Tuesday, May 29, 2012

Dell's Valuation

Clearly, there are businesses with better stories to tell than Dell (DELL) these days.

The company is going through a tough transition and those convinced it won't work out are probably smart to stay away. Dell's economic moat seems anywhere from extremely small to non-existent. As I've said previously, my bias is against tech stocks as long-term investments even if I do happen to own a small number of Dell shares.*

Having said that, let's look at some numbers.

Based upon Dell's closing price, its market value sits at $ 22.1 billion.

Cash and investments is $ 17.2 billion.

Short-term and long-term debt equals $ 9.0 billion.

That puts Dell's net cash at over 37% of market value and puts the company's enterprise value (market cap minus net cash and investments) at just under ~$ 14 billion.

Even after the recent "disappointing" quarterly results (and they certainly were not great), Dell is currently expected to earn close to $ 2/share or more than $ 3.4 billion. Time will tell if that's optimistic but Dell doesn't need to earn anywhere near that much at its current valuation.

The question isn't whether it can earn a little less than $ 2/share or something close to that number.

The question is whether the business is in some kind of hard to stop tailspin.

If it isn't, we have a bit of a disconnect here.

Now, the amount of money needed to buy back all the shares outstanding NOT owned by Michael Dell near the current market price turns out to be ~ $ 19 billion.

So that means in a bit more than half a year, all the shares not owned by Mr. Dell could be bought back using the cash and investments on the balance sheet plus the company's earnings.**

While the company will still have the above $ 9 billion of debt to service, the interest costs on that debt would continue to be small fraction compared to current earnings.
(Even if earnings shrank more than a bit and continued to disappoint for some time, it easily covers the interest expense.)

Otherwise, just as a too high price eventually trumps the most wonderful business story, a low price (compared to a conservative estimate of value) also eventually trumps an ugly story.

Besides, what if, after shrinking somewhat, it turns out the company eventually ends up resuming a growth trajectory post-transition?

If a price is paid where nothing good has to happen to make a nice return, then I doubt long-term investors will complain much if something unexpectedly good ends up occurring.

There are reasons why the aggressive buyback scenario will likely not happen in the real world and is not even a wise thing to do.***

Until repaired with future free cash flow, the buyback would make the balance sheet much less conservative (and uncomfortably leveraged for a tech business with little or no moat facing rapid change). This would temporarily make the company less flexible/resilient under economic stress and may even prevent important strategic investments from happening.

It also may lead to more expensive borrowing costs and more difficulty getting financing when it comes time to roll over the outstanding debt (especially if a crisis hit at just the wrong time).

So there's plenty of risk to such a move. A more balanced capital allocation approach almost certainly makes more sense.

Yet, the even bigger risk is a catastrophic drop in earnings power instead of an earnings trajectory that's on a more gentle downward slope.

Those who think that's going to happen obviously have a legit argument against the stock's current valuation.

The fact is that, within three years, Michael Dell could not only own all the shares outstanding of the entire company but have it debt free if the stock price and earnings power stays near current levels (whether earnings will remain persistent does seem at least doubtful at this point). Alternatively, he could reduce debt to more conservative levels, rebuild cash on the balance sheet, while still making strategic acquisitions and other investments over that time frame.

It's a useful exercise but that doesn't mean Dell is a wise investment. Though I do own a small number of shares, the stock is just barely worth the bother considering alternatives. While it sells for a low multiple of earnings, a very large margin of safety is needed due to the wide range of possible outcomes.

Basically, I won't be surprised if those who own the stock first end up enduring much suffering while the business challenges are being sorted out over time. What seems cheap will probably just get cheaper in the near-term or even longer. I'm willing to look past the awful price action (with eye toward possible attractive longer run outcomes) but it will always be a very small position in the portfolio considering the specific risks.

I'll follow-up with some more thoughts on Dell in a separate post.

