Raising Questions about Dell’s Working Capital
Are the PC maker’s working capital numbers all they’re cracked up to be? Maybe not. Two former
Dell executives have described how the company manages its working capital -- in accordance with
generally accepted accounting principles, but at a cost to the performance of its business -- so it can
present a rosier picture to investors. Sadly, it seems the gaming of financial statements is endemic in
corporate America.
By Whitney Tilson
Unpublished article, December 2001
After reading one of my Motley Fool columns questioning Dell’s (Nasdaq: DELL) reported returns on
capital (Questioning Dell’s Returns on Capital), two former executives of the PC direct seller
contacted me independently with similar stories: that Dell’s working capital metrics -- specifically
inventories, accounts receivable, and accounts payable -- while excellent, are not as phenomenal as
they appear to be.
According to these sources, Dell engages in a number of what both called “unnatural acts” to make
inventories and accounts receivable as low as possible, and accounts payable as high as possible,
on the four days a year in which it reports these figures publicly. The assertion is not that Dell
fabricates its numbers, but rather manages its business near the end of each quarter to make its
working capital metrics appear, for a day, substantially better than they are under normal business
conditions. How much better? My sources estimate that without the “unnatural acts,” the inventory
levels Dell reports at the end of each quarter would be twice as high and that operating cash flow
would be hundreds of millions of dollars lower.
In the case of inventory and accounts payable, my sources believe Dell’s “unnatural acts” have real
economic costs to the company. Despite this, Dell engages in such activities in part, my sources said,
because the company believes its competitors do so as well, and so it can present a better picture to
investors.
Reasonable people may disagree about the implications of my sources’ claims. “I believe in my heart
that Dell plays the earnings game very well,” one source told me, “and well inside the rules. The endof-quarter games are played by everybody -- Dell is just better at it. Dressing up a balance sheet at
the end of a quarter is like cleaning up your house before strangers are invited in. There is not an
integrity issue here.”
But I’m not so sure. I believe these revelations might cause many investors to seriously question
Dell’s efficiency, not to mention management’s priorities. That’s certainly been the case with me -- an
admirer of the company and former shareholder.
In response to a summary of my sources’ statements, Dell spokesman Mike Maher said via email:
“Any balance sheet is a snapshot in time that shows the health of a company. Take inventory levels
for example: The amount of inventory we have on hand fluctuates (at times daily, and at times we
have as little as two hours of it on hand for some components) and is cyclical with business demand,
which ramps up near and at the end of a quarter then drops off in the first part of the next. Suffice it to
say Dell has a healthy balance sheet with well-managed, strong cash flow.
“We’re not going to engage in discussions around speculative information from anonymous sources.
It goes without saying that the reporting of our numbers follows standard accounting practices, and
they are thoroughly audited by independent, outside accountants. To suggest otherwise is patently
wrong.”
Maher is no doubt correct in saying Dell is operating within the law and generally accepted
accounting principles. My sources do not dispute this. (Dell’s auditor, PriceWaterhouseCoopers,
signed off on the company’s annual report.) He also makes a valid point about using anonymous
sources. Obviously I would prefer my sources went on the record, but both were adamant about not
doing so given the nature of their revelations and their many personal relationships with past and
present Dell employees. I have, however, spoken and emailed extensively with both sources and
have verified their backgrounds. One worked in finance, the other in procurement, so both were able
to observe firsthand how Dell manages its working capital. Furthermore, although they contacted me
independently, their accounts corroborate each other in almost every detail.
My sources are speaking out, they say, not because they wish the company harm, but because they
are concerned that Dell is both misleading investors and also damaging the company. “Reporting this
story responsibly,” the former procurement executive said, “will be a force for good change within
Dell.”
The most troubling aspect of this story is the virtual certainty that these issues go well beyond Dell. If
the company’s alleged behavior is the norm in corporate America -- and many outspoken market
observers believe it is -- then we have a crisis on our hands. Reliable financial statements are part of
the bedrock of our capital markets. If widespread violations of this trust are occurring, it is a serious
matter indeed.
