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Is Dell Inc. A Value Trap? An Easy Way to Avoid Value Traps

March 03, 2011 | About:

Computer maker Dell inc. (DELL) is in the portfolios of many value gurus we track. DELL stock is traded at 40% lower than it was 10 years ago, and 60% lower than its all time high in 2005. With today’s close of $15.72, P/E at around 11, Dell does look cheap.

As all long term value investors know, buying stocks at cheap does not necessarily makes you money. A cheap stock can get even cheaper, if the business fundamentals have deteriorates. This is so called “value trap”.

How do you avoid falling into a value trap? As written by our distinguished columnist Geoff Gannon, “You can use something called the F-Score. The F-Score was created by an accounting professor at the University of Chicago. He wanted to use a simple checklist to separate troubled companies from companies that were going to pull through … It’s a list of 9 different questions that can be answered yes or no. If you answer them yes it counts as a 1 and if you answer them no it counts as a 0. It’s basically an on/off switch. You tally up the score and see how the stock does. Most stocks score somewhere between 3 and 7. A few get very low scores like 0, 1, or 2. And a few get very high scores like 8 or 9...”

Among the 9 questions of calculating the F-Score, question number 8 is the change in gross margin. If this year’s gross margin is higher give the stock one point. If last year’s gross margin is higher give the stock zero points.

While F-score is useful, we believe that one reliable way is to look at the long term trend of the gross margin. This can be easily done with the 10-year financial charts at GuruFocus. For instance, in the case of DELL, please go to Dell 10-year financials page. In the area of ratios, click on the line of Gross Margin, We see the history of the gross margin of Dell:

We can see that the long term trend of the gross margin of Dell has been on decline over the past 10-years. It did recover in 2008, but it declined again afterwards. This can be even clearly seen from the operating margin, the 10-year historical chart can displayed by clicking on the row of Operating Margin (%). We got this:

Observing the long term trend of the profit margins can help us from getting excited when the profit margin rebounds temporarily, this may well be what is happening at Dell. The operating margin for the quarter ended on Oct. 31, 2010 was 6.7%, a dramatic increase from 4.8% in the previous quarter. We cannot say for sure that this is a temporary improvement, but this has happened before several times for Dell in the last decade. Just to see it declined again and the loss to investors continued.

For comparison, this is the operating margin of Wal-Mart (NYSE:WMT). The profit margin has been on the rise. The business has the price power that it can protect its profit margins from competitions. It even increase its profit margin as the company becomes more efficient. That is the moat we have been talking about. As the business grows, the earnings grow. If you buy the stocks at reasonable valuations, the stock prices will follow the earnings.

Dell’s profit margin looks quite similar to an industry that we all know is in declining, the newspaper industry. Just look at the gross margin of newspaper company Gannett Co. (NYSE:GCI) below. How similar is that to Dell’s?

As pointed out by Geoff Gannon, buying a really cheap value trap may still make you money if you quickly flip it for a profit. But that requires good timing in both buying and selling, and favorable macro environment, and is REALLY cheap. It is just too much to ask and too hard to do. Therefore, I wouldn’t consider Dell for my portfolio. I rather buy a company that has sustainable or expanding profit margins (moat) and long term revenue and earnings growth, even if it is not that cheap!

Didn’t Warren Buffett say that the best? “I rather buy good companies at fair prices than fair companies at good prices.”

About the author:

Charlie Tian, Ph.D. - Founder of GuruFocus. You can now order his book Invest Like a Guru on Amazon.

Rating: 3.8/5 (28 votes)


NFichter - 6 years ago    Report SPAM

You made the point yourself that many noted value investors own DELL. How do you reconcile that with your observations about margin trends? Surely Watsa, Nygren, Hawkins, etc. are well aware of the margin issues you highlight, yet they continue to own large positions. Why might that be? Presumably they see other characteristics that they feel more than outweigh the margin considerations. In other words, maybe there is more to the story.
Gurufocus premium member - 6 years ago
This is what Mason Hawkins said in his latest shareholder letter:


Dell's stock declined 6% over the year after rising 4% in the fourth quarter. Our appraisal also grew in the quarter. The company delivered strong margins and earnings that far outpaced market expectations thanks to reduced component costs and a strong corporate refresh cycle that the company had predicted as well as double-digit growth in the solutions side of its business. Although many focus on the small consumer portion of Dell to evaluate the company's prospects, strategic advantage and future growth are tied to Dell's distribution strength which allows it to sell fast growing servers, storage, and services to small and mid size business as well as government and healthcare customers. While the company repurchased discounted shares in the year, much larger opportunity exists to do more. Michael Dell increased his own personal stake in the company by $100 million in December. Dell's adjusted free cash flow yield is over 20% and the top line is growing, yet the market multiple on the stock implies a business in decline.We cannot think of any previous investee that has obliterated the Street's EPS expectations by such a huge amount but had its stock lag. Our best guess is that the market's yawn assumes the results are from a one-time corporate refresh when in reality, the earnings were broad-based.
Halis - 6 years ago    Report SPAM
The thing that worries me is when you have a stock with declining margins and the leverage has increased exponentially since 2008. Since listing the net income, and therefore the net margin, is basically an accounting judgment call, it is possible that their situation is worse. They very well could have been padding their net income and using leverage to make the decline look less bad than it really is. Just an idea.

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