Capital Allocation

Brian participated in a fireside chat at the Morgan Stanley Annual Technology Conference yesterday.  You can sign up and be notified in advance via email of these events.  He started off by providing a brief overview of our latest quarterly and fiscal year results and then did some Q&A. In his message to investors, Brian emphasized profitability and liquidity as the two foremost priorities for us in this current economic environment and expressed confidence in our ability to extract further cost improvements in the business and emerge in a stronger competitive position.  As a short recap, I've included a few questions and answers Brian took during the meeting. I encourage you listen to the full webcast by clicking here.  As always, please provide your comments on Dell Shares.

1.       How would you characterize the current demand environment?

• The demand environment continues to be pretty tough year to date and we are seeing a lot of customers deferring purchase decisions due to the economy.
• We expect broad-based challenging environment to continue as budgets are likely to remain pressured at least through the first half of 2009.
• Our demand in Q4 was more linear than Q3 but the trends late in Q4 and in early Q1 are still negative.
• Do not know what magnitude of slowdown will be - but we will be nimble enough to rapidly adjust to the realities of the demand environment.

2.       How are you going to maintain gross margins in this environment?

• We have made significant progress in taking cost out of the box but there's more work to be done.
• We continue to make progress on the price and sell-to-value side of the equation as we introduce new products and will place an emphasis on smart pricing of these products.
• Progress here has provided a buffer to declining volumes late in the year and enabled us to remain competitive and deliver stable gross margins.
• We are confident in our ability to extract cost improvements even in a slowing demand environment and emerge in a stronger competitive position.

3.       Why haven't you made more acquisitions?

• Historically, our focus has been on organic growth... that model has worked for us successfully in the past.
• Having said that, we have made 9 acquisitions in the last year and a half and will continue to look for more opportunities that make strategic sense.
• We continue to look for opportunities in enterprise products, software and services, but it take two willing parties to make an acquisition work.
• In this environment, there's not much M&A activity going on because companies are not willing to sell at these low valuations.

4.       Can you comment a little bit on how you are managing working capital at Dell?

• Liquidity is #1 priority for us in this environment.
• During this period of declining revenue growth, we are aggressively managing our cash conversion cycle.
• For inventory, we have reduced our strategic buys, which also helps us benefit from cost deflation.
• Our payables have been impacted by the demand environment but we do not expect any significant structural changes.
• Given the current demand environment we would like to maintain our cash conversion cycle, and we continue to believe there are opportunities to improve our cash conversion cycle over time.

5.       Where should we expect to see Dell 2 years from now?

• We will take advantage of this downturn to reshape our revenue portfolio and better position us competitively.
• Over time, our goal is to move the weight of our portfolio to higher margin offerings and recurring revenue streams.
• We will accomplish this by migrating to a solutions-driven business with an increased mix of enterprise products, services and bundled solutions.
• We will also make strategic acquisitions as necessary that fit our model.

Today we settled three tranches of debt (see 8k filing) that we issued earlier this week in private placement transactions: $600 million at 4.7% yield due April 15, 2013; $500 million at 5.65% yield due April 15, 2018; and $400 million at 6.5% yield due April 15, 2038. This debt is considered "investment grade" by various rating agencies - for example it is rated A2 - Stable by Moody's.

As we discussed in our FY 2008 10K, filed on March 31, 2008, we use cash generated by operations as our primary source of liquidity and believe this cash is enough to support our business operations.  In FY 2008 we generated $3.9 billion in cash flow from operations, accessed $5.3bn in cash form a subsidiary outside of the United States, spent $4 billion on share repurchase, $2.2 billion on acquisitions and $831million on capital expenditures.  We ended the year with $9.5 billion in cash and investments.

Like many multi-national companies, a substantial amount of our cash balances are held outside of the U.S. and so like other companies we have chosen to access the capital markets to supplement our liquidity in the United States - which means raise debt.   The last time Dell raised long term debt was in 1998. 

