Archive for May, 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.

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 net cash at over 37% of market value with an enterprise value (market cap minus net cash and investments) 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 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.*

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 it turns out the company eventually ends up resuming a growth trajectory post-transition after shrinking only modestly during the 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 many reasons why the aggressive buyback scenario will likely not happen in the real world** and is not even a wise thing to do. It temporarily makes the balance sheet more dangerous (and makes the company less flexible/resilient under economic stress). It could also end up preventing important strategic investments from happening.

So a more balanced capital allocation approach likely makes more sense.

Yet this still can be a useful exercise when attempting to find investments with a margin of safety.

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 and earning power stays near current levels.
(Or, at least, over that time he could reduce debt to a more conservative level while rebuilding a portion of the cash on the balance sheet that was used to buyback stock.)

Still, until repaired with future free cash flow, for a time the buyback would make the balance sheet much less conservative. This more aggressive balance sheet 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 is some risk to such a move. 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 owning the stock.

I’ll follow this up with some more thoughts in a separate post.

Adam

Established a long position in DELL slightly above the current price and intend to add if there’s a further decline.

* $ 17.2 billion of cash and investments plus $ 1.8 billion of the $ 3.4 billion the company is expected to earn could buy all the shares not owned by Michael Dell at the current price leaving $ 1.6 billion of cash on the balance sheet after a year. So net debt could be ~ $ 7.4 billion ($ 9 billion minus the $ 1.6 billion)
** 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. Also, Dell earns a substantial percentage of profits from outside the United States. So there are real tax issues related to repatriation of the cash.

I do not make stock recommendations as that comes down to individual circumstances. The site is for informational and educational use and opinions found here should not be treated as investment advice. 



Tags: ,

Wednesday, May 30th, 2012 Investments No Comments