Background: Dell’s reported working capital
Because of its direct model, Dell is able to operate with lean inventory levels and can often collect
payments from customers before it pays its suppliers. This gives the company a short -- or even
negative -- cash conversion cycle, which is calculated by adding days supply in inventory and days of
sales in accounts receivable (money owed by customers), and then subtracting days in accounts
payable (money owed to suppliers).
The cash conversion cycle represents the number of days from the time a company takes delivery of
raw materials (the first stage of inventory, which is followed by work in process and finished goods) to
the time it collects from its customers and pays its suppliers. Obviously, shorter is better.
While a short cash conversion cycle may not sound exciting, it’s enormously powerful. Most highgrowth companies -- even highly profitable ones -- consume a great deal of cash as they grow due
largely to rising working capital. (In other words, inventories and accounts receivable increase faster
than accounts payable.) But over time Dell has been able to cut inventories and accounts receivable,
and extend accounts payable, so that its balance sheet consumes little cash -- and, at times, even
generates cash.
The working capital numbers Dell reports are phenomenal. In last quarter’s earnings release (Q3
2002, reported November 15, 2001), the company reported a mere four days supply in inventory and
32 days of sales in accounts receivable, versus 70 days in accounts payable, resulting in a cash
conversion cycle of -34 days. That’s a substantial improvement from -30 days in the previous quarter
and -16 days in the same quarter a year ago.
What are the average numbers?
My sources, however, provided different numbers.
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“Dell boasts of having only five days or so of inventory,” the procurement executive said,
“which is true at quarter end. During the quarter, however, inventory routinely runs in the 12- to
13-day neighborhood.” The other source confirmed this, saying Dell’s average inventory levels
are at least ten days.
Dell’s average accounts receivable figure is an estimated 25% higher than what it reports at
quarter end.
Dell averages 40 to 48 days in accounts payable, not the 70 days it reported for the end of last
quarter.
Let’s examine Dell’s cash conversion cycle using the estimates provided by my sources. To give the
company the benefit of the doubt, let’s use 10 days of inventory, 40 days of accounts receivable and
48 days of accounts payable. That yields a cash conversion cycle of 2 days -- still an excellent
performance, but nowhere near the -34 days reported last quarter.
The new estimates if applied, would also have a marked impact on Dell’s balance sheet. Assuming
10 days of inventory rather than four, inventory would have jumped from the $269 million Dell
reported last quarter to $675 million. Accounts receivable would have increased by 25% from $2.69
billion to $3.27 billion, and accounts payable would have fallen from $4.77 million to $3.24 billion.
The result of these adjustments would be a dramatic decline in the operating cash flow figure Dell
reports.
What Dell is apparently doing
Let’s try to understand exactly how Dell allegedly manages its inventory, accounts receivable and
accounts payable so it can report more favorable figures.
Inventory
As Dell spokesman Maher noted, the company’s inventory fluctuates during a quarter, depending on
demand. Like most companies, Dell does a disproportionate amount of business in the last month of
each quarter -- the former procurement executive estimated 45% -- and no doubt the last week of the
quarter is particularly busy. Therefore, according to this source, inventory peaks during the middle of
the quarter and would naturally reach a low of eight or nine days by the end of each quarter. He
estimated that the average is 12 to 13 days.
These figures are already exceptional, but Dell strives to make them appear even better, according to
my sources. Once the company determines exactly what it will produce and ship in the last five days
or so of each quarter, they said, it tells suppliers not to deliver any inventory other than precisely what
will be needed for production. Dell’s factories are thus nearly empty at the end of each quarter,
allowing the company to report minimal inventory levels.
“I don’t consider cranking inventory down by emptying out the factory at the end of the quarter to be
excellent working capital management,” said the procurement source. His finance counterpart
agreed, noting that there is a cost to Dell because “the factory would open on [the first day of the new
quarter] without much to do. It would take us until the end of the day to start getting stuff out the door.
