DELL (II): a company in transition

In its heyday, DELL, as now, assembled and sold desktops and laptops, primarily to business and government but also to consumers.  The desktops were utilitarian, the laptops not particularly stylish and a bit heavier than others.  But all DELL’s products were serviceable and they were cheap.

DELL’s advantages…

DELL had several advantages over its competition:

1.  it dealt directly with the end consumer, assembling machines to order.  So it had virtually no finished goods inventory

2.  component manufacturers suffered from chronic overcapacity.  So their prices were generally falling.  DELL took delivery of parts on the day a machine was assembled and sold, rather than having a finished machine sitting on a shelf for three months before purchase.  This gave the company a several percentage point cost of goods advantage over rivals.

3.  competitors were weak.  IBM wasn’t sending its best and brightest to make PCs.   A Jobs-less AAPL was drifting.  Compaq was very inefficient, as was HP.  HP then compounded its problems by hiring Carly Fiorina–a marketer with little manufacturing experience–and acquiring Compaq.

4.  DELL uses a negative working capital business model.  That is, customers pay for their DELL computers at present on average 36 days earlier than DELL pays its suppliers and workers for making the machines.  Also, DELL receives payment for warranty or other service contracts in advance.  When short-term interest rates were higher than now, DELL could earn hundreds of millions of dollars in interest income on these “floating” balances.

..where did they all go?

What happened is this:

1.  component making became more sophisticated and expensive.  Suppliers consolidated or dropped out of the business.  Chronic overcapacity abated.  We now appear to be entering, if anything, a period of component shortage.

2.  IBM sold its PC-making business to Lenovo.  Jobs returned to AAPL.  Fiorina was shown the door at HPQ, which promptly hired a veteran manufacturing manager, Mark Hurd, from NCR.  Acer and ASUS emerged as global players in the PC market with low-cost netbooks.

3.  Consumer tastes shifted from heavy and clunky to smartphones, netboooks and sleeker Macs.  DELL didn’t adjust, although it’s trying to do so now.

4.  Vista arrived, causing consumer disenchantment with MSFT-driven computers and encouraging businesses to stay with Windows XP.

5.  The Great Recession developed.  Not only did this reduce demand, but it lowered short-term interest rates to almost nothing, all but erasing DELL’s once significant interest income.

Not all the issues were external, however.

6.  DELL’s quality control and customer service, at least in its consumer business, slipped badly.

Where to from here?

Michael Dell, the company founder, returned to the helm to right a troubled ship in early 2007.

His initial goals were to reduce manufacturing costs and increase production efficiency, in order to raise margins and reverse a sharp slippage in the effectiveness of the company’s negative working capital model.

DELL has also been trying to rationalize product lines (fewer models) and simplify product design.  To this end, it is increasingly turning away from its own manufacturing plants and using contract manufacturers.

I’ve read that Mr. Dell also at least initially wanted to expand the company’s consumer device offerings.  But I can see no specific evidence of this desire in company documents on the website.  And in any event, it seems to me that this market–which is now iPhone, iTouch, Blackberry, Android, netbook–has pretty much run away from DELL.

(By the way, I’ve found the company website much more open and accessible than it was a few years ago, when it was impossible, even as a professional investor, to arrange to get on the company’s email alert list.  The new reporting format this year is also a big step up in delivering relevant investor data.)

International expansion is another theme.

So to is creation of a much larger service business, so that DELL can have more recurring revenue and be less dependent on the PC replacement cycle with large enterprises and government entities.  Hence, the $4 billion (cash) Perot Systems acquisition, which has just closed.

A tough row to hoe

To sum up:   DELL appears to have decided to  start down the same path that IBM began to tread in the late Nineties and onto which HPQ turned two years or so ago.  This seems to be the natural evolution of the IT business–from hardware to software and services.  Two big issues for DELL:   it’s a little late to the game, and the competition is not only ahead of it in this move, but also much less concentrated than DELL is on enterprise and government PCs and servers (about 80% of the company’s business).

Progress so far is hard to assess

This is partly due to the recession itself, partly to DELL having to try to restructure the corporate house during an economic tornado.   I’m not sure how the reorganization is faring, but then I’m not an expert on DELL.  But I didn’t get the sense from listening to last week’s conference call that professional Wall Street tech analysts have a much better idea than I do.  So maybe lack of communication from DELL also plays a part.

