including marketable securities) is over 100x long-term debt.

Flow ratio: 0.76

Net profit margin: 10.6%

Gross profit margin: 22.0%

Some selected additional data, all very nice:

Days of inventory: 7

Days of accounts receivable: 36

Days of accounts payable: 51

Return on invested capital: 217%

Historically, Dell has been on an absolute tear. Since January 1994, the stock has risen from $5 per share to $62 per share. In four years! Its stock growth started when it abandoned its approach to selling computers through its own stores, instead committing to selling them strictly by mail order, telephone, and the Internet.

Now all of this looks really, really good. Except for the gross margins of 22% -- which fall short of our 50% target -- Dell looks like one of the purest Cash-King stocks out there. What gives, Al, why wouldn't you recommend this one for the CK portfolio?

Indeed, gross margins do represent my chief concern, but I'll cover that in a minute. First a word about Dell's current position in the PC industry. Dell has pioneered a winning model for building and selling computers. As such, the company is sailing through extraordinary growth -- Zacks shows the consensus estimated earnings growth among Wall Street analysts sitting at 30% per year. This at a time when the PC market is projected to grow 15-20% per year.

In a few years, Dell may well become the number #1 PC maker in the world, at which point its growth should naturally slow to the industry average. My fear is that, at that point, the stock can only be relied on to produce returns consistent with the relatively low-margin commodity business of making personal computers.

Even though it should be noted that Dell has concentrated to date on the higher-margin end of that business, the returns we have seen in the past few years from Dell aren't repeatable over the next fifteen years. Those returns are based on growth over and above the total growth of the market during a time that the wealthiest individuals and corporations were upgrading their computer systems repeatedly. As more buyers enter the market, prices will come down. And further speeding that process will be a number of PC makers porting distribution of their machines to telephones sales and the Internet. It's copycat time, and Compaq is sporting whiskers.

And this takes us to the question about the defensibility of Dell's margins and what they mean to this business model. As I've noted before, we're very selective in the industries we invest in over here in Cash-Kingville. Our favorite businesses favor ideas over parts, software over hardware, medication over the hospital, soft drinks over bottles. The word we use to capture our desired business model is light. Light, light, light.

That quality is pretty obvious in our selections of Microsoft and T. Rowe Price and Coca-Cola, and a little less obvious in Intel (though it is primarily a chip designer). In all cases, the lightness shows up in the margins, particularly the gross margin. Dell has done its best to be light by moving exclusively to the direct sales model. They have done absolute wonders with efficiency of capital. But assembling high-priced machines while battling price wars makes it difficult. The commodity nature of the PC business takes its toll. While Coca-Cola's gross margins have been consistently rising through its history and now sit at 68.1%, Dell's are likely to decline from their present perch of 22%.

Additionally, in spite of analysts' forecast, it isn't a slam-dunk for Dell to continue increasing its market share. Its principal competitors in the direct-selling market include giants Compaq and IBM. They're competitors that certainly have the wherewithal to ramp up and battle Dell, driving down margins.

The bottom-line for this Dell investor is that I couldn't be happier right now with my company's performance. If the next few years are half as profitable as the past nine months, I'll still be smiling from ear to ear. But at the same time, I'll also be keeping a much closer eye on my Dell stock than is worthy of a true Cash-King -- a focused pupil, at least, on every quarterly report. While I'll study the quarterly reports of all Cash-King investments, I can't imagine acting terribly quickly on one of them. With Dell, I feel I have to be more mindful.

Why? Because there simply isn't the same assurance of continued progress with Dell that there is with the stalwarts in the Cash-King portfolio.

Normally, tomorrow would be Q&A day. But Rob Landley (one of our four CK managers -- the man they call "Oak" on the Web boards) has a different view of Dell. He thinks I'm blowing more hot air than Vesuvius ever has. So he's stepping up to the plate tomorrow with his take on Dell. I'll then be back here Thursday with some Q&A from the message boards. Until then...

Fool on,

Al (alanl@ix.netcom.com)


Stock  Change    Bid 
 CHV   -  13/16 82.06 
 KO    +  11/16 72.44 
 EK    -1 1/2   60.94 
 XON   -1 5/16  62.88 
 GM    +  11/16 72.00 
 INTC  -  15/16 76.69 
 MSFT  -1 11/16 80.31 
 PFE   +1       89.25 
 TROW  +1 11/16 71.06 
                  Day   Month    Year  History 
         C-K      -0.15%  -1.14%   0.61%   0.61% 
         S&P:     +0.11%   2.96%   7.91%   7.91% 
         NASDAQ:  -0.50%   0.50%   7.65%   7.65% 
     Rec'd    #  Security     In At       Now    Change 
    2/3/98    22 Pfizer        82.30     89.25     8.45% 
    2/6/98    28 T. Rowe Pr    67.35     71.06     5.52% 
    2/27/98   27 Coca-Cola     69.11     72.44     4.82% 
    2/3/98    24 Microsoft     78.27     80.31     2.61% 
    3/12/98   17 General Mo    72.41     72.00    -0.56% 
    3/12/98   15 Chevron       83.34     82.06    -1.54% 
    3/12/98   20 Exxon         64.34     62.88    -2.27% 
    3/12/98   20 Eastman Ko    63.15     60.94    -3.50% 
    2/13/98   22 Intel         84.67     76.69    -9.43% 
     Rec'd    #  Security     In At     Value    Change 
    2/3/98    22 Pfizer      1810.58   1963.50   $152.92 
    2/6/98    28 T. Rowe Pr  1885.70   1989.75   $104.05 
    2/27/98   27 Coca-Cola   1865.89   1955.81    $89.92 
    2/3/98    24 Microsoft   1878.45   1927.50    $49.05 
    3/12/98   17 General Mo  1230.89   1224.00    -$6.89 
    3/12/98   15 Chevron     1250.14   1230.94   -$19.20 
    3/12/98   20 Exxon       1286.70   1257.50   -$29.20 
    3/12/98   20 Eastman Ko  1262.95   1218.75   -$44.20 
    2/13/98   22 Intel       1862.83   1687.13  -$175.71 
                               CASH   $5666.26 
                              TOTAL  $20121.14 
 *The year for the S&P and Nasdaq will be as of 02/03/98