That’s four days a year of lost productivity, which may not sound like much, but when you’re a lean,
low-margin producer, it’s material.” (He noted, however, that he believed Dell’s actions “didn’t have
much impact on a comparative basis because everyone else does this too.”)
In short, both sources said, Dell is incurring real economic costs in order to report the absolute lowest
inventory levels possible. Why? Perhaps so Michael Dell can say, as he did in an earnings release
last year: “Lowering inventory by more than one-third even as we’re increasing shipments by nearly
20 percent defies traditional thinking, but we’ve always done business differently.”
There’s another part of Dell’s inventory story that’s worth considering. According to the former
procurement executive, Dell requires all of its suppliers -- with the exception of a few of the big ones
that won’t do it -- to hold two weeks of inventory at “hubs” very close to Dell’s factories. “Of course,
suppliers factor this cost into their prices, so we pay for this,” he noted. In other words, Dell pays for
an extra two weeks of inventory, even though it doesn’t appear on its balance sheet. This raises the
question: Couldn’t just about any company show minimal inventory levels if it required (and paid) its
suppliers to hold a large amount of inventory nearby?
Accounts receivable
My sources said Dell is excellent at quickly collecting its bills, and simply makes a big push to collect
as much as possible at the end of every quarter, which results in temporarily lower accounts
receivable levels.
Accounts payable
Dell’s reported accounts payable is the least representative number of the three, according to my
sources. “[The first quarter of FY 2001’s] 59 days is obviously ludicrous,” said the former finance
executive, “since the best we were ever able to negotiate was 45 days, and it was less for large
suppliers. To boost accounts payable at the end of each quarter, we would tell suppliers to hold a
shipment for a day or two at the end of the quarter, or hold checks by one or two days, which can buy
15-30 days of payables, especially in Europe. We have particular flexibility to delay payments -- and
refuse to take inventory -- at the end of our quarters since they do not coincide with the end of our
suppliers’ quarters, and thus do not affect their reported numbers.
“In contrast to Dell’s genuinely strong underlying performance managing inventory and accounts
receivable,” he concluded, “there’s no wonderful asset management going on [with accounts
payable].”
My other source provided slightly different figures: He said Dell was able to negotiate terms longer
than 45 days with certain vendors, and that the average days of accounts payable was around 45 to
48 days. (This small discrepancy -- the only one in the information I was provided -- is not surprising,
as the procurement executive worked at Dell more recently, and the company has been extending its
payables rapidly.)
Both agreed, however, that Dell made every effort to boost its accounts payable at the end of every
quarter. “Dell routinely withholds three weeks or so of payments from vendors at the end of every
quarter,” said the former procurement executive, “which keeps an extra $500 million to $1 billion on
the balance sheet... I don’t consider holding three weeks of vendor payments to pump up accounts
payable excellent working capital management. In my opinion, it is hurting our long-term relationships
with many of our suppliers.
“Since we’re big and still growing,” he explained, “and their business has slowed, we’ve been able to
squeeze them recently [by delaying payments], but we’re causing some of our suppliers real pain. We
can do this now because we’re in a position of strength, but it could come back to haunt us when the
tables are turned and, for example, we need to get a component that is in short supply.”
Dell spokesman Maher disputes this account, saying: “We have and continue to maintain good
relationships with suppliers, evidenced by our ability to serve customers and continue growing at
multiples of the industry.”
It’s so unnecessary (or is it?)
At first, I found my sources’ accounts perplexing because the alleged actions appeared so
unnecessary. As the former finance executive source noted:
“Please don’t get the impression that Dell’s asset management is all smoke and mirrors. The
improvements in average working capital numbers -- not to mention Dell’s overall performance over
time -- have been remarkable, so why risk our credibility by overstating our case? I feel like even if
people knew there was two weeks of inventory, and what it took to run on this lean level, they’d
understand that it’s an incredible feat. Instead, we went through a lot of hoops to present the absolute
best numbers we could. If Dell just stuck to the fundamentals, they’d be much better off.”
