perfidy

Things are more interesting for Dell, Inc. than perhaps the former and once again current CEO, Michael Dell would prefer. In today's Wall Street Journal, you could find a report that "Dell's Internal Accounting Probe Uncovers Evidence of Misconduct".

Dell Inc., after a lengthy internal probe of its accounting practices, said it had found evidence of misconduct but didn't specify what it was.

The computer maker said the investigation also found a number of accounting errors and deficiencies in the financial-control "environment." Dell stressed that its investigation isn't complete, however, and said it will delay filing its annual 10-K report with the Securities and Exchange Commission, originally due April 3, past an extension date of April 18.

In the wake of the options backdating feeding frenzy of the past year, additional news of corporate skullduggery large and small has started just bouncing off of me, leaving no meaningful impression, positive or negative. Such was the case with today's Dell news, particularly given that Dell hasn't filed a 10-Q with the SEC since June, 2006. They're now going to be late with their 10-K for the fiscal year ended February 2, 2007, as well.

All rather ho-hum, to be honest.

Until, on the way home Friday evening, I heard a story reported by Jeff Tyler on the always enjoyable Marketplace radio show. (audio available at the link, in RealPlayer format). Excerpt:

JEFF TYLER: Dell has not clarified what kind of "misconduct" has been uncovered. And that's left stock analysts guessing: How bad are the skeletons in Dell's closet?

Morningstar analyst Rick Hanna says the company is giving investors little to go on.

RICK HANNA: They haven't filed a quarterly report for over three quarters now. Think about an analogy. We're kind of driving in the fog and it's hard to see very far in front of you, because there's not a lot of light that's being shed on the situation.
Morningstar rates management practices at various companies. And Hanna says:

HANNA: They grade relatively poorly, quite frankly. On the Morningstar report card, Dell's management gets a "D."

In terms of consumer satisfaction, the company isn't looking so hot either. A new survey shows Dell is losing PC customers to other brands.

{...}

Taken together, Dell might not seem like a very attractive stock. But despite the dark clouds, Morningstar analyst Rick Hanna says the business model is solid and the stock is under-valued.

HANNA: As an example, they've probably got close to 5, $6 a share, just in cash, sitting on the books. They're still incredibly financially healthy. I mean, this is still a very, very solid, very strong company.

On a rating of 1 to 5 stars, Morningstar still gives Dell its strongest recommendation: 5 stars.

(ellipsis mine)

Since Dell's 10-K isn't actually due until Tuesday, they're not truly lacking quarterly reports for "over three quarters now", only two (Q2 2007 ended ≈7/2006 and Q3 2007 ended ≈10/2006). Nevertheless, the market has had earnings releases from the company, and so is not flying completely blind about reported performance. In other words, the analysts, such as Mr. Hanna, have the company's reported income statements and conference call information to use in providing ratings and advice. It's not quite like "driving in a fog", and all due respect to Mr. Hanna, it's not even like "it's hard to see very far in front of you". Perhaps a better analogy would be that it's hard to determine if the speed bump you just plowed over did any damage to your muffler.

As near as I can tell, what the market is missing are balance sheets and statements of cash flow for all periods after the 13 week period ending early in August, 2006, as well as any management discussion of results, aside from whatever occurred in company conference calls. Introductory accounting tells us that income statements represent what you did (or what you say you did), and balance sheets represent what you have. Clearly, one flows into the other, and without that last bit, attaching credibility to the income statement can be difficult.

Also, absent any reported balance sheet since August 4, 2006, Mr. Hanna's assertion that Dell's got $5 or $6 per share in cash is ill-founded. On that August balance sheet, there looks to be about $3.50/share of cash, and that's a number that's been trending down quite noticeably since January 2005. Receivables are growing, cash is shrinking, and the vaunted Dell model of years past, with days sales outstanding (DSO) measured in negative numbers seems long gone. They may have a solid business model, but it's not obviously the model that got them to number one in the industry. (To be completely fair, the old model had practical limits, of course).

Given the unreported, and unknown, basis of the concerns about accounting errors, deficiencies in the financial-control environment, and the possibility of employee misconduct, a cautious analyst would treat the last-reported numbers with, well, caution, and in no event would that analyst inflate (inadvertently, I'm absolutely certain) the reported numbers such as cash to provide a basis for retaining a high rating on the stock.

Particularly with a company whose management rates a "D", from that same analyst.

Morningstar's rating of Dell seems based more on "iconography"; on what it used to be rather than what it demonstrably is right now or will be in the reasonably predictable future - a company whose finances, customer service, and market dominance are all a bit sketchy for the time being. Dell's in no danger of disappearing, and isn't, to my mind, a bad company to deal with - I've bought more products from them than I can count, I consider myself a happy customer, and I will in all likelihood buy from them in the future. There are good companies with dubiously valued stocks, bad companies with rightly valued stocks, and two other permutations that don't support my thesis and which I'll let you calculate on your own. Dell arguably looks to be in that first category for now.

The stock would need to have performed twice as well as it has in the past several years just to rise to the mediocre level of "dead money". It's been a stone loser, in other words. And unless Morningstar has just recently raised its rating to "5 Star" (a hypothesis I doubt, but which doubt I can't support, since I don't subscribe to Morningstar), then Morningstar's ratings are based something far more ethereal than anything I'd be able to use to make an informed decision about a company's equity.

If it's at a bottom now, of course it could go up. It could also, based on the results of its financial review and competition from a rejuvenated HP, start digging from the bottom it's allegedly reached, acquiring a new bottom. And even if that doesn't happen, there's still no way to tell when or if Michael Dell will be able to bring the operations and market position back to their former luster.

Moral of the story? I still don't know what constitutes a Morningstar "5 Star" rated stock, and I'm understandably (I hope) skeptical of such a rating on Dell, and by extension on all other similarly rated stocks.

(also posted at a issuesblog.com)

[wik] In the weekend version of the WSJ, (subscription, but will be on Marketwatch site next week) curmudgeonly columnist Herb Greenberg, who's never a shortseller but seems to respect shortsellers more than he does stock-boosters, published a piece on Dell. With Seattle money manager Bill Fleckenstein as his source, he wrote:

In an August 2004 column on his Fleckensteincapital.com Web site, he reminded readers that it was the balance sheet, not the income statement, "that provided the tip-off that disaster loomed" for Dell rival Gateway, which rapidly became one of the PC industry's fastest financial fiascoes.

{...}

Mr. Fleckenstein was also uncomfortable with the size of the "long-term investments and long-term receivables" and "long-term liabilities" line items. It was a balance sheet, Mr. Fleckenstein wrote at the time, that "looks more like that of a financial institution than the box maker that it is." He continued: "If there turns out to be a problem with 'other current assets,' or any of these long-term investments or long-term receivables, you can see that when you match off these assets and liabilities, there could potentially be a lot less left than what people now think."

Therein lies the quandary for investors banking on a return to the powerful Dell model of the past: If Dell has to rearrange its balance sheet to show that it wasn't as profitable as analysts once believed, it may not be as profitable in the future as they are expecting.

(ellipsis mine)