Plain sight is usually not the place to hunt for investment bargains but when Dell popped up on one of my screens I was intrigued. Digging a little deeper, it seemed the company was indeed a cash-generating machine that had fallen out of favor with Wall St, making it statistically cheap:
|EBIDTA / EV||3.05|
|Debt / Equity||103%|
The question for us prospective investors is whether Mr. Market’s pessimism is overdone?
Why Is It Cheap (Negatives)
Most people, myself included, think of Dell as a personal computer retailer and manufacturer. In fact, only about 20% of revenue and 7% of operating income derives from it’s consumer products business. The remaining 80% of revenue and 93% of operating income comes from their enterprise, small business, and public segments.
Both businesses have been under pressure; the shift from PC’s to tablets and other mobile devices has put a hurting on revenue and margins in the consumer division. Segments that service larger public and private institutions have been impacted by budget constraints and a reduction in discretionary spending.
Once a leader in discount PC retailing, Dell has lagged rivals such as Lenovo and Acer in offering quality alternatives to basically anyone who isn’t buying an Apple. I realize I am not a typical American consumer, but you don’t have to be Steve Jobs to see Dell’s computers are ugly and boring. The business is bleeding; last quarter had the dubious distinction of being the first unprofitable quarter for the consumer segment. I am ready to declare that part of the company dead.
The decline and fall of Dell as a retailer makes for good copy, and has undoubtedly had a disproportionately large impact on the stock; but the unfortunate reality is that Dell has been underperforming in its larger segments as well. In Q3 both revenue and profitability were down significantly on a YoY and sequential basis almost across the board.
The fate of these other operating businesses will determine the future of the company. Later I’ll address the competitive outlook and take stab at prognosticating what the future holds.
Dangerous Liaisons (Acquisitions)
Though it has not had a distinguishable impact on the stock, another big question mark – especially in light of what has happened at HP – is Dell’s all-cash purchase of Quest Software completed in November of this year. I thought the best way to ensure Dell hadn’t fallen victim to the same kind of fraud HP did would be to apply some of the accounting scrutiny John Hampton did to Autonomy to Quest.
Below is what Hempton wrote in a recent blog post about Autonomy’s dubious accounting following the incident:
(Autonomy) Sales were $870 million.
Receivables were $330 million – which is four and a half months of receivables.
Deferred revenue is $177 million – just over half of receivables.
This is really perverse for a software company. Software companies sell stuff that is barely tangible – they sell it up front and for cash. They have very few receivables.
They do however have an obligation to service that software for a long time after they sell it – so the unearned income is relatively large (usually a multiple of receivables).
Autonomy was booking as income lots of cash it had not received (which is why the receivables were large) and not booking any obligation to provide future services for that income.
This is prima-facie suspect (and you could tell simply by looking at the balance sheet). All it required was basic applied accounting.
And here is what Quest looked like at the time of Acquisition:
Quest’s receivables appear to be significantly lower as a percentage of both revenue and deferred revenue than Autonomy’s were. Based solely on this metric it doesn’t appear that whatever funny business occurred at Quest was also happening at Autonomy.
Another reason I think it less likely that Dell would fall victim to such a scheme is Mr. Dell having such a large ownership stake in the company. Whether or not the acquisition will provide worthwhile is another question entirely.
Dell & Taxes
Varying from 17.65 to 29.20 and averaging 23% since 2006, Dell has managed to pay an effective tax-rate well below the statutory 35%. In their most recent 10-k they make the following disclosure that makes it seem like the proverbial tax holiday may soon be at an end. (Emphasis Mine)
“Income and Other Taxes
Our effective tax rate was 17.6%, 21.3%, and 29.2% for Fiscal 2012, Fiscal 2011, and Fiscal 2010, respectively. The decrease in our effective income tax rate for Fiscal 2012 as compared to Fiscal 2011 was primarily due to an increase in the proportion of taxable income attributable to lower tax jurisdictions. Our effective tax rate can fluctuate depending on the geographic distribution of our world-wide earnings, as our foreign earnings are generally taxed at lower rates than in the U.S. In certain jurisdictions, our tax rate is significantly less than the applicable statutory rate as a result of tax holidays. The majority of our foreign income that is subject to these tax holidays and lower tax rates is attributable to Singapore, China, and Malaysia. Our significant tax holidays expire in whole or in part during Fiscal 2016 through 2021. The differences between our effective tax rate and the U.S. federal statutory rate of 35% principally resulted from the geographical distribution of taxable income discussed above and permanent differences between the book and tax treatment of certain items. We continue to assess our business model and its impact in various taxing jurisdictions.”
