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Red Ink Changes Dell's Tune on Investments

Sometimes it's profitable to change the rules when it suits you. So maybe you can't blame Dell (DELL) for giving its bottom line a boost.

Dell Thursday affirmed fiscal second-quarter sales and earnings targets, bumping its stock up 4.4%. Receiving less notice, however, was a plan to take a $700 million charge against earnings. About $200 million of that will go toward covering the cost of writing off the value of certain investments made by the company's venture capital arm, Dell Ventures, according to a company spokesman.

Does the charge matter? As a one-time, extraordinary event, it shouldn't. But it's not so simple in Dell's case. The company's decision to exclude the Dell Ventures losses from its earnings per share marks an about-face from its past practice of including the results of investment activity on its bottom line. Moreover, the move raises the question of how much investors are supposed to trust what companies say about their earnings.

Is Turnabout Fair Play?

Dell has been including its investment results in its earnings-per-share figures for several quarters. Not surprisingly, when the stock market was strong, those results were always gains. The effects of this strategy haven't been inconsequential: It was a larger-than-expected investment gain of $145 million that allowed Dell to meet its third-quarter earnings estimates back in November of 2000.

Padding It Out
Four quarters of earnings at Dell, with and without investment gains
Figures are based on a 30% tax rate.
Source: The company

Dell's equity investments have plunged along with the general downturn in tech stocks. Once valued well in excess of $1 billion, by May 2001 their value had fallen to $757 million, which the company said was more or less at cost. With names like Internet Capital Group (ICGE)), divine interVentures (DVIN) and Red Hat (RHAT) included in Dell Ventures' portfolio, it's easy to see how the losses arose.

Now, with the equity market having turned against it, Dell is changing the rules.

"Yeah, they took the gains from Dell Ventures in their P&L, and now they're separating out the losses," says Dan Niles, an analyst at Lehman Brothers.

Dell isn't the only company that has included investment gains in its earnings. A wide range of tech companies, including Intel (INTC), have engaged in that practice. But not everybody does it. IBM (IBM), for example, includes both losses and gains from its investments in its bottom line. The company said Wednesday that it plans to take "asset impairment" charges worth a nickel a share in the second half of 2001. Unlike with Dell, analysts will include that charge in their earnings estimates for IBM, and the earnings-per-share figures IBM reports will include them, too.

Froot Loops

"In general, I wish my companies excluded the investment gains and losses completely," said Lehman's Dan Niles. "It would just make it easier. Otherwise, you're including it one time and not including it the next, and I don't think it's quite apples to apples. Most investment professionals would like it if companies just left their venture capital stuff out of the P&L. Because that's not why we're buying these companies. We're buying them for the operational excellence and not for their investment acumen." (Lehman Brothers hasn't done recent underwriting for Dell.)

So where would Dell's earnings be if the company hadn't changed its reporting standard? Earnings of 16 cents a share implies net income of about $440 million, assuming Dell's shares outstanding remain relatively constant from the prior quarter. A tax rate of 30%, pretty much where it's been in recent quarters, would make Dell's operating income about $630 million. Factoring out a loss of $200 million on investments brings that figure down to $430 million, and taxes bring that down to about $300 million. That works out to a meager 11 cents a share, 5 cents below expectations.

Of course, there's nothing improper about Dell's treatment of the investment results. "So long as the accounting standards let you do that, it would be to Dell's disadvantage not to," says Niles.

How do you like them oranges? It's something to think about when the company starts making year-over-year comparisons when it reports its results next month.

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