Monday, June 4, 2012

Dell's Valuation - Part II

A follow up to this previous post. I'm not a big fan of Dell's (DELL) business though I do happen to own a very small number of the company's shares.*

Dell's Valuation

In this follow up, let's take a look at Dell to further explore margin of safety**, an all-important subject in investing.

At the recent market price, Michael Dell owns a bit under $ 3 billion of the stock. At his current level of share ownership, the proportion of Dell's earnings attributable to the shares he owns sits at just under $ 500 million. In the previous post I noted...

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

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

If that likely rather impractical scenario (impractical and probably not even wise for reasons noted in the other post) but still useful to consider (useful as a way to gauge the margin of safety) actually played out, Mr. Dell would have increased his proportion of the earnings from the current level of $ ~ 500 million to, well, all of it.
(Currently $ 3.4 billion but likely lower in the near future.)

The company's balance sheet cash/investments and much less than a year of free cash flow is all that's being used to accomplish this. Michael Dell doesn't personally have to write a single check though, of course, he is a partial owner of the earnings and cash being used.

Under the above scenario, Michael Dell currently with just under a $ 3 billion investment in the stock (as currently valued by the market), ends up owning the entire business and all the earnings that are produced by it.
(Mr. Dell himself buys no incremental shares but the shares he already owns become the only that are outstanding upon completion of the buyback. So he will not have had to personally buy a single additional share of stock, ends up owning the whole company, and it could all happen in a relatively short amount of time. As I mentioned in the prior post, there'd still be the debt to service or to be paid down in future years.)

Now, let's assume earnings (backed by solid free cash flow while all the necessary capital expenditures get made) decline at a rate of 10% every year for the next ten years. How much excess cash alone will be produced by the business even if it is just stuffed under some mattress (i.e. not reinvested in anything that would produce even greater returns on the capital)?

~ $ 22 billion

At that rate of decline in earnings, Dell would still be generating over $ 1 billion in earnings/year in ten years all of which goes to the benefit of him as the sole owner from that point forward. Even if that $ 1 billion/year continues to decline the cash flow compared to the investment produces a very nice return.

Once again, all that cash goes to Michael Dell as THE owner for his investment that the market is now valuing at a little less than $ 3 billion.
(A really brutal drop is what's needed to justify the recent price...not merely 10 percent per year over time. As always, the value of a business is the cash it has or will produce for shareholders over time, discounted appropriately.)

The same math (in proportion to shares owned naturally) would also apply to other long-term shareholders who buy near the current price and do not sell.

Something worth considering:

A company can be taken private/be acquired below intrinsic value. It's a sometimes ignored but real potential risk factor for an investor. Let's say a stock is bought by an investor comfortably below likely per share intrinsic value (not a precise number, of course). It then continues to drop in market price due to serious but manageable near-term challenges. Then the company is bought out well above the recent market prices, but below a reasonable if rough estimate of intrinsic value. Nothing worse than correctly assessing the approximate per share value of a business and its future potential only to see it bought at a price that doesn't reflect that value. That's why investing alongside as many long-term value-oriented co-owners as possible and reasonably sound governance matters.

Think of it this way. If it were actually small enough to acquire, the owners of Berkshire Hathaway (BRK-a) would be unlikely to let the company be bought below what it's worth. The kind of board they have and the long-term oriented owners pretty much assures that.

A company that has lots of short-term oriented shareholders and/or a board not focused on long-term value creation effects may not be so concerned about outcomes (for the less influential owners) beyond a successful trade/quick sale. That's especially true if there are some difficult to solve near-term business challenges. The offer may be nicely above the recent market price yet not fully reflect current intrinsic value and longer term potential value.
(There are obviously many reasons Berkshire is far from an ideal target but it's a good example of sound governance with lots of long-term oriented owners.)

If Dell were taken private, the continuing shareholders beyond that event (possibly some with meaningful percent ownership of the public company now) may still have their eye on the longer term and could benefit down the road. Yet it won't matter (or be enriching) for the public shareholders who had to sell when the company went private.

Beyond that, as is always the case, another risk is that resources will be squandered in some way. At the very least, considering his substantial ownership, any dumb moves as far as capital allocation goes would hurt Michael Dell himself in a meaningful way.

If earnings decline steadily but not catastrophically, there is some fairly simple arithmetic at work here. Of course, Dell may actually see a much greater drop in earnings than just 10 percent per year.

It all comes down to what someone thinks the trajectory of Dell's earnings stream will be.