Combine this with the tax discussions around the fiscal situation in Washington and it seems likely Dell will be paying more in taxes in the future.
This is not vital for assessing the short-term outlook for the company but it is definitely something to take into consideration when employing a DCF valuation. Which is to say that whatever terminal margin we assume should use an assumption of a tax rate closer to the U.S. statutory rate.
Strong Ownership (The Positives)
Since founding the company circa 1985, Mr. Dell had been CEO until 2004, when he stepped down to let then COO Kevin Rollins takeover the job. Almost immediately the company went into a tail-spin (whether or not this is Mr. Rollins fault is debatable). By 2007 Mr. Rollins had resigned and Mr. Dell resumed the role of CEO and chairman of the board.
When we look at what’s happened to HP it becomes painfully obvious how important it is to have someone who cares at the helm. Especially when the company is undergoing a transition, the temptation to make “strategic” acquisitions just to be seen as doing something can be huge.
Through a combination of share repurchases and stock based compensation Mr. Dell has come to own roughly 15% of the outstanding shares, up from 11% in 2006. This makes him the company’s largest shareholder, far surpassing the largest institutional owner.
Now, is Mr. Dell a great businessman? I don’t know. He may just be a smart guy that was in the right place at the right time but that is good enough for me; he’s smart and he cares about the future of Dell. What more can you ask for in this day and age?
A Commitment to Returning Cash to Shareholders
According to Hedgefundletters.com, the analysts at Baupost concern themselves not only with the intrinsic value of an asset but also what catalysts might be expected to bring it back to fair value. In the case of Dell, the most obvious of the latter has to be the company’s commitment to returning at least a quarter of the firms free-cash-flow to shareholders in the form of dividends or share-repurchases:
SHANNON CROSS: Okay. And then, as a follow-up, I’m curious, from a capital structure perspective, or at least from a use of cash perspective, given that stock is under-pressure after hours, obviously it’s been under pressure for quite a while, is there any thought to being more aggressive with share repurchase at these levels, or how are you thinking about the cash balance that you’re holding given some of the changes, I guess, that have occurred in the marketplace?
BRIAN GLADDEN: Yes, Shannon, I would just reiterate what we said this summer, that we’re committed to deliver between 20 and 35 percent of our free cash flow to shareholders. We’re going to be pretty disciplined about that. We’re over that on a year-to-date basis and on a trailing 12-month basis. As you know, we did a substantial amount of acquisitions this year, $4.7 billion, and we’re going to continue to manage to that in a disciplined way.
Source: Dell Q3 Earnings Call Transcript
Assuming, and this is a big assumption, that the cash flow is there – this is huge. If Mr. Dell and management can be disciplined with acquisitions and maintain the business at close to its historical FCF yields, the market won’t be able to ignore the value for long.
I used a DCF calculation in trying to approximate a value for Dell. Assigning weights to three scenarios roughly corresponding to bear, median and optimistic outcomes for the company I arrived at the below valuations, depending on which discount rate was used.
Even using relatively stringent criteria in terms of assumptions and discount rates Dell seems undervalued.
I place this section last because I feel in Dell’s case it is the most important. DCF valuation is all well and good but it has serious limitations. Understanding the competitive forces the company will have to contend with is definitely more important than being able to estimate the right discount rate or terminal NOPAT margin.
As the consumer electronics market has become more bifurcated, companies like HP and DELL increasingly are looking to the enterprise solutions market to generate both profits and growth going forward. New entrants will increase competition, keeping margins and market share under pressure. Luckily these firms are not offering pure commodity products. Reputation for service and reliability cannot but play an important role in how a business chooses their technological solutions. Therefore Dell’s reputation as a leader in the PC market has and will continue to help it win converts as it enters new lines of business.
On the other hand, Dell’s failure to keep share in the consumer market makes me wonder just how well we can expect the company to perform in its new endeavors against more seasoned competition.
For me it’s a tough call, and I think my scenario weights in the valuation above reflect that.
I want to like this company; it generates free-cash-flow, it has strong ownership, and has made a commitment to returning cash to shareholders. But it is it a value investment? No. Not in the sense of Graham, Buffet or Munger, at least not for me. The reason being that I don’t have a strong grasp of the company’s product offerings and its context in the industry. What I’m missing is the perspective of a Dell enterprise customer to assure me that the enterprise Dell is not the consumer Dell of 2005.
With that said, there are good reasons to like Dell, and I wouldn’t blame anyone for putting it into a diversified equity portfolio but neither would I feel comfortable betting the ranch.
Disclosure: Long DellFULL POST