On the surface, Dell's (Nasdaq: DELL) third-quarter results were not all inspiring of the future economic recovery that we have come to see from other blue-chip type companies. Total revenue was down 15% compared to a year ago, and net income was down a whopping 54 percent.
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It's Not All About Profits
Without question, net income matters to a business over the long term. Often, however, investors can become fixated on the short-term profitability of a company. Such a limited view can often lead to focusing on the trees instead of the forest. In Dell's case, the company is in the midst of completing several strategic initiatives geared to reducing operating expenses. One can see signs of these initiatives working by analyzing the cash flow statement. (For further reading, check out The Essentials Of Cash Flow.)
Count The Cash
One of my favorite investors today is Bruce Berkowitz, who oversees the Fairholme Funds. One of his key investing parameters is focusing on companies where he can count the cash easily. In other words, Fairholme is more concerned with free cash flow (FCF) than net income. That's why Fairholme Funds holds big positions in names like Pfizer (NYSE: PFE), Coca-Cola (NYSE: KO) and Forest Labs (NYSE: FRX).
In a similar fashion, observing Dell's cash flow numbers helps provide a more complete picture. Dell generated $800 million in operating cash flow (OCF) in the quarter compared to an $86 million use of cash from operations one year ago. For the first nine months of the year, OCF was $2.6 billion compared to $1.2 billion in 2008. FCF, as measured by deducting capital expenditures from OCF, was approximately $400 million in the Q3 and $1.5 billion for the nine months of 2009. That compares with no FCF in the comparable 2008 period. (For related reading, check out Analyze Cash Flow The Easy Way.)
Headed In The Right Direction
Looked at in this way, Dell is clearly headed in the right direction. The company's market cap is $28 billion, but once you take out a net cash position of $9 billion, the EV is $19 billion. In 2007 and 2008, Dell produced more than $3 billion in free cash flow. In 2008 the number was $1.5 billion, the same amount Dell has produced so far this year. So while Dell shares currently fetch about 17 times earnings, the company is trading for about nine times EV/FCF based on an estimated $2 billion to $2.2 billion in FCF for the year. That's an attractive multiple for a company of this quality.
Compare that with Apple (Nasdaq: AAPL), which currently commands an EV of $157 billion, which earned $9 billion in FCF in 2008 and approximately $6.3 billion so far in 2009, suggesting an EV/FCF multiple of 15. Microsoft (Nasdaq: MSFT), with an EV of $236 billion, produced about $16 billion in FCF last year, or a ratio of 15 as well.
Cash matters a lot, and Dell produces tons of it. Successful execution of its strategic initiatives should lead to more cash generation and a much more valuable enterprise. (For more, see Spotting Cash Cows.)
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