My Take on Dell Case Study

Dell Big

We first spoke here of Dell http://wp.me/p2OaYY-1G2

Dell Case Study

So begins my analysis of Dell. Please be aware that I have been a recent shareholder of Dell, but no longer own shares. These comments should be taken in context of potential self-serving, hindsight bias.  My methods may or may not be applicable to your investing, but I will lay out my assumptions.

First, I look at Dell_VL_2013. I love Value-Line for all the historical information that it packs into one page. However, I use it for a first screen and as a tickler to focus my reading when I go to the proxy and annual reports. Next, I go to the history of Return on total capital (“ROTC”) and ROE. In 2002 Dell had almost a 40% return on total capital averaging close to 50% until the plunge down to 17% in 2009—not unexpected given that computers could be considered a capital good. Use of debt was minimal.

My eye notices that ROTC has not really recovered to the pre-2009 glory days and now averages about 14%, a normal return on assets for an average business. Having read about Dell over the years, I know Dell had a business process advantage. Dell had a lower cost structure in computer assembly and distribution over its competitors. If you go to www.hbs.org you can download dozens of case studies on Dell’s manufacturing advantage. The market and competitors changed. Dell lost its cost advantage RELATIVE to its competitors. Now Dell is a commodity business. The proof lies in the history of its ROTC.

Next, I see sales growth per share about quadrupled from 1996 to 2000 during the Internet boom/bubble before flattening out at a ten-year 5.2% compounded annual growth rate from $35 billion in revenues in 2002 to about say $57 billion estimated in 2012. Wow, a big sales deceleration.

Dell has been buying back shares continually since 2001 both to sop up option issuance and shrink share count. My eyeball says management started shrinking the share count by 900 million shares from 2001 at an average price of $25—almost 90% above Dell’s current $13.65 offer. Dell’s management spent roughly $22.5 billion on share buybacks. The shareholders who remain sit with a current market cap at $24 billion (1.73 billion outstanding shares times $13.7 current share price). The shareholders who sold are the ones who benefited while the long-term and long-suffering shareholders saw the firms capital squandered.

If Dell’s management destroyed capital buying their OWN company, what does that say about their ability to make acquisitions outside their area of expertise going forward? I wonder….?

I jump to Dell’s proxies:2012 Dell Proxy and 2010 Dell Proxy. Michael Dell already owns about 13% of Dell which I don’t begrudge him since he did create the company and develop a better way to assemble and distribute than his competitors, for a time.

But why does he receive a dollop of 500,000 options every year? How does receiving more options incentive him more than his 13% stake and on top of his generous salary?  My prejudice is that Mr. Dell looks out for number one first and shareholders second.  I think Dell comparing itself to Intel in its peer group is absurd. Intel has to spend much more on R&D, for example, than Dell. They are different businesses. Dell’s compensation plan has the makings of fancy consultants. Read more on M. Dell’s compensation: http://www.footnoted.com/perk-city/dells-tale-of-two-proxies/

For a brief history but biased slanthttp://www.motherjones.com/politics/2011/02/michael-dell-outsourcing-jobs-timeline

Dell Michael

Now from Dell’s 2012 Letter to Shareholders Dell Sh Letter 2012:

I’m proud to report we delivered on that promise in fiscal year 2012. We made big investments to expand our portfolio of solutions and capabilities and to build an expert global workforce to deliver them to our millions of customers. By the end of the year, enterprise solutions and services accounted for roughly 50 percent of gross margins—a record result, and great validation that we’re on the right road and delivering the technology solutions our customers need.

I am excited about our future. Information technology is a $3 trillion industry, and we currently have roughly a two-percent share. The opportunity to grow and, more importantly, to help our customers achieve their goals is tremendous. That is—and will always be—our ultimate goal.

That ladies and gentlemen is called the “Chinese Glove Theory.” If I can garner 1% of the Chinese Glove market by getting 1% to 2% of the 2 billion Chinese to wear one glove (like Michael Jackson), we will be rich.  Of course, what edge do I have and/or profits will be made doing that relative to competitors?

Ok, Dell has made big investments to grow but how does Dell have a competitive advantage in any of its businesses? If I can’t answer that question—and I can’t—then Dell’s GROWTH has NO value, zilch, nada, none.   Returning money via dividends and share purchases is good provided the company shrinks itself faster than the decline in its business or does not squander its cash with overpriced acquisitions or share buybacks.