Would Dell be better off, as my source claims, if it changed its way? Perhaps. But Dell’s rapidly
improving working capital management -- which led to rapidly increasing cash flow and returns on
invested capital (ROIC) -- was instrumental in boosting the company’s earnings multiple -- and market
value -- since the mid-1990s. (Dell stopped reporting ROIC in the past two quarters.)
This is important for two reasons: First, Dell’s top executives, like those at most companies that issue
lots of stock options, own a great deal of stock and have, over time, been regular sellers -- to the tune
of billions of dollars. This gives them a powerful incentive to try to keep the stock price as high as
possible. Second, stock options are an important piece of compensation in the technology sector, so
a high and rising stock price is absolutely critical to attracting and retaining talented people.
My sources, however, do not believe Dell initially intended to manipulate its working capital and ROIC
to inflate its stock. Instead, they say, it was a case of creeping incrementalism. “When we first started
measuring return on invested capital,” said the onetime finance executive, “it was an internal measure
and it really drove the right behaviors. It wasn’t intended to dupe anyone. Then [management] had
the idea to compare our ROIC to other companies’, and ours was high -- even higher than companies
in other industries that had earnings multiples twice ours.”
“We began selling this story to Wall Street,” he continued, “and were extremely successful at it. But a
couple things really bothered me about how we sold it. Internally, we measured it on average working
capital throughout the quarter, but to the outside, we only reported working capital once a quarter.”
This fine point seemingly opened the door to the alleged manipulations of working capital that came
later.
Once Dell established ROIC as an important measure of its business, it was under pressure to show
constant improvement ROIC to satisfy investors. “You become a slave to what you did last quarter or
the same quarter a year ago,” said the former finance executive. “For a time, we could rely on
genuine, large improvements in our working capital management. But as our efficiency improved, it
got harder and harder to show incremental improvements, so that’s when the games began. Initially,
it was small, but grew larger and larger over time.”
My other source confirms this. “Dell has increasingly gone after getting the ‘cash/cash flow’ they show
at the end of the quarter,” he said. “Due to flattening earnings recently, large manipulations in working
capital management are necessary -- holding more and more days of vendor payments at quarter
end and an unnatural emptying on Dell’s part of the supply chain -- just to keep the working capital
portion of the balance sheet from being a cash drain.”
“Let me reiterate that I think Dell is a great company that has evolved as many great American
companies have,” he continued, “with executives increasingly focused on the reporting, forecasting,
and delivering to the quarterly focused investment community. I think that a certain bit of financial
statement ‘pumpery’ is just a fact of life with American companies -- but I do think when it starts to
impact the basic functioning of the company -- and extends a myth (i.e., 891% ROIC reported in the
first quarter of the current fiscal year) -- that it’s gone too far.”
How widespread is financial statement gaming?
I’ve spoken about the issues raised here with a range of knowledgeable people -- investors, corporate
attorneys, and so on -- and a number of them asked, “What’s the big deal? Nearly all companies try
to spruce up their numbers at the end of a quarter.” Warren Buffett agrees. In his 1998 annual letter
to Berkshire Hathaway (NYSE: BRK.A) shareholders, he wrote: “In recent years, probity has eroded.
Many major corporations still play things straight, but a significant and growing number of otherwise
high-grade managers ... have come to the view that it’s okay to manipulate earnings to satisfy what
they believe are Wall Street’s desires.”
Buffett returned to the topic in his 2000 annual letter, in which he wrote: “Over the years… I have
observed many instances in which CEOs engaged in uneconomic operating maneuvers so that they
could meet earnings targets they had announced. Worse still, after exhausting all that operating
acrobatics would do, they sometimes played a wide variety of accounting games to ‘make the
numbers.’ These accounting shenanigans have a way of snowballing… [which] can turn fudging into
fraud.”