Do we as investors need to know?…probably not.

In a case like this, the relevant investment question is:  do I need to know this information, or can I make a decision about the stock without it?  Here, my guess is it’s unlikely that we’ll get strong earnings acceleration from ongoing cost-cutting.   If anything, we may get further unusual losses.  So restructuring is probably a neutral or a mild negative.

Things probably can’t get any worse in the consumer business, since results are close to zero now and DELL seems determined to protect margins at the expense of incremental sales.  Public will go its own counter-cyclical way.   Half of small and medium business customers have already upgraded to Windows 7.

Therefore, the next big potential lift to earnings, I think, will come as and when enterprise customers start to buy new PCs again.  This is unlikely to happen before yearend–and possibly not before the middle of next year.  So my conclusion on DELL  is the best course of action is to watch and wait.

One more post

I have one more post to do on DELL–an analysis of its negative working capital situation and what constraints it potentially places on the company.  It will be out in the next day or two.

The Sands China IPO has priced–at the low end of the range

The Macau subsidiary of LVS, Sands China Ltd., priced today in Hong Kong.  The good news is that the IPO was fully subscribed.  The less good news was that it priced at the bottom of the range.

The “low” pricing, at 13.5x anticipated earnings for next year, is understandable, for two reasons:

–the high end would have Sands China trading at a substantial p/e premium to Wynn Macau, which is, I think, a better-run company, and

–Wynn Macau itself is trading at about 20% below its October 9th high, and almost 10% below its IPO price.

Trading for Sands China starts on November 30th.

Here’s a link to my original Sands China post.

DELL (I): a disappointing quarter for a company restructuring itself

My look at DELL last week

I haven’t paid much attention lately to DELL, one of the great growth stock stories of the Nineties.  I knew that Michael Dell returned in early 2007 to take over the reins of a struggling firm.  My family and I experienced first-hand the slippage in DELL’s product quality and customer service–so much that two of us (including myself) are now using Macs and another has an IBM laptop.

I haven’t owned the stock in this decade and felt no great compulsion to buy shares.  But I couldn’t help noticing last week that DELL reported disappointing earnings after the close on Thursday and the stock dropped 10% in trading on Friday.  A real contrast with other tech names!  So I decided I’d look at the numbers and listen to the earnings conference call to figure out what had been so surprisingly bad.

Two posts

The result is two posts, today and tomorrow.  This post will deal with the conference call and my assessment of the near-term situation with the stock.  Tomorrow I’ll  write about what I think the structural issues with DELL are.

Framing the DELL quarter

DELL reported revenues of $12.9 billion for the three months ending in October and earnings of $.17 a share.  Adding back in $.06 in unusual losses, earnings per share were $.23.  This compares with revenue in the August quarter of $12.8 billion and eps, also adjusted for unusual expenses, of $.28.  In other words, sales were flat but profits were off by close to 20%.

company guidance

In the August quarter earnings announcement, DELL’s management suggested to investors that they should expect a seasonal pickup in consumer business during the October quarter and cautioned about possible weakness in sales to its large corporate customers.

the consensus estimate

The Wall Street analysts’ consensus, with this general guidance in mind, seems to have formed around revenues of $13.1 billion or so and eps of $.28.  Just using the back of an envelope–with plenty of room left over for revisions, or doodles–I might have come to the same conclusion.  Roughly speaking, enterprise weakness and consumer strength might well offset one another in both revenue and profit terms.  Given that the late summer and early fall were a booming time for consumer PCs, I could easily wind up a little low.

Looking to the past, the third quarter is normally a bit stronger than the second, though.  Considering that, and after seeing most companies with September quarter ends report slightly lower than expected revenues but surprisingly strong profit growth, I might shade my revenues a little lower and bump the eps number up a penny or two.  On the other hand, trade figures have been showing that DELL has been losing consumer market share.  So maybe, I’d just stand pat.

the actual results

As the eps number above shows, the quarter didn’t quite pan out as management expected.  The operating profit results, by segment, were as follows:

———-3Q fiscal 2010———2Q fiscal 2010

consumer    $10 million     $89 million

smb             $282 million     $246 million

public            $352 million     $383 million

enterprise     $174 million     $172 million.

(smb = small- and medium-sized business)

Another way of assessing these numbers is to compare them with the year-ago quarter.  Those results are:

consumer      $142 million

smb           $374 million

public          $361 million

enterprise     $254 million.

