Dell's numbers don't add up

By Bill Fleckenstein

I'd like to devote this week's column to Dell, because the response to the recent revelation -- that an internal (not SEC) audit "has identified accounting errors, evidence of misconduct, and deficiencies in the financial-control environment" -- is illustrative of the current state of Wall Street "analysis."

First of all, let me explain why this investigation matters to Dell (DELL, news, msgs) and its shareholders.

What big Dell-toids you have!

Back in May and August of 2004, I wrote about the unexplainable, explosive growth in balance sheet items like "other assets" and "other other assets" (some of which were subsequently reclassified in February of 2006 as "financing receivables"). The growth in those items made no sense to me, and I suspected that perhaps it might have been allowing Dell to overstate its profitability, especially given the state of the PC world at that time.

I had seen morphing of the balance sheet at Gateway, and I wrote about it on Oct. 23, 2000, in a column titled "Fudgement Day." It was a tip-off that something wasn't right. Gateway was a little different, because at the time it was opening up retail outlets, so there were more levers to be pulled. Therefore, those line items had the potential for more creativity.

Dell is not Gateway. But we don't know exactly what Dell was/is, either.

To sum up: I suspected that Dell was not as profitable as folks believed. And we knew next to nothing about what those line items actually contained. Given that they were so large, they potentially posed a risk to Dell.

Lotta heft behind a hunch

Fast-forward to last August, when Dell admitted it was the subject of an ongoing SEC investigation. In the fashion of the man with a hammer, for whom the whole world looks like a nail, I concluded that my suspicions might have been correct.

To this day, we still don't know. But given the following three points and Dell's own admissions, it would require an enormous leap of faith to assume that nothing was wrong and everything will be copacetic going forward:

• The length of the investigations.
• The size and growth rate of financing receivables and other current assets -- i.e., from January 2002 through January 2006, as revenues grew 55%, earnings grew 80% (as did most balance-sheet categories, these two combined items grew 56% faster than current assets).
• The number (and rank) of the people who have left.

Yet, all of that is what the dead-fish community is willing to ignore. Of the 31 analysts who follow Dell, three have sells, 16 have buys, and the 12 others have some form of neutral.

Pollyanna in trousers

Recently, I commented on the Goldman Sachs dead fish who had a lack of concern over the balance sheet and SEC investigation. And, within a couple of hours of the most recent announcement, I was forwarded a defense piece by the dead fish at Citicorp. In his words, the press release contained "more good news than bad." His first reason for thinking that this was a positive is because the investigation was nearing an end.

While an investigation will be ending, it doesn't necessarily mean the news will be good. Another reason he cited for feeling comfortable: Dell said the audit committee was "working to determine whether accounting errors necessitate restatement." This dead fish says "this quote suggests that accounting errors may be so minor as to not require restatements."

That bit of legalese has plenty of wiggle room, so it doesn't de facto indicate that the adjustments will be minor, especially in light of what I have written above. But if he believes that, you'd think he'd back it up with some rationale, as I have done for my reasons to think otherwise. He did not.

Beauty lies in the eyes of the stockholder

Instead, he attempted to back up his belief by stating the following regarding the misconduct that Dell said occurred: It "merely suggests a passive lapse in supervision or control, rather than an active attempt to deceive." While that thinking on his part is consistent, again he offers up no data. Neither does he (nor any other dead fish) discuss what impact a balance-sheet restructuring might have on Dell's massive $1.37-a-share book value and its ability to utilize a large negative working-capital position (roughly $4 billion), which has also boosted profitability.

As for me, I go back to what I've already said. Given the size of what looked suspicious, the length of time the investigation has run, and the number of people who've left the company, it would seem to me that concluding this was a passive lapse is a giant leap of faith.

And one must not forget that Dell found itself in trouble back in the early 1990s for inappropriate treatment of the company's trading of foreign exchange. A friend who knows the analyst who broke that story told me the analyst endured a great deal of grief from Dell while trying to ferret out what happened.

Analytical rigor versus cerebral rigor mortis

So I think it's not unreasonable to conclude that something might be amiss and that maybe Dell's past wasn't as bright as folks thought -- ergo, its future won't be as bright, even if it can manage to turn itself around, which would require a heroic effort, indeed. All of this blather about new management is absurd, since the top dog has not left.

Maybe I'm dead wrong, but to me Dell is a risky idea -- a turnaround story in an awful business, with absolutely no margin of safety in the valuation. Hence, my short position. Hopefully, readers will find this an interesting contrast to what Wall Street regularly calls research.

At the time of publication, Bill Fleckenstein was short Dell and long Dell puts.