Et Tu, Dell?

John Mauldin | Thoughts from the Frontline
July 19, 2002

For the past two weeks, I have presented a host of evidence that Price to Earnings (P/E) ratios would have trouble improving, even as actual profits and earnings grow in a modestly recovering economy. Changes in accounting standards, corporate governance and public perception will so change the rules as to how we measure profits, that public corporations will be fighting a strong head wind to show improved P/E ratios. Since this is a primary measure of the value of a stock, this "new profits era" will be a major downward pressure on stock prices for several years.

This week, several articles crossed my desk which illustrates this point perfectly. I bring them to your attention so that we can then explore the search for the bottom that seems to occupy so much of the thought process of analysts and economists.

Et Tu, Dell?

First, the indefatigable Dennis Gartman (more on him later) brings this absolutely stunning and deeply disturbing analysis of the earnings of Dell Computer. I quote at length:

"APPLAUD BRILLIANCE, BECAUSE IT IS RARE : A year ago, we noted work done by our very good (and very wise friend) Mr. Mike Lyons of ScotiaMcLeod in Toronto which brought to our attention that the options programs in effect really did "steal" wealth from non-employee shareholders. Mike has taken the time to look again at Dell's options program, and we are taking the time to bring it again to our clients' attention, for this is real wisdom, worthy of our time:

".... people are just now waking up to the fact that they've been duped for years by the option game. I use Dell as an example only because it is so clear with Dell in that they not only issue massive amounts of stock options but they also repurchase similar amounts of stock in the market to avoid dilution. This gives me the opportunity to quantify the cost of the game. Companies that only issue options but don't repurchase stocks are still, in my opinion, stealing wealth from non-shareholders but it is harder to calculate exactly what this figure is.

For the fiscal year ended February 1, 2002, Dell reported total net income of $1.246 billion. They definitely know how to make and sell computers profitably. Unfortunately, they don't know how to husband those profits so that the poor [investors] who own the stock can reap any benefits. We can see this by looking at the statement of cash flows and the statement of stockholders equity to see how the option buy back program worked. For the year, Dell issued to employees 69 million shares and received total benefits of $853 million (this includes the tax benefit U.S. companies receive upon option exercise).

"In the same year, they bought back 68 million shares for a total cost of $3.0 billion. On average, they paid $44 per share and received $12 per share for a realized, book and pain in cash loss... of $2.169 billion. For the year, the loss from the options game exceeded the profit from operations!!! Unbelievable... and as far as I can see, unmentioned on Wall Street.

"Investors let Dell get away with this, preferring to believe that the company is making money and working on their behalf rather than acknowledging the horrific truth--- they were mere pawns in a management enrichment program. These are strong statements to be sure; however, has Dell ever paid a dividend to its shareholders? No. Has Dell stock appreciated since July of 1998? No. Has Dell at least grown its book value for shareholders, independent of how the market treats its stock? Again, no.

"Though it has reported enormous profits over the last four years, Dell has been unable to grow its book value per share. Why? Because options accounting is a difficult and currently quite imperfect matter and companies have taken advantage of that situation to portray themselves in a far more flattering manner than the underlying truth. Most worrisome is that I can make all these statements about Dell, one of the best run companies around. Imagine how much worse it gets at some other companies."

As Gartman adds, "This is powerful information. It is brilliant, and sadly it is true. Dell is the best of the lot in our estimation. It tried not to allow for dilution; imagine what has happened to the money in Enron, World Com, etc. If the best is bad, what then of the middle of the pack? What then of the worst?"

Let me illustrate how devastating this is to shareholders. Let's say you and I own 10% of a company that makes the ever popular widget. Management comes to us and says, "Mike has been doing an incredible job for us, and we want to give him 10% of the company so he will be happy and keep doing a good job." The part of the company that you and I own is now diluted to 9%. That means we get 10% less profit-sharing at then end of the year.

You and I are clearly losers in that game, unless Mike really does something great to increase profits. But under current accounting rules, the fact that these options to Mike have clearly diluted the value of our holdings is of no importance. So companies get to report a profit to shareholders, even as their shares are worth less in terms of book value.

Interestingly, when the company reports earnings to the IRS, they deduct the value of these options from profits.

But what if, as in the case of Dell, management realizes dilution may not be in the best interest of shareholders, so they go to the shareholders and ask if any of them will sell their stock so they can give 10% to Mike without diluting any shareholders? Now, they take profits that should be distributed to you and me or re-invested in the company and use them to buy stock.

I am a big proponent of the principle that "the laborer is worthy of his hire." I believe in incentives and performance based pay. But I also believe that shareholders and investors must be fairly compensated for their risk. The reason those options have value is because investors are willing to buy the shares of a company. It is the responsibility of the board of directors and senior management to return value to shareholders.

To P/E Or Not To P/E?