Note the average annual P/E ratio has moved down from the hyper growth 62 P/E in 1999 all the way down to the current 6 or 7 P/E net of cash. High expectations have collapsed to low expectations. Good, I seek low expectations.

Also, note the wisdom of crowds (the market). See the dotted line showing Dell’s share price relative to the market that declines from the end of 2002 to today. Note the decline accelerating while Dell made a high of $42.60 during 2005. The market (like it is doing with Apple today) was and is handicapping Dell’s future prospects. The “market” sensed the change in competitive dynamics occurring in Dell’s business. Respect the market because the onus is on you to be right or contrary to the consensus.

So what is the business worth? 

Post tax “cash flow” is about $1.90 per share.  Capex is estimated at 30 cents per share, but it was 38 cents per share in 2011 and back in 2006 and 2007 almost 40 cents.  I want to err on the side of conservative so I put 40 cents for capex.   $1.90 per share in “cash flow” minus 40 cents leaves me about $1.50 in free cash flow (“FCF”).  For a discount rate with NO GROWTH I use about 11% to 12% because that rate is the average equity return for an average business. Yes the 30 year bond (“risk-free”) rate is 4% but normalized the rate is closer to 6% or 7% and I think historically the equity premium has ranged much higher (go read The Triumph of the Optimists for a history of equity premiums by country).

$1.50 divided by my discount rate of 11.5% leaves $13 per share for the operating business. The excess cash is $11.3 billion in cash minus $5.3 billion in long-term debt or $6 billion in net cash or about $3.50 per share.  But I can’t get my hands on that cash, and taxes would have to be paid to repatriate that cash—I will knock off 25% and use $2.50 to add back to my operating value. I see that total debt is $9 billion so I need to check out the terms of the debt, but I will use $2.5 per share to add to $12. 50 to $13 per share operating business value with no growth of $1.50 per share FCF using a 11% to 12% discount rate.

My back of the envelope value is $15 to $16.5 per share. Now, that value range assumes no growth but also no decline. I am receiving about 4% per year of the $1.50 in free cash flow in dividends and share buybacks. On the other hand, I have Mr. Dell’s high compensation, poor capital allocation record on share buybacks, and “me-first” attitude towards shareholders.

Since growth has no value, I am buying a non-franchise type company. Profitable growth will not bail me out, so I need a 30% to 40% discount for my margin of safety AND I can’t make it more than 2% to 3% of my portfolio. A major position for me is 5% to up to 15%. 30% to 40% discount from $15 to $16 leaves me a buying range of about $9 to $11. I will be conservative and look at $15 as my level of value so $9 to $10.50 will be my range. I bought in Sept. 2012 at about $10.60 and again in November at about $9.15 for an average price of $9.80.

Dell small

Yes, I could be making all this up with hindsight bias, but this is from a simple man.

Upon the announcement of Dell going private, I waited a day and sold at $13.55. Why sell when the minimum value I placed on it was $15 and up to $16 per share?  I am not an arbitrageur. I will leave it to them to make the last nickel or dollars.  The business seems cheap, but I ride with a poor capital operator in a commodity business. I don’t see much future value and perhaps I was TOO AGGRESSIVE in my valuation. My return for investing in Dell is 39% for six months. Good, but it doesn’t factor in my losses for when I buy a “Dell” and all hell breaks loose and I may have to sell at $5 or $7. But I had excess cash, free cash flow, shareholder angst (Pzena and Southeastern) and LOW EXPECTATIONS at my back. My expectations of management and the business were low as well, but perhaps not low enough. Time will tell.

If you read Southeastern’s letter Dell-Board-Letter_by_Longleaf, they place a value of $24 on Dell (Southeastern paid about an average of $25 for Dell’s stock over the past five years (see 13-FH filings).  They mention Dell paying about $12.94 per share at cost for their acquisitions buttressed by Dell’s CFO saying to that point had delivered a 15% internal rate of return.  Perhaps, but I am skeptical that Dell’s acquisitions will generate more than an average rate of return.  What does Dell bring to the party in its acquisitions? Scale? Technology, Patents? Customer captivity? Ironically, if Dell isn’t worth at least $13 per share for those acquisitions, then Dell’s current bid is another nail in the coffin for its reputation in building shareholder value.

