It having been some time since we last thoroughly reviewed Dell’s (DELL) financial statements, notes and all, we were surprised by the level of deterioration in some items. It will be interesting on Thursday to see how some of these issues are playing out:
* Since Q3 2004, DELL has been reporting results that include the consolidated results of its customer financing subsidiary. However, they continue to have a special purpose entity through which they “securitize” receivables - selling them to themselves and taking them off the balance sheet. They did this more in the latest quarter than they had the prior year, which accounts for the decline in long-term receivables. Nonetheless, their total accounts receivable have been rising considerably, and we worry that they may be selling to lower-quality customers.
* Prices are declining at a faster rate than usual, demonstrating how competitive the industry landscape has become. The price declines are nearly obliterating the effects of relatively strong unit sales.
* The company accelerated the vesting of out-of-the money employee stock options. This is nothing but an accounting gimmick to avoid having to expense the stock options under new accounting rules. Shame on DELL for resorting to this tactic, as well as to using a lower volatility assumption when calculating the value of options it issues now. The lower volatility results in a lower accounting cost for the option - but any DELL holder can attest that DELL’s volatility has gone up considerably in the past year, not down.
* DELL reported a significantly lower tax rate for 2006, possibly suggesting lower earnings quality. The lower rate was because the company got a repatriation benefit rather than penalty as in the previous year. Since the benefit/penalty effect can fluctuate, the lower tax rate is likely unsustainable.
* Working capital has been creeping up. We don’t like the growth in receivables, but we actually think they should ramp up the inventory a little more to keep popular items in stock.
* The company trumpets its share repurchases, but most of these are simply covering stock options that the company issued (and doesn’t want to expense). Not convinced there is a cost to stock options? DELL spent $7 billion buying back stock last year but reduced the share count by only 100 million. That implies a $70 per share effective repurchase price, or $60 if you count the money they receive when the options are exercised. The difference between the $70 and the (much lower) average share price last year is the economic cost (rather than accounting cost) of the options.
We think there are worse problems to have than some of those DELL faces. However, we think they should focus more on managing their business and less on managing their earnings. Our guess is that would do wonders for the share price.
DELL 1-yr chart: