6
Month Market Review
What
Goes Up...
An Exerpt from Return
on Equity III: Assett
Management
06/21/97
by Randy Befumo
(TMF [email protected])
Five quarters ago, Dell Computer realized that one of the ways it could improve
shareholder return was to notch up its asset management policies. Specifically,
Dell realized that if it could more efficiently manage its inventory of computer
components, it could increase the return on equity. As inventory and accounts
receivable are Dell's two most significant assets, by minimizing these the
company could increase the sales per dollar of total assets employed and
therefore increase the basic return on equity of the business. The money
that went into inventories to generate a dollar of sales decreased, leaving
Dell with more cash on the balance sheet to distribute to shareholders in
the form of stock repurchases.
Because Dell has focused on direct sales since it was founded, except for
an ill-conceived venture into the indirect channel in the early '90s, the
company has always required less working capital than its indirect channel
competitors like Compaq Computer. However, Dell only became a full-fledged
asset management story five quarters ago when the stock got pounded because
of fears of slowing computer sales in early 1996. As a man who owned an enormous
percentage of the company's stock, Chairman Michael Dell knew that without
some kind of change Dell would always trade at 11 to 12 times earnings because
of the perception that it was in a low margin, commodity business. The question
was how could Dell Computer change the way that people saw its financial
model to increase the value of the company?
Dell conceived an ambitious and ingenious plan. It would launch itself pell-mell
into the high margin server business, either improving its own margins or
killing those of competitor Compaq Computer. At the same time, it would notch
up the number of times it could turn its inventory over each year. Inventory
turnover is one of the main asset management measures that investors can
easily calculate. Simply by dividing the cost of goods sold over a period
by the inventory left at the end of the period, an investor can see how many
times a company "turned" its inventory in that period. As a company like
Dell increases its inventory turns, it dedicates less assets to generate
a dollar of sales, increasing the amount of cash left over to do other things.
In Dell's case, the crucial third part of its plan was to use all excess
cash flow to repurchase the stock it viewed as undervalued, magnifying the
earnings per share growth.
Dell Computer is a clear case of how improved asset management can increase
shareholder return. Better asset management eventually shows up in the form
of high profit margins, but high profit margins by themselves do not guarantee
that shareholders will receive excellent returns. In order to ensure that
return on equity is high, investors must look for businesses that have high
margins and high asset turnover rates, whether it is sales-to-assets or looking
at the inventory turns, the days sales outstanding (or collection period),
the payables period, or the turnover in fixed assets. The last variable in
the return on equity equation that can affect overall return is financial
leverage. |