I do agree with Southeastern’s letter that Dell should allow shareholders the option to remain invested in the company if they so choose while breaking up the company.  If shareholders have traveled this far, let them decide.  Basically, Michael Dell wants to use more cheap debt (available today) as a tax shield to juice his after-tax returns.  I don’t blame him, but let the shareholders decide.

Beware of sum of the parts valuations. If you do use them, analyze the competitive advantages of each business segment.

I could spend a year on Dell reading about their divisions but I would have no edge over industry analysts. My edge (I hope) is sniffing out despair with a cynical eye.

Dell is not an obscure, forgotten company/stock, but it was laden with disappointment, despair and low expectations. I just had to wait for my price or walk away.

Hope this helps you to find our own way.

 

UPDATE: FEB. 12, 2013:

Mason Hawkins Buys More Dell While Opposing the Deal

The future of the Dell (DELL) deal is looking dimmer as its largest outside investor Southeastern Asset Management buys more shares while openly opposing the deal. Southeastern Asset Management bought almost 17 million shares in the past weeks. It now owns 146.8 million shares, which is about 8.5% of the company. Southeastern Asset Management has openly opposed the Dell deal, which is led by Michael Dell and plans to buyout other shareholders at $13.5 a share. Southeastern Asset Management said that the deal “grossly undervalued the company,” and believes that Dell is worth $24 a share, according to Barron’s.
Southeastern Asset Management has been a long-term holder of Dell, and started buying the stock when it was trading at above $30. Its average cost is estimated to be above $25. If the deal went through at $13.5, Southeastern would have lost almost 50% of its original investment, excluding dividends.

I will be out until Friday………until then.

 

 

15 responses to “My Take on Dell Case Study

  1. I like those back of an envelope calculations! Instead of writing 60 page reports about Dell – sell side analysts should educate people a little more, confuse them a little less and start with straight forward basic back of the envelope calculations. If people then want to continue they can still read page 57 to see which type of new server Dell made…

    They could make themselves a lot more useful if they would rethink their way of publishing…

    Again just my 2cents:)

  2. I don’t think I have read a Wall Street Research report in 15 years–what do they typically say, “We won’t recommend until uncertainties clear or while the overhang persists or the market price already discounts our recommendation.?”

    Avoid Wall Street and go main street. Read primary sources.

  3. I like your thoughts. For situations like this, in which I’m not as clear on the business segments or am unsure of the future, I tend to discount rather heavily. That doesn’t mean I’m not interested; I took a very hard look at Dell at $11 and bought a stake, only to find a better opportunity and exit for better waters.

    I am not kicking myself about not getting in at $8-9 range, seeing as I prefer my current holdings, but it was on the back of my mind and my due diligence was somewhat similar to yours.

    Didn’t disagree with you on much, which is pretty rare for me haha. Good work.

    ^as for PT above, I disagree entirely. Sell siders aren’t trying to educate others, and typically they don’t even care if they’re right. It’s just about maximizing their compensation. I’ve seen some pretty pathetic situations. Which is sad. Sometimes they’re more confused than I am on a company, even when it’s the only one they follow. Better to just pretend they don’t exist.

  4. Dell has been in my “too hard” basket for a long time. I have never had enough clarity to say it was cheap or overvalued.

    Now, reading your analysis, I was nodding all along the way. Suddenly I could see clarity.

    This is one awesome analysis!

  5. Dell poped up in my list in the beginning of January. I’ve added them to my shadow list and ‘sold’ this morning. Gross profit was about 24%.
    Thanks for your analysis!

  6. Great writeup. I did my own analysis a week or two before Goldman upgraded them to a buy and came to about the same conclusion. If you interested you can see it here:

    http://nomeansum.com/2012/12/03/dell-inc-dell-a-cash-cow-but-will-it-last/

  7. Thanks NoMeanSum. It is always good for readers to share their analysis with others to help us all learn.

  8. Zeke Ashton did a good mea culpa of the mistake that he made on Dell (courtesy Value Investing Letter).

    The largest loss experienced in the portfolio in 2012 was due to our investment in Dell. Dell represents a bit of a unique experience for us, in that it is extremely rare for us to suffer a bad outcome by investing in a business at a low-single digit multiple to free cash flow that also has a very strong balance sheet. In reviewing our work on Dell, we think that our initial purchase decision was reasonably well supported by the available information, and at one point in early 2012 Dell was actually a large winning position for us. However, we believe that one of the problems with our valuation work on Dell was that we anchored heavily on the numbers produced by our discounted cash flow (DCF) model, which produced fair value estimates of $20+ even when using what we felt were pessimistic future cash flow projections.

    After further consideration, we don’t believe that there was a flaw with the model per se, but rather with our use of it. Any DCF model embeds an unstated assumption that all the future cash generated by the business will come back to the investor in the year it is produced. Thus, when one pays a 5X multiple to cash flow, the model thinks that after the first year the investor has already received 20% of the initial capital outlay back. After five years, a DCF assumes the investor has received all of the initial capital back (assuming 0% growth) and any remaining business value is totally incremental. While most companies don’t return 100% of the cash flow generated by the business to investors every year, there is an implicit assumption that the cash flow will convert to value in some form: as additional cash on the balance sheet, as reduced debt, or as productive investment in the business. This is why capital allocation by management is such an integral part of our evaluation of our portfolio companies.

    In retrospect, the DCF model was not the right tool for the job in the case of Dell. Dell is in the middle of a transition period as the company reinvests its resources away from its traditional core PC business to better compete in higher-value areas of the IT systems food chain. The company’s strategy has been to buy rather than build these capabilities by acquiring other companies, and it has been paying much higher multiples for its acquired companies than we were paying for Dell. Given that so much of Dell’s cash is being allocated in this fashion, our valuation work needed to be adjusted to better fit the reality of how Dell was using its cash flow as well as the execution risk involved in its business model transition. Had we recognized this analytical nuance earlier than we did, a timely sale in early 2012 would have delivered a very acceptable return for the Fund rather than the loss we ultimately experienced.

    The Fund entered 2013 with a modest long position in Dell given that we believe the stock continued to trade at a meaningful discount to our new, lower value estimate. Interestingly, as of this writing Dell is at the top of the financial news as it appears it may take itself private at a price in the $13-15 range, which is consistent with our revised assumptions. Of course we are disappointed that our analytical shortcomings cost the Fund what could have been a good outcome on Dell, but we have learned much from the experience and expect that we will make better decisions in the future because of it.

  9. Awesome and well thought out post on your analysis of Dell and you were quite right to be conservative in your valuation of Dell due to managements ‘me first’ attitude, their destruction of capital and their lack of good performance in terms of acquisitions.

    Just goes to show that when you combine conservative valuations with despair, it can yields good results. Thanks for sharing.

  10. A Reader’s Question:

    Hi John,

    I was working with the Dell case study. This was a great exercise and your take about the case was clear and straight to the point, very different from most articles.

    My question is this, you said post tax cash flow was $1.9 per share. I was looking at the last 10-K and the EPS is $1.9 ($1.9 basic, $1.88 diluted). Maybe this is a silly question but are there adjustments to the operating cash flow or something like that, maybe you are using EPS minus Capex as a proxy?.

    MY REPLY:

    Go to the DELL value line posted in the case. I was using Value-Line’s “cash flow” which is EBITDA minus Taxes then minus capex. I want to know what the owner’s earnings are (See Buffett).

    For more explanation google Value Line instructions to read about def. of cash flow.

    I keep it simple because I look at many companies. Of course, you need to make adjustments if there are disposals, one-time gains. You always want to normalize the numbers. If you can’t walk away.

    I will post this in the comment section of the Dell Post.

  11. One of my favorite posts. Curious about what you would’ve done differently if this were a more solid business that DID have a competitive advantage?

    Would you have dared to factor in growth? e.g. CF (1+g) / (r-g)

    Or would you have just required a lower margin of safety?

    Thanks for your notes.

    • Loaded up because then I would have the tailwind of profitable growth.

      The secret to Greenblatt was his ability to load up in the right situations. Dell isn’t it.

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  13. Did you do additional work on your Dell investment or just the back of the envolope calculation? How do you decide if additional work is warranted? Based on the position size? You mentioned you would not invest more than 2-3% based on the non-franchise status of the investment.

    Thanks for your help!

  14. Yes, back of the envelope calculation because 1. I believe this was a special situation, I have followed DELL over the past decade and it was simply based on asset value. I don’t believe Dell had a franchise.

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