Dell's 10-K Reveals Some Risky Business - TheStreet

Dell's 10-K Reveals Some Risky Business

Possible problems exist in the company's relationship with Tyco and in its stock buyback plan.
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On Wednesday the computer maker filed its fiscal year-end report with the

Securities and Exchange Commission

, but investors may not like what they see. It goes without saying that fiscal 2002 was an incredible year for Dell as far as seizing market share and humiliating the competition were concerned. When other companies' shares were tanking, during calendar 2001 Dell's stock price climbed 55%.

But a closer look at Dell's financial inner workings shows two items that investors may not be comfortable with, both of them longstanding mechanisms that helped fuel the Dell machine in the past but may not stand up in the future.

The first falls into the now-loathed category of off balance sheet accounting. Dell is involved in a partnership with the CIT financing division that troubled



is considering taking public.

The two companies work together on Dell Financial Services, an entity that financed $2.7 billion in Dell sales in 2002, or 9% of overall revenue, after contributing $2.5 billion in 2001, or 8% of revenue and 7% of 2000's sales, or $1.8 billion. Dell may not have any liabilities from Dell Financial Services, because the venture is not technically a part of Dell, but the venture has provided almost 1% sales growth a year in the past few years.

The way the business works is that Dell gives DFS leads and collects a fee that it counts as revenue, totaling some $70 million in 2002. Losses from the overall financing organization get lumped on Tyco, while 70% of net profits after paying the bills go to Dell and 30% head for Tyco.

In the 10-K filing, Dell says that if it had to take DFS onto its balance sheet, it wouldn't have a material effect on 2002's revenue or earnings, meaning that DFS didn't bring in enough money to move Dell's top or bottom lines with financing work. But should faltering Tyco have trouble keeping up its end of the deal, Dell would have to find a quick replacement for the financing vehicle of almost 10% of its 2002 sales.

Dell would not speculate on the future of the program or on its relationship to Tyco.

Buyback Splashback

Another red-flag item in the filing is the effect of rainy stock market days on Dell's famous stock buyback plan. Instead of buying back shares at market prices as most companies do, for six years Dell has taken a more risky but previously profitable strategy. Dell reacquires its shares through a bullish options strategy of selling puts and buying calls. When Dell's stock price went up and up, it could buy its shares for cheap and make money on the transaction as well.

Now that the stock market stinks, Dell disclosed that in fiscal 2002 that it bought 68 million shares for $3 billion, for an average price of $44.11. That's expensive, given that Dell's shares traded in the $20s during the year. The computer maker's critics argued years ago that Dell's buyback program was too risky and could have such a result.

But Dell spokesman Mike Maher defended the technique, saying it "has been an exceptional value for shareholders." Maher added that if Dell had to pay for all its obligations right now, it would've bought almost 1 billion of its shares back for $12 billion, "which is less than half our stock price today. It's been an extremely good use of cash."

The company noted that it now is obligated to eventually buy 51 million shares with a repurchase price around $45 -- well above Dell's current trading range in the mid-$20s -- to be bought in stages through 2004. Then again, Dell has only 60 million shares left in its buyback program, with 940 million of the 1 billion goal already bought.

Investors who recently witnessed the implosion of another Texas company that courted much more risk, though, will take note of Dell's disclosure that the 51 million share obligation contains a footnote. If Dell's share price drops to $8, it has to settle up. Of course, no company thinks it will suffer a stock catastrophe, but if that were to happen somehow, Dell would have $2.3 billion in put obligations to cover, a fine portion of the $3.6 billion in cash it had on hand when it ended fiscal 2002 on Feb. 1.

Maher rationally explains that "given the strength and value" of Dell's operations, such a scenario does not taint the buyback plan. But the investing world is much different in 2002 from what it was six years ago when Dell took on the risk, and investors may not be quite as comfortable with Dell's gambles after seeing other stable highfliers hit the skids.