These figures show the extent of the  year over year falloff in enterprise and smb segments.  Smb has begun to bounce back.  Enterprise probably won’t begin to recover until next year (if then).  The most important question, though, is why consumer profits disappeared for DELL at a time when overall consumer sales of PCs were strong.

The conference call

Oddly, DELL didn’t talk at all about the consumer  or why the October quarter ended up weaker than expected.  The company may have assumed (incorrectly, for me) that the numbers were self-explanatory.  But it gave no insight as to what was behind the poor showing or when the situation might change.  The analysts on the call tiptoed around the issue; none asked.  DELL provided lots of disjointed facts, delivered in corporate jargon, but no sense of strategy.

DELL did say it didn’t like selling netbooks because there was so little profit for it in DELL.  Otherwise, nothing.

DELL does believe the cyclical low point for its business came during the summer.  Each month of the October quarter was better than the previous one.  November is shaping up to be better than October.  Smb business has turned up for the first time in almost two years.

US business was a bit soft.  The rest of the world was strong.

DELL, like everyone else in the industry, is experiencing upward pressure in component pricing.  Shortages are emerging in some areas especially memory and LCD panels.

My reactions

1.  DELL has been an exceptionally strong stock since the low in March, matching its much sounder rival HPQ in performance before fading a bit since mid-September.  What must the market have been thinking for the reported earnings to have triggered such a negative reaction in Friday trading?

To me it looks like some investors were making the simple argument that, just as second-tier companies suffer most in a downturn, these same companies bounce back the most when business gets better.  That’s true in a normal inventory-cycle recession, and to some extent even now.  But for DELL, structural change in the IT industry is a more important factor.

In this recovery, I think, there won’t be enough demand to create the rising tide that lifts all boats.  Instead, the market story over the next year will likely be one of separating winners from losers.  It seems as if not everyone has caught on to that yet.  To me that’s a big surprise.

3.  One of Dell’s historic strengths has been its ability to operate a negative working capital business model.  It gets paid by its customers on average 36 days before it has to pay for the materials and labor it uses to create its products.  For a negative working capital business, the eye-catching feature is the large amount of cash often on the balance sheet.  But it’s important to look at the working capital figures as a whole very carefully, because the cash may give an impression of greater financial strength than a company possesses.

More on this in my next DELL post.


More on hybrid bonds and contingent convertibles

Plato vs. Aristotle (the Greek version of Mr. T vs. Chuck Norris)

Ancient Greece, the cradle of Western civilization, lacked both bowling alleys and XBoxes.  This forced citizens to spend their leisure time debating the nature of reality.  On one side of the discussion were Platonists, who asserted that the physical world and all that is in it are imperfect copies of eternal, changeless and perfect Forms–the latter being the only truth. Aristotelians made up the other side.  They believed that truth was to be found through observation of the actual characteristics of things in the physical world–that there were no otherworldly Forms that worldly things aspired to be.

considering hybrid bonds

In looking at hybrid bonds (see my post earlier this week for a definition), Moody’s originally fell on the Platonist side.  In rating hybrids, the agency appears to have assumed that because the prospectuses called them bonds, that’s what they were.  It didn’t matter that they might have quirky characteristics–for example, not looking much like a bond at all (remember, too, that like all rating agencies, Moody’s was paid for its opinion by the issuers).

During the credit crunch, bank regulators have revealed themselves to be firmly in the Aristotelian camp, to a greater or lesser degree.  If it walks like an equity and quacks like an equity, they are saying, it is an equity and not a funny kind of bond.

Why does this make a difference?  In a reorganization or liquidation, equity holders generally lose everything but bondholders retain at least a part of their original investment.  Also, although I’m not aware that this issue has come up formally yet, investment management contracts with clients normally specify very clearly what kinds of assets a manager is permitted to buy.  Bond managers, who appear to be the majority holder of hybrids, are supposed to buy bonds, not equities.  If they buy a security outside their mandate and lose money on it, they expose themselves to possible lawsuits aimed at forcing the management company to compensate the client for those losses.

Moody’s has a new rating method for hybrids

Moody’s appears to have shifted to the Aristotelian side of the debate last week, although it is still referring to the securities as bonds.  It announced that it has developed a new methodology for rating hybrids.