We plan to use the funds we raised this week for general corporate purposes - which includes discretionary spending like share repurchase and acquisitions.  Share repurchase remains our primary use of cash.  Dell believes this is good for Dell and for our shareholders because it lowers our weighted average cost of capital enhancing our current capital structure.  

We do plan on exchanging the debt we raised this week for public debt later this year.

Last Thursday, we announced that in the next several weeks, Dell XPS and Inspiron PCs would be carried in over 900 U.S. Best Buy locations and at bestbuy.com. With this agreement, Dell PCs will be available in over 10,000 locations worldwide, which in turn helps us drive towards one of our key strategic priorities: focusing on consumer. We've received several questions from the press and investors seeking additional insights into retail initiative and its impact on our business model. Since we've announced partnerships with Staples, Wal-Mart, Sam's Club, Gome, Carrefour, Bic Camera, Carphone Warehouse, and others over the past several months (with the intention of forging 1 to 2 partnerships in the top 20 countries over time), we thought this would be a good opportunity to discuss what the impact retail partnerships will have on our P&L and cash conversion cycle (CCC).

Let's tackle the impact of retail on our CCC first. To review, CCC is a metric used by investors to understand how long it takes a company to create cash flows. This metric takes into account the number of days a company keeps inventories (DSI), the amount of time it takes a company to collect money from customers (DSO), and the amount of time a company waits to pay its suppliers (DPO). In short, CCC = DSI + DSO - DPO. The shorter a company's CCC, the less time capital is tied up in the business, and hence, creates better cash flows. The beauty of the Dell model is that we typically don't take possession of parts inventory until a customer has ordered and paid for a system. Meanwhile, customers typically pay for systems immediately (with a credit card in the case of consumers), and we we'll usually ship a PC to a customer within a matter of days. Meanwhile, our suppliers don't receive payment for roughly 2 months after we take possession of parts (last quarter it was 81 days), so Dell's CCC was -35 days in Q3'08. Dell's strong cash position is then reinvested back into the business in the form of capital expenditures or acquisitions, as well as returned to shareholders in the form share repurchases.

So back to the impact of retail partnerships on our CCC. The most consistent question we've received is whether we'll see our days DSI and DSO go up when dealing with a large retailer. The best way to answer this question is to think of a retail partner similar to a commercial customer. Retail, like commercial customers, will order 100s, if not 1000s of PCs at once. And these PCs will likely consist of just several specific configurations. We'll build these PCs to the customer's specification from one of our 11 global manufacturing facilities, leverage our world-class supply chain, and ship directly to the customer much as we would a commercial customer -- so there's little impact on DSI. As for the impact on DSO, we expect retail's accounts receivables will look much the same as our commercial customers. And remember; roughly 85% of Dell's business today is driven by commercial customers, so the impact on overall DSO should be minimal.

From a P&L perspective, the retail model impacts our business differently than our direct-to-consumer model does. Though it's early in the initiative, we expect retail-driven gross margins will be lower than direct since we'll have to share part of the margin with our partners. On the other hand, the sales and marketing costs associated with the retail model should be lower since our retail partners will shoulder much of these costs. Further, another benefit of our retail model could be that these additional revenues will help offset some of the fixed costs associated with our direct business.

But it's important to remember that our US consumer business posted -1.4% operating profit in Q3'08. While the retail partnerships are a step in the right direction, there's still a lot to do to return this business to profitability. It could take time to ramp and fine tune the initiative, but eventually, we expect retail will be accretive to our bottom line.

Yesterday, Dell held its annual shareholder meeting for fiscal-year 2007.  It was postponed from July of this year due to the delay in the filing of our Fiscal 2007 10K and Proxy.  It's been a busy few days for our IR team - our first earnings conference call in over a year - which was also a strategy call - quickly followed by the shareholder meeting.  So I am a bit later with this post than I'd like - and I apologize for that - I'm still learning about how to communicate in a blog environment! 

I thought this would be a good time to talk about the mechanics of a shareholder meeting and its role in the corporate governance process.  I will also discuss speculation surrounding our share repurchase program.  I hope this will help to answer some of the questions people have asked us recently via calls, emails and this blog.

