Let's learn from Dell Inc.'s midlife crisis

  • Article by: ISAAC CHEIFETZ
  • Updated: August 15, 2010 - 3:23 PM

Growing up is hard to do, as some formerly fast-growing companies have discovered.

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Michael Dell, founder and Chairman, Dell Inc.

Photo: Damian Dovarganes, Associated Press - Ap

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In this challenging era for investors, another Wall Street favorite made the news, negatively. On July 22, the Securities and Exchange Commission fined Dell Computer $100 million for misleading accounting statements in the fiscal years 2003 through 2006. Additionally, Michael Dell, the founder and CEO, was personally fined $4 million.

In the post-dot-com era, Dell was among the handful of companies held up as the gold standard for corporate success in the global economy. Dell's business model changed the competitive landscape so drastically that the rest of the PC industry became unprofitable. Dell leveraged its origins as a mail-order house (with no sales channel partners) to replace the rigid, mass manufacturing that was common in the PC industry with flexible, lean manufacturing. Dell built each PC only after a customer ordered it, and purchased the parts for each PC on a just-in-time basis from suppliers, eliminating the depreciation of parts and completed unit that plagued the rest of the industry.

The SEC charges were a deeper investigation of the scandal that arose in 2007, when Dell admitted to a "lax accounting environment" in those years, in which "managers moved money around to make financial goals." (This so-called "revenue smoothing" had been accepted practice in the 1980s and 1990s).

The recent SEC investigation dug deeper, revealing that Dell was manipulating its finances for strategic, not just tactical reasons (though not fraudulent ones -- Dell was not accused of falsifying revenue like Enron or WorldCom a decade ago). Dell, it turns out, was receiving billions of dollars in payments from Intel, the 800-pound gorilla computer chip manufacturer, as incentive not to use the products of competitors like Advanced Micro Devices, and so maintain their dominant market share.

The GE experience

It was not illegal for Dell to accept these incentives, which are common in many industries. But it was a violation for Dell to mask the size and purpose of these incentives in SEC quarterly financial statements, with the express purpose of implying that Dell was still growing at the fantastic rate it did in the 1990s, rather than the reality of being temporarily propped up by a strategic partner. Without Intel's payments, according to the SEC, Dell would have missed Wall Street analysts' profit estimates in every fiscal quarter from 2002 to 2006.

In some ways, the revelations about Michael Dell and the firm that he founded are reminiscent of those of General Electric in the Jack Welch era (1981-2001). Both leaders were wildly successful growing their companies' revenue and profits for 15 years, despite being in industries where commoditization had driven down profit margins for their competitors. Wall Street analysts and investors venerated both, raising GE and Dell to historically high market capitalizations.

Like Dell, Welch's successes were substantive and real. But the remarkable consistency of GE's earnings under Welch, quarter after quarter, was a phenomenon unnatural for a large company. He too engaged in "revenue smoothing" to achieve the desired consistency of earning performance.

Welch also used cash not derived from revenue to inflate profits. As described in a December 2005 article in Barron's by Jonathan R. Laing, Welch played an accounting game toward the end of his reign. "During the last five years of the Welch era, ended in 2001, GE's reported earnings jumped from 72 cents a share to $1.37, a rise of 65 cents a share, or 90.2 percent -- spectacular for a behemoth like GE. But without a massive under-reserving at its reinsurance unit, the company would have shown a cumulative earnings gain of just 4 cents, or 5.6 percent."

Here are four lessons executives, investors and analysts can learn from Dell's blunder:

•Growth spurts are temporary. No company can remain a "growth company" (i.e. growing significantly faster than the overall economy) forever. Such a rapid rate of expansion would eventually lead to it overwhelming everything in its path.

•Act your age. Companies that deny the realities of being a mature enterprise and try to unnaturally perpetuate their rate of growth (and maintain an artificially high price-to-earnings ratio) tend to act foolishly or worse, as the examples of Dell and GE demonstrate.

•"Grant me the serenity." In the Alcoholics Anonymous "Serenity Prayer," wisdom is defined as the ability to distinguish between things you can change and things you can't. For example, in 1969 Warren Buffett liquidated his investment partnership, despite having had his most profitable year to date. He recognized the stock market was spectacularly overvalued, and that not even he would be able to find bargains for a few years, until the market had declined significantly, creating new opportunities. He did not pretend he could make money under any market conditions.

•Revenue smoothing is an oxymoron. It is foolish to believe that a company can consistently grow on a smooth curve, and predict that growth exactly. Penalizing a corporation for having an occasional poor quarter or year creates enormous pressure for executives to tell investors what they want to hear, like a king threatening a weather forecaster with beheading if he does not predict the exact temperature, every day.

  • About the author

    Isaac Cheifetz is a Minneapolis-based executive recruiter and author of "Hiring Secrets of the NFL" (Davies Black Publishing). His Commerce Chain column runs occasionally in Monday Business Insider. Reach him at isaac@opentechnologies.com.

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