The new scheme (unlike the original one) incorporates the  possibility that:

–the issuer might exercise its right to defer or eliminate payment of income on the hybrids and that

–in a reorganization an Aristotelian bank regulator would classify the securities, less favorably for the holder, as equities.

Individual hybrid results will be made known over the next three months.  It appears that the vast majority will be downgraded, some by more than one notch.  From the Moody’s announcement, it sounds like at least part of the downgrading will be a result of the differing behavior of bank regulators as to how they regard hybrids.

Contingent convertibles

The press is now calling them CoCo bonds.  Despite the cute acronym, the concept doesn’t appear to be going over well with bond buyers.  Over the past few days, regulators have been eager to say that they aren’t solely focused on CoCos, but have lots of other ideas as well.  Myself, I hope the other ones are better than this.  It’s a little disconcerting, though, that they talked about this one first.

Just for the record:  I think CoCos are non-starters in today’s world, where the chances of financial company restructuring are way higher than zero and where the scars of investor losses, in part due to carelessness, lack of analysis and excessive optimism, are still fresh.  Give it a few years though.  When the sun is shining every day and profits are rolling in, CoCos will likely come back–and be eagerly bought by bond investors with short memories (meaning almost everyone).

How your broker gets paid (II)–how the brokerage firm benefits

How your brokerage firm makes money

In my earlier post on broker pay, I wrote about how the individual broker is compensated.  This post deals with the broker’s firm, which also gets paid for its customers’ activity in several ways.  Please note that I’m writing about practices in the US.   My experience has been that it’s the same in other countries are similar, however, other than that foreign charges (ex IPOs) are generally much higher.

Let me count the ways:

1.  commissions/fees The broker’s firm keeps a percentage, 50%+ in the case of traditional brokerage firms, of the gross commission/fee income that an individual broker generates.  It pays the remainder to the broker.

2.  margin interest The brokerage firm may arrange for or provide loans itself to clients to buy stocks on margin.  Its cost of funds is now something around 1%.  But it will charge clients, say, 4%-7% interest on the loans, netting the difference as profit.

3.  stock lending In all likelihood, when you opened your brokerage account you signed an agreement giving your permission for the brokerage firm to lend the shares in your account to third parties, from whom it collects fees.

4.  trading fees Yes, you may pay a commission on many trades.  But your broker is doubtless a market maker for some of these securities and earns a bid-asked spread whenever he matches a buyer with a seller.  In the case of options or other derivatives, this spread can be 10% of the principal value of the transaction.  For an “active” trader, who moves in and out of securities frequently, these spreads can really mount up.

Your firm may also direct order flow for securities it doesn’t handle internally to third parties in return for a fee (there are rules to protect you from abuse, and fees are lower now than they once were, but this is still a source of income).

5.  distribution fees In addition to their trading activities, brokerage firms around the world are the predominant vehicle for distributing securities of all types.  In the institutional market, this means handling public offerings of stocks and bonds.  In the US, the typical fee a company pays to a broker for underwriting and selling a stock offering is 7% of the amount raised (much higher than in the rest of the developed world).  A broker can’t get an assignment like this without strong customer relationships.

The equivalent in the world of individual investors (I’m assuming that individuals normally only get the dregs of the IPO market) is distribution fees for mutual funds.   Just as in the institutional world, a strong distribution network, whether online or through registered reps in bricks-and-mortar offices, is a very valuable asset and isn’t given away for free.  So, just like a supermarket collects a stocking fee from companies wanting shelf space, a broker may collect a percentage of the mutual fund management fee in return for providing “shelf space” for that fund on its distribution platform.

Arguably, this is an issue between the broker and the fund company, since it’s about who gets the management fee you’re paying, not how much you pay.  It can be a matter of concern, though, if it turns out that when your broker runs an asset allocation analysis for you in his office, the only mutual fund recommendations that pop up are the ones who share the management fee.   They may still be the best funds, but in this case I think you have a right to know the brokerage firm’s interest.

Conclusion

For an investor, who will typically make a small number of focussed transactions each year, the commissions and fees he pays are the largest share of the compensation a brokerage house receives.  We’re not their favorite customers.  On the other hand, for “active” traders, who transact often, use margin and trade in derivatives, the commissions and fees are only the tip of the iceberg.  No wonder the TV commercials for discount brokers all focus on how cool and sophisticated rapid-fire trading is (there are more reasons for this tack than just it makes the most profit for the broker to encourage trading…but that’s a topic for another post).