I, too, have no doubt that financial manipulations are pervasive, and more serious than a little
“housecleaning.” I think many investors are being misled to a material degree, and when this
eventually becomes known -- as it sometimes does -- it undermines investors’ confidence in our
capital markets.
I believe the greatest threat comes from the legal bending of the rules, which is what my sources say
Dell is doing. Outright fraud, while highly publicized, is far more rare.
Why is this happening?
Why are companies engaging in accounting games, given the enormous potential costs? The case of
Waste Management, which overstated earnings by $1.4 billion in the 1990s, is illustrative.
Management’s troubles began with a few little white lies, which the company’s auditors, Arthur
Andersen, were apparently willing to overlook because they were not “material.” But then, to maintain
the fiction, bigger and bigger lies were necessary that eventually led to massive fraud.
It’s easy to see how even good people can get on a slippery slope that leads to destructive behavior.
As Terry Hatchett, Arthur Andersen’s managing partner for North America, noted last year, “the
pressures on management to meet expectations are greater than ever in a market where information
and capital move instantaneously.”
Buffett, in his 1998 letter, wrote about these pressures: “Many CEOs think this kind of manipulation
[of earnings] is not only okay, but actually their duty. These managers start with the assumption, all
too common, that their job at all times is to encourage the highest stock price possible (a premise with
which we adamantly disagree). To pump the price, they strive, admirably, for operational excellence.
But when operations don’t produce the result hoped for, these CEOs resort to unadmirable
accounting stratagems. These either manufacture the desired ‘earnings’ or set the stage for them in
the future.”
“Rationalizing this behavior,” he continued, “these managers often say that their shareholders will be
hurt if their currency for doing deals -- that is, their stock -- is not fully-priced, and they also argue that
in using accounting shenanigans to get the figures they want, they are only doing what everybody
else does. Once such an everybody’s-doing-it attitude takes hold, ethical misgivings vanish. Call this
behavior Son of Gresham: Bad accounting drives out good.”
What can be done?
There are two general strategies for reducing undesirable behavior: Set up mechanisms to prevent it
from happening or, failing that, expose and punish it so others in the future will think twice before
proceeding themselves.
Using this framework, what might be done to discourage companies from playing accounting games?
One idea is to put more pressure on the auditors, who often face terrible conflicts when they, for
example, are selling consulting services to the same companies they’re auditing.
To its credit, the SEC is taking steps in the right direction, as in the case of Waste Management, in
which Arthur Andersen agreed to pay a $7 million fine, and suffered the humiliation of having its
employees’ dishonest behavior appear on the front page of major newspapers. (The employees
involved also paid fines and were sanctioned.) “Arthur Andersen and its partners failed to stand up to
company management,” said SEC Enforcement Division Director Richard Walker in a recent
statement, “and thereby betrayed their ultimate allegiance to Waste Management’s shareholders and
the investing public.” This is the type of action I hope will send a powerful signal to all auditors in the
future.
Even more so than auditors, company insiders, such as those from Dell who spoke with me, are the
best positioned to know of and expose financial games -- ranging from fraud in the case of Waste
Management to Dell’s managing of its business to show the best numbers possible.
Finally, here’s an interesting idea from the former Dell procurement executive: Require companies to
release financial statements more frequently -- perhaps monthly -- which would make it much harder
to manipulate them. “Companies prepare financials every month,” he said, “so why don’t they just
release them to the public?” This idea isn’t as radical as it may sound: Retailers report same-store
sales monthly -- in fact, Wal-Mart (NYSE: WMT) releases some sales data weekly -- and auto insurer
Progressive (NYSE: PGR) recently began reporting underwriting results monthly.
Eliminating all financial games isn’t likely to happen, but it’s critical to begin taking stronger measures
to halt and reverse current trends.
Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC [now T2 Partners LLC], a New
York City-based money management firm. He did not hold any position in Dell at press time, though
he has owned the stock in the past. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com.
To read his other writings, visit www.tilsonfunds.com/.