So let's start with the shareholder meeting.  The requirement to have an annual shareholder meeting is usually set forth in a company's By-Laws.  Many companies also have a meeting of their Board within a day or so of the shareholder meeting, and then have the Board members stay on for the shareholder meeting.  Shareholders of "record" - meaning they have to have owned shares on a certain date - can submit proposals to the company for inclusion in the proxy so long as the proposal meets certain requirements.   For a shareholder to be able to submit a proposal, they must either own 2,000 shares of the company or hold shares equivalent to 1% of the company's stock.  Also, the company can submit its proposals; such as nominations to the board of directors, compensation plans, and ratification of auditors. 

This year we had five proxy proposals and the results from the proxy vote can be found here.   For shareholder proposals that were not passed, shareholders can resubmit the proposals the following year if specific support thresholds were achieved.

At the shareholder meeting Don Carty talked about the financial health of the company and our commitment to growing the company in a responsible and profitable way - a way that can generate sustainable cash returns, which ultimately drives shareholder value.  Michael Dell talked about our five key priorities.  Following which, they both answered questions from the audience and the web.  Investors were interested, among other things, in expressing their interest in Dell paying a dividend, as well as commenting on our compensation practices.  Shareholders also asked for management's take on why the company's stock declined last week despite announcing a 9% Y/Y increase in revenue and a 26% increase in EPS.

So now let's turn to share repurchase.  We voluntarily suspended our share repurchase program in September of 2006, choosing instead to wait until after our Audit Committee completed its independent investigation and we filed our past due SEC filings.  All of this was completed by October of 2007.  We did not resume our buyback then because we were in "blackout" from earnings last week.  "Blackout" is the period before and after a company's earnings when it cannot buy back its stock.   

Dell's Board met on Monday, Dec. 3^rd where they voted to authorize a $10 billion share repurchase program.  There has been a lot of speculation about this program - unfortunately we could not talk about it until the Board actually made a decision on what we were going to do.  A company can invest its capital in several things.  And it can get its capital from several places.  At the end of the day a company wants to generate a return on its capital that's in excess of what it costs the company to obtain that capital - that's how it creates value for its shareholders. 

Let's start with how companies obtain capital.  First, a company can generate cash from their business: over the last four quarters Dell generated about $4 billion in cash flow from operations.  Second, a company can have money already "saved" in the form of cash and cash equivalents -- or investments.  Third, a company can borrow money - or debt.  Fourth, a company can sell more stock in the company - or issue equity.  And fifth, a company can sell some of its assets.  Since Dell has historically generated cash in excess of the cash required to run the business, we've saved a lot of cash and then used this cash from operations to buy back our stock. 

As far as how a company can invest its capital - it can do a few things.  First, it can invest in its own business by building manufacturing facilities or other buildings- these are called capital investments.  Second, it can use capital to buy other companies - or acquisitions.  Third, it can buy back its own stock.  And fourth, it can pay a dividend.  How a company allocates its capital across these opportunities varies from company to company.  And depending on the current business priorities, economic environment or company valuation, a company's capital allocation can change over time.  No two companies are alike.

So why does a share repurchase program matter?  Simply stated, ceteris paribus, buying back shares reduces the number of shares outstanding and increases shareholders' stake in the future cash flows of the company.

Some have asked if we will borrow to fund our share repurchase plan since most of our cash, like many global companies, is outside of the United States.  We look at our investments in aggregate - so this includes share repurchase, capital expenditures and acquisitions. Right now we believe we have sufficient liquidity to fund these activities - but this could change over time and we have said that we could use the cash we have on our balance sheet as well as debt to fund investments.  At the end of the day we want to maintain our financial flexibility.

Since we will start to execute this current authorization through open market purchases, many people would like us to say exactly when and how we will buy the stock. This is really not prudent and most companies don't do it.  What we have said is that share repurchase will likely be one of the key uses of our capital both now an in the future.