Dell Inc: Not So Fast Mr. Dell

There is a good live case study at csinvesting on the Dell Inc. (NASDAQ:DELL) private buyout being led by the founder Michael Dell and private equity firm Silver Lake Partners.

The big question is whether the consortium’s bid of $24.4 billion or $13.65 per share for Dell is fair.  Using the Value Line information supplied by csinvesting, I will value Dell using the back of the envelope calculations of free cash flow yield.   I typically define free cash flow (FCF) as operating cash flow less capital expenditures. However, for this valuation I will use Value Line’s “cash flow” per share as a proxy for FCF.  Value Line defines cash flow as earnings per share plus depreciation and amortization per share.  Using this definition of cash flow is not my preferred method but it will work for a back of the envelope calculation.

About what is Dell worth?

I would require a 10% cash flow yield on my investment.  Using single point valuations, this would estimate the intrinsic value of Dell at $16.70 per share in 2008 and $25.10 per share in 2011.  This assumes no growth in the cash flow for the company.  If 3% annualized growth is assumed, then the 2008 value would be $23.90 per share and the 2011 value would be $35.90.  Using the average and median cash flow per share from 2007 to 2011 as normalized cash flow, the intrinsic value comes in at $17.30 to $17.90 per share.

I can get to a higher intrinsic value if I assume 3% cash flow growth into perpetuity but I have a hard time justifying that.  Dell’s cash flow has been pretty lumpy and stagnant since 2007 and the future of PC sales is looking overly mature for much growth so I would be reluctant to bake growth into my valuation without more investigation on the future of the company’s other business segments.

Are the valuations in the Barron’s article valid?

The Saturday, February 9, 2013 Barron’s article The Dell Deal May Die mentions that Southeastern Asset Management believes Dell is worth $24 a share while Pzena Investment Management believes the shares are worth $25 each.  Using the back of the envelope valuation, it appears that both managers are baking some growth into their valuations.  If I assume 3% cash flow growth I arrive at an intrinsic value estimate of $24.70 to $25.60 per share.  These valuations are valid if you believe the company can grow cash flow and you don’t need to apply a larger discount to the valuation due to poor stewardship by management.

Barron’s presents a chart for the Dell buyout showing the initial equity and new debt versus five years later.  The annualized return on the equity would be 29% assuming all the debt is extinguished in five years.  With $5.2 billion in cash on the books, assuming normalized earnings to be the median cash flow per share of $1.73 and there is no growth in the cash flow over the next five years, it looks like Dell will have generated enough cash flow to pretty much pay off all the debt in five years.

Barron’s expected annualized return might be pushing it a bit but if we assume only ¾ of the debt is paid off in five years, the annualized return only falls to 24%.  The valuations in the Barron’s article are much more valid than the consortium’s bid.

Does growth have value?

Absolutely, growth can have value.  Sustainable and predictable growth has more value than transitory and speculative growth.  Growth for growth’s sake or growth that doesn’t provide a return greater than the cost of capital can decrease the value of a company.

What aspects of Southeastern Asset Management’s letter put heat on Michael Dell?

Southeastern Asset Management, the advisor to the well-regarded Longleaf Partners Funds, responded to Dell’s proposed go-private transaction in a letter stating they would oppose the transaction.  As the largest outside holder of Dell’s shares with an 8.5% stake in the company, Southeastern has a lot at stake.  They clearly articulate a rational valuation to Dell shares.  Through a sum of parts valuation, they arrive at a value of $23.72 a share.  Southeastern puts the most heat on Michael Dell when they highlight that Dell has spent $13.7 billion or $7.58 per share on acquisitions since 2007.  The well phrased throw down is pretty damning after I think about it.

In addition, since Michael Dell resumed his role as CEO in 2007, the Company has spent $13.7 billion or $7.58 per share on acquisitions intended to transform the Company into a sustainable IT business and lessen its reliance on the PC business. During Dell’s June 2012 analyst day, Dell Chief Financial Officer Brian Gladden said that in aggregate the acquisitions to that point had delivered a 15% internal rate of return. The Company has neither taken nor discussed the need to take any write downs of these acquisitions. We therefore conservatively believe the acquisitions are worth a minimum of their cost. Taken together, these items total $12.94 per share before we even look at the other businesses.  The current bid therefore places a value of less than $1.00 per share on the remainder of the Company. By any objective measure, that is woefully inadequate.

So not only has Dell made capital allocation decisions since 2007 equal to over half the buyout offer, money that could be returned to shareholders, but the acquisitions are returning a 15% internal rate of return.  The acquisitions are doing well and it looks like Dell wants to buy the future profits for a song.

What in Michael Dell’s prior history makes you perhaps not surprised by his current actions?

As nicely illustrated in the recent New York Times article Dell’s Up and Downs with Options, Dell has a long history of buying back stock in order to prevent dilution from issuing stock options to executives.  Amazingly, over the life of Dell, the company has spent $39.7 billion buying back overpriced stock.  The current market cap is approximately $22 billion.  The amount of money spent buying back stock is nearly twice the current market cap!  This is astonishingly bad capital allocation.  Michael Dell has profited handsomely by fleecing his shareholders over the years with handsome stock option grants.  Now that stock options are more properly accounted for, he is using a different but more visible tactic, lowballing the price of the company to take it private and leave shareholders out in the cold.

Should Dell offer to do a tender offer?

If Dell stock is undervalued at $13.65 as it certainly appears to be based on my back of the envelope calculation and Southeastern and Pzena’s valuations, a tender offer that allows for stub stock to trade so remaining holders can participate in the future cash flows of the company would be one of the best courses of action.  Company buybacks below the intrinsic value of the stock adds value to the intrinsic value of the remaining outstanding shares.  This would be a good capital allocation decision, something Dell has little history with.

Dell looks like a classic value trap.  By the numbers, Dell looks cheap.  How can you avoid a value trap like this?  One way is to use qualitative factors in addition to quantitative factors such as low P/E, P/B ratios and valuation.  While cash flow trends look robust enough for the company to comfortably transition its product mix from the PC business to more sustainable IT products and services, management motivations and incentives have to be brought into the equation.  An analysis of the capital allocation history of management would provide good insight.

If the price collapsed to $9 or $10 based on the deal being pulled what would you do?

While a $9 or $10  purchase price looks very attractive to my rough $17.30 to $17.90 intrinsic value estimate and extremely attractive to Southeastern’s $24, I would be reluctant to buy the stock without identifying a catalyst for closing the price to value gap.  If more activist investors got involved, I would be more interested if it meant I’d have to wait for the activists and buy the stock at $11 or $12.

Disclosure:  No position in DELL

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2 Responses to Dell Inc: Not So Fast Mr. Dell

  1. George Pica says:

    I’d love to see how you get to a $16.90 intrinsic value. The problem is that PC sales are in a secular decline. Even when the economy is back on a normal course, PC sales will continue to decline. Perhaps Dell will be able to adapt but the combination of execution risk combined with management’s dismal capital allocation history make it a poor investment.

  2. JW says:

    Very interesting commentary. I put the intrinsic value at $16.90.

    Dell is still a powerhouse in the corporate environment. Maybe they just need to ride out the rest of the recession?

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