Porter Stansberry in the Daily Reckoning brings us yet another egregious example of a major company where management is using the company to line its own pockets at the expense of shareholders (I have taken the liberty of editing Porter). Please note that this company has a market cap of $13 billion, so it is in a lot of technology portfolios:

"Options allow executives to hide the effect of their enormous compensation packages from the bottomline. For example, the CEO of the Maxim Integrated Products (MXIM) realized over $57 million in compensation from exercising options in 2001. That was more than 25% of his company's net profits for the year. Meanwhile, on the income statement, only his $300,000 salary counts against earnings.

"On average, over the last six years, this CEO made $32 million per year. Almost none of that expense showed up on the income statement. Companies would never dream of paying executives so much money, except for the fact that investors don't see the effects of this compensation on earnings.

"According to current GAAP accounting standards, MXIM produced outstanding EPS growth - 168% over five years. Even in 2000, when the market tanked, this company still grew earnings by 21%. Because of this growth and its status as a leading big cap stock, you can perhaps understand why the stock still trades at outlandish prices: 78 times earnings and over 10 times sales.

But, if you deduct the expense of options grants using the Black-Scholes method to determine the value at the time of issue, you see an entirely different picture. After you expense the value of the options granted, instead of 168% growth over five years, earnings only grew 39% over five years. Hardly remarkable, especially for a high tech company with great position in the market. After all, there was a high tech boom, remember?

Accurate accounting also shows that, like most companies in the sector, Maxim had a sizeable decrease in earnings in 2001. As should be reported to shareholders, earnings after stock compensation fell by 29% in 2001. You have to wonder how the market would price this "growth stock" if shareholders knew that really, counting all costs to shareholders, the earnings per share didn't grow by 21%, they fell by 29%!

Here's what else the market apparently doesn't recognize about Maxim: Options expenses are rising. Employees' options that will vest in the next ten years now equal more than 25% of the entire capital stock of the company. If employees choose to exercise their options, there will be a 25% tax on earnings growth as the number of shares grows.

"...Maxim made $223.8 million from operations in the last six months of 2001, according to its most recent filing with the SEC. But, during the same period, it repurchased $354.4 million of its own stock...which was trading at prices that today look, well, slightly expensive: 20+ times book value, 100+ times sales and 140+ times earnings.

"If management thought its shares were attractive enough for the company's money...why are the same shares not attractive enough for management to even hold?

"In the last six months, management has sold nearly 1 million shares of stock. And, despite 20 years of large-scale option grants, insiders own less than 1% of the total shares outstanding. Incredibly, the founder and CEO of the company in question currently don't own a single share of stock. Nor, according to SEC filings, do five of the company's Vice Presidents.

"If stock options were truly meant to align the interests of management and shareholders, the management would at least hold some of the shares they're granted. But, these managers don't. Instead they cash out of every single share.

"What's more, Maxim is in the highly competitive analog semiconductor field. It's been the dominant company in this sector for a long time. Rapidly changing technology requires huge capital investment for research and investment. Yet, while the company spent $350 million on its own stock in the last six months of 2001, it only parted with $250 million on research and development - for all of 2001." (End quote.)

Both Dell and Maxim are profitable companies who are leaders in their market sectors. They produce high quality products at competitive prices. They will be in business, and probably will grow their business, over the next decade.

Yet, are these good stocks to own? Maxim will have to spend, by my calculation, over $3 billion (at today's prices) in stock buybacks over the next ten years just to keep from diluting current shareholders. They will have to substantially grow net income in order to do that.

Understand, these are companies which are highly regarded. When you search for reports on Maxim and Dell, you get glowing praise. But when investors start to realize these companies make little or no money after options are accounted for, how long do you think their stocks will trade at outrageous multiples. Maxim is at a P/E of 82, and today, as the market melted 400 points and the NASDAQ fell 3.5%, Maxim actually rose in price. Investors clearly think this is one of the best run companies with bright prospects.

The question that will be on the investor's mind in the future, as we progress into a secular bear market and accurate accounting standards, will be just who is the benefit of such bright prospects? If Dell and Maxim are the best, what do the average and poor companies look like?

If Intel used proper accounting, its profits would drop 80%. Microsoft's would drop 40%. Cisco would have no profits. All Cisco's 35,900 employees get stock options. Cisco spokesman Steve Langdon said, "Expensing options is not a good idea and would prevent companies from offering stock options to their rank-and-file workers."

It is hard for me to believe that all 35,900 workers are so critical that salaries alone are not enough to keep them. If options are truly such an important component of their pay that employees would not work there without them, then Cisco is selling products for less than it costs to make them. It seems to me that options at Cisco are preventing the workers from offering profits to their shareholders.

The Capitulation Tango

And that brings us to the topic de jour: capitulation.

The pundits on TV and the press tell us the bear market can't end until we get to some magical condition called capitulation. This is that wonderful state of affairs when all the wimps and fearful sell everything including the kitchen sink and there is no one but optimists and strong investors left. That is when we see the bottom and the next phase of the bull market will start.

Massive sell-offs are the sign of this state of capitulation, and this weekend we will see many pundits tell us that the 700 point drop in three days certainly looks like capitulation. Now we can get ready to enjoy the summer rally.

