A Blue Chip Priced for 20% Annual Returns

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Sources: Capital IQ (a division of Standard & Poor's), Yahoo! Finance, and Motley Fool CAPS.

This week's pitch :
What if I told you that a major blue chip company is priced to deliver 20% annual returns? Would you be interested? If not (really?), then you are just like the 'investors' who sold Dell following its spectacular Q1 report. Apparently a 20% annual return isn't good enough for a company that delivered 21% total top-line growth and 47% revenue growth in the high-margin servers and networking areas. Oh, and of course earnings growth of nearly 18% doesn't mean anything either.

Dell has plummeted by 25% since its wonderful report on May 19th (with friends like these, who needs enemies?). You would think from the market's reaction that the company is on life support, but this is not the case. During the worst of times in 2009, Dell generated $3.5 billion in free cash flow, and investors can buy the company for roughly $17.35 billion once you take into account the company's large net cash position. That translates into a 20% real annual return on your investment, assuming the company has NO growth above inflation. Ben Graham, meet your margin-of-safety.

The real beauty of it is that most of what Dell shareholders can take home or reinvest - its free cash flow - is not even taxed! Thanks to a brutally efficient cash conversion cycle (Dell cycles through its inventory about once a week) the company generates gobs of free cash flow in excess of its reported earnings. In 2009 the company was only taxed on about $2 billion in pre-taxed net income, about half of the $4 billion in pre-tax free cash flow in generated for shareholders. At the end of the day, Uncle Sam only took $591 million and shareholders ran off with about $3.5 billion.

You may want to ask, "but cbaines2, isn't Dell a terrible company with no competitive advantage?" Do you consider Apple [(Nasdaq: AAPL)] or Google [(Nasdaq: GOOG)] to be terrible companies? I ask this because Dell’s return on capital is consistently above or at the level of Apple or Google. Yet, Dell trades for only a fraction of their valuation. But don't just take my word for it: the value hounds at Longleaf Partners own about 7% of the company.

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