Again, Dell as a business may not have the kind of compelling "story" to tell but eventually the price relative to prospects (even not so great ones) is what counts in the long run.

This may not seem unlike the idea of Selling Wal-Mart Back to the Walton Family, but one big difference is that Wal-Mart has a substantial economic moat in my view. For me, gauging Dell's longer run prospects is extremely difficult. The result being it needs to have a much more substantial margin of safety to become a really interesting investment.

Of course, Wal-Mart does not and has not sold near a valuation like Dell's either.

Also, what if (and I covered this to an extent in the prior post) after shrinking somewhat, it turns out the company eventually ends up resuming a modest or better growth trajectory post-transition? What if, post-transition, Dell emerges a decent return on capital business and some kind of an economic moat is built?

Nothing like that seems likely now. Yet, if something even close to that happens over the long haul, it'd be quite an understatement to say those that remained long-term investors will have done just fine.

If an asset can be bought when a not great scenario produces a nice return, every now and then a slightly better than not great scenario may even end up playing out.

In the prior post, I said:

...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.

Another real issue is the amount of acquisitions they need to do to remain competitive. If all or much of the free cash flow is being used to buy businesses (especially if they overpay) in order to sustain free cash flow, then the long run economics will likely end up being far from attractive. This is something that will be crucial to watch for long-term investors.

Otherwise, at the current price and considering its balance sheet, using Dell's lack of exciting business prospects and some of its very real challenges as an argument against it isn't enough. Something more extremely negative has to be in the cards.

If Dell's capital is, in general, intelligently allocated and earnings doesn't fall off a cliff not much has to go right.

Basically, something fairly economically devastating has to be in front of the business for the recent price to make sense.

I think there's plenty of risks to Dell's core businesses and there are many of investments out there with far more certain and predictable prospects. For that reason alone, I still think it's generally best to not own Dell in a world where the shares of many other superior businesses are available at attractive valuations. 
(I also may be underestimating Dell, of course.) 

Yes, there appears to be a substantial margin of safety but, lacking an obvious moat, still lots that could go wrong.

I do own a small number of shares but still think, for the most part, Dell's stock is barely worth the bother considering alternatives. The margin of safety may appear large, but I certainly will not be surprised if owners of the stock first end up enduring much suffering while the business challenges are being sorted out. Most will, understandably, not want to endure that kind of just awful price action. There are simpler ways to invest with a narrower range of outcomes.

Besides, this is not really meant to be so much about Dell specifically. It's just a convenient example. As I've said before, I generally don't like tech stocks as long-term investments.

This kind of margin of safety exercise can be a useful way to better understand the downside risk.
(The chance for permanent capital loss...not lousy stock price action.)

When an investor concludes a particular stock is attractive (understands the business sufficiently well based upon facts and reasoning), an exercise like this, or one of many other variations, may help to more objectively gauge how much downside protection against permanent capital loss there really is.

"You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right." - Benjamin Graham

An investor, with a high level of conviction that the margin of safety is sufficient, is more likely to hang in there when the price inevitably drops further. I like to keep the approach as simple yet meaningful as possible. There's no formula.

Also, the more compelling the "story" is for an equity investment, the more I make sure to ignore that story when in the process of gauging the downside. A great sounding story can cloud objective reasoning. When something has a great narrative, it's easy to make the mistake of expending too much energy confirming the potential upside (confirmation bias). Yet, confirming that the price being paid really protects against unexpected (unknowable) future outcomes and permanent capital loss deserves at least as much (if not more) attention.

Until I understand the risks and potential of an investment at some level of depth, I never buy it no matter how compelling the story sounds and do my best to ignore what others think or say about it.

Adam

Small long position in Dell

Related posts:
Dell's Valuation
Technology Stocks

* My 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 possible 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)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.

** Dell is in a tough business though I wouldn't bet against it eventually being sorted out. The transition, if it works out, will surely take quite a bit of patience. I wrote this mostly to explore one way of looking at margin of safety, not the specific merits of Dell as an investment. The quality of Dell's prospects seem hard to gauge at best compared to alternatives. There are many superior business franchises out there. I won't be surprised at all if the stock does quite poorly in the short-term or even much longer. I'm guessing what seems cheap just gets even cheaper before this is all sorted out between the long-term investors (concerned with what the business can produce over time) and those more interested in betting on near-term price action.
*** Naturally, if the stock keeps dropping it would take even less money. (With this in mind: Why would any investor with true longer term horizon prefer the shares of a business they like to go up in the short run?)
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.
 
Site Meter