Adam

Small long position in Dell

Related posts:
Dell's Valuation - Part II (follow-up post)
Technology Stocks (prior post)

My current position in Dell is a small one and far from a favorite. Unlike the stocks I favor the most (those that have wide moats/less dynamic competitive environments), Dell's shares will always remain, at most, a very small position that's accumulated slowly as the price declines. A much larger than typical margin of safety is needed. As I said in this post and others, there's just no technology company that I'm comfortable with as a long-term investment. That doesn't make owning shares of Dell a short-term trade. A situation this challenging is unlikely to be resolved quickly. I rarely buy anything -- and that includes Dell -- unless I'm willing to own the shares for several years or even longer (though frequent traders likely consider several years to be long-term). When I say long-term, I mean that shares of good businesses (bought initially at a fair price or better) can often be held indefinitely. That's just not the case with most tech stocks. So owning some Dell shares fits a very different investing model than what I traditionally favor. (Long-term favorites are in the Six Stock Portfolio and Stocks to Watch. The stocks listed in those two posts are mostly core long-term positions. I generally buy more shares of these if and when they sell at a discount to my judgment of value. Unfortunately, most are not all that cheap these days.) As always, I never have an opinion on what a stock will do in any time frame less than a few years. I'll let others try to figure out short or even intermediate run price action though I won't be surprised if Dell's shares drop substantially from here and remain lower for quite some time. My focus is risk-adjusted returns over longer time frames. As I've said in other posts, it's actually beneficial when the stock price of a sound business franchise drops further for continuing long-term shareholders. Less money is required to buy each additional share over time while each buyback dollar goes further. The same amount of intrinsic value, whatever it happens to be, is bought for less. Of course, intrinsic value must be judged well and that's far from easy to do with Dell. The question is always what the core economics of a business will be over the long haul. Well, the company has -- to say the least -- difficult competitive threats. So whether it is a sound business franchise is reasonably in doubt. That's where the very low multiple of earnings and margin of safety comes into play. Time will tell whether it can all be sorted out in a way that generates attractive returns. There's certainly a wide range of outcomes. Those that think Dell's business prospects are on a path to negative free cash flow (or similar undesirable outcomes) are naturally wise to avoid the shares. Otherwise, the valuation is such that Dell's business can actually shrink substantially from here and still deliver shareholders a satisfactory long-term result. 
(i.e. They don't have to become the next IBM: IBM. They need to manage technology shifts, deal with the related operational challenges, enhance competitiveness in key areas, and allocate capital effectively. Dell needs to focus on developing sustainable advantages and avoid the high cost pursuit of growth. It won't be an easy transition.)

There are huge execution risks and smart capital allocation will be crucial (not overpaying for acquisitions, buying back the stock when cheap). There's also the real risk that a buyout occurs below intrinsic value (a subject worth covering in a follow up post at some point). Trying to understand the risks to a business franchise and whether a sufficient discount exists considering those risks is a good use of time and energy. Guessing what the near-term stock price action will be, at least for me, is not. A heavily price action oriented culture may dominate the market environment these days but it's still an option (and in my view wise) to choose to not participate in it.
** $ 17.2 billion of cash and investments plus $ 1.8 billion of the roughly $ 3.4 billion the company is expected to earn (though, of course, it's hardly certain that they will earn that much) could buy all the shares not owned by Michael Dell at the current price. So ,after a full year, that would leave $ 1.6 billion of cash on the balance sheet assuming no other investments happen. Net debt, using these assumptions, would be ~ $ 7.4 billion ($ 9 billion minus the $ 1.6 billion) at that time. Keep in mind that there are acquisitions yet to close that will reduce Dell's cash position and capacity to do this. These numbers are more meant to reveal the company's substantial financial flexibility.
*** First of all, buying back that much stock would almost certainly move the share price up. Also, some cash resides outside the U.S. (though less for Dell than some large cap tech peers), while Dell earns a substantial percentage of profits from outside the United States. So there would be tax issues related to repatriation of the cash.
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