The problem is that there isn't much historical precedent for capitulation. Bear markets don't end in explosive sell-offs. They end with massive indifference on low volume days when no one cares anymore.

Weeks like this last one are typical of the middle of bear markets, not the end. I was discussing this with Dennis Gartman this morning, and he reminded me of the vicious drops and rallies in 1974. The bear continued for quite a bit longer.

We will soon have a bear market rally (I hope), and I think it could be something to behold. I note in passing that short selling interest is up, especially among smaller investors. Just like day-traders piled in bidding everything up in 1999, now we have a new breed of short-seller ready to make money on the way down.

And after the rally, the market will sell off again. This cycle will keep repeating itself for quite some time. It will be like watching a couple doing the tango, back and forth, across the room, sometimes flowing effortlessly, and sometimes with hard stops and violent movement.

But the Capitulation Tango will not end until the Dells and Maxims of the world begin to deliver true shareholder value.

Bush and the Dollar Woes

Dennis Gartman is one of the premier investment writers in the country. He writes a daily letter, The Gartman Letter, which goes to about 400 institutions for $400 per month. He is widely read among traders and major financial managers, as a solid source to keep up with a broad view of the markets and the world economies.

He argued early on that the Bush steel tariffs would tank the dollar. He feels the psychological damage done to the markets is serious. When the rest of the world sees the biggest proponent of free trade essentially cave in to political interests, and then follow that up with decisions on lumber, textiles and agriculture, what are they to think? If free trade has been the engine for world growth, what will be the result of a new era of protectionism?

I wrote in 2000 that I was afraid for the world economy if Gore was elected, because I felt he would implement protectionist policies. Such a move would be a huge mistake, similar to those taken in the aftermath of 1930, and could have the same results.

I am an ardent supporter of Bush in most things, but in this, I agree with Gartman that the President and his advisors (that's you, Karl) are wrong. We are sending the wrong signals at precisely the wrong time.

Gartman says the following, and I can't say it better:

"We've argued, and we'll argue in the future, that the dollar's weakness stems from the Bush Administration's ill advised decisions on steel, textile and lumber tariffs and/or restrictions. The dollar will continue to fall as long as the US continues to abrogate its responsibility as the world leader in free trade. So too the US stock market.... and so too the prospects of the Republican Party at the upcoming elections in November. We are and we have been long standing, overt, very public supporters of this President and his administration, but we find these decisions on trade inordinately ill-advised. Would that the President went before the nation and the world, admitted the errors involved, reversed the decisions immediately and accepted responsibility for them. That, however, is very wishful thinking."

The steel tariffs in particular have cost more jobs than they have saved, and driven up costs. The decisions to invoke tariffs were made with an eye to help with the fall elections. I have sat in private briefings with his political advisor Karl Rove (an extremely bright man) where he has pointed out that you can't change policy if you can't get elected. He is right.

But the direction of the dollar and the markets is not going to help Republicans win this fall. This political move has back-fired with a host of unintended consequences. I think it is no coincidence that the world markets, including the US markets, along with the dollar, began their recent slide with the announcement of tariffs. The sooner we reverse these policies the better.

Since the euro has risen over 20% from its bottom, as well as many of the currencies of other steel producing nations, Bush could save face with a repeal by noting that the currency moves have strengthened the position of Big Steel vis-a-vis the rest of the world, and they no longer needs government protection.

Just as I was hitting the send button, in comes a note from Greg Weldon. He points out that the trade deficit reaches an all-time high, and when you look at the details, the cross European numbers are horrendous. Those looking for a dollar rebound will need to look for some other source. With the conservative Bank Credit Analyst telling us the dollar is still over-valued by 15%, those readers who bought euros from Everbank when I first mentioned them last spring are quite happy today.

Greg points out further evidence that the Fed will not tighten comes as inflation continues to drop. In February inflation and the Fed rates were roughly equal. Today, Fed fund interest rates are 0.65% above inflation. This means monetary policy is tightening, and is actually pushing us toward deflation. That is not what Greenspan wants, and thus unless inflation starts to come back, the next move the Fed is likely to make is to lower rates. But more on that and other fronts next week.

I See Disney World in My Future

It seems I have to make a last minute business trip to Orlando next Friday. (What a place to headquarter a hedge fund!) That means #2 son gets to go with Dad, and while I work, he will do Universal, and then we will do other parks on the weekend. And since I save $1200 airfare by coming back late Monday, it seems logical to find a golf course Monday morning. I can test my new swing and see if I can find enough length to out-drive my 13 year old son.

We are putting up new features on the web site, and soon will have a wide array of services and features. I hope to be able to have a section where I post the 3-4 articles I read each week (out of several hundred) that I think of are important and that I don't get to comment on. If you have any other suggestions, please let me know, as we are in the designing stage. Next week's letter will come out on Thursday.

Your can't believe he criticized President Bush in public analyst,

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