Saturday, 24 November 2012

Dell - Value or Value Trap?

Dell is cheap - very cheap.  The computer giant's market cap is around $17 billion.  However, with cash and investments of $14.2 billion, minus $9 billion in debt, Dell's net cash position is about $5.2 billion, giving the company an enterprise value of under $12 billion.  In 2011, free cash flows (net income + depreciation and amortization - capital expenditures) were $3.75 billion, up from $3.2 billion the year before.  Results, to be sure, have softened significantly in 2012.  For the first 9 months of the year, free cash flows have amounted to $2.3 billion, down from $2.9 billion in the comparable year-ago period.  Still, if Dell were able to generate $2.7 billion in FCF for the full year, the company's enterprise value/FCF ratio would stand at a paltry 4.5x multiple.
How can a cash-rich, highly profitable industry leader sell at such a dirt-cheap price?  Dell's stock has swooned largely due to fears that the personal computer is about to go the way of the floppy disk.  Are these fears warranted?  Probably not.  Certainly, the rise of smart phones and tablets have bit a chunk out of Dell's business, and the days of the PC being a fast-growth market are likely over.  However, most consumers - at least in the developed world - still have a PC, in addition to a smartphone and/or tablet.  Moreover, businesses remain more comfortable equipping staff members with personal computers, at least for now. 

In fiscal 2012, it must be admitted, PC makers have seen their sales fall substantially.  However, two short-term factors have converged to cause most of that decrease.  First, retailers have been drawing down inventories, so not all computer purchases by consumers have resulted in a sale for PC manufacturer.  Second, the long-awaited arrival of the latest version of Windows has led to a predictable delay among would-be buyers.  The next couple years, then, should see a return to modest growth, or at least a flat lining business. 
As a low-cost producer in a commodity-type business - except in the case of Apple's products, consumers regard one computer as about the same as all the others, so price matters - Dell has a long-held competitive advantage, and one that's likely to endure.  Moreover, Dell has expanded its software and services businesses to counteract slowing growth in its main operation.  Indeed, this fiscal year alone, the company has spent nearly $5 billion on acquisitions.  Corporate shopping sprees rarely work out well, though.  At minimum, it makes Dell's stream of future earnings more difficult to predict, since it may not have the same competitive advantage outside its core PC business. 
However, let's imagine that Dell's earnings hold steady over the next 5 years at $3 billion in FCF per year.  Let's assume further that the company commands a 12x multiple at the end of five years.  In that scenario, the company would be worth $15 billion in future earnings over five years + $36 billion in market value + $5.2 billion in present cash = $56.2 billion.  Divided by the current share count of around 1.74 billion, an investment in Dell would be worth roughly $32, more than a triple its current price.  Moreover, given ample room to repurchase shares at today's cheap prices, management has an opportunity to create even more shareholder value.  To illustrate, imagine that they used all $5.2 billion in net cash to buy back shares at current prices.  In this hypothetical scenario - and, alas, management has slowed repurchases recently, even as the share price has plummeted - the value of an investment in Dell would jump from $32 to around $42 ($15 billion + 36 billion = $51 billion/1.22 billion shares = $42).

These are significant ifs, of course.  The PC may indeed die off at a faster rate than this writer predicts, which could make Dell not a value, but a value trap.  For example, Kodak traded at 5x earnings all the way down to zero.  But if investors' fear of rapid change turns out to be overblown, Dell may present an opportunity, albeit more of the yield than of the growth variety.

Here is a later article on the debate between Mason Hawkins of Southeastern Asset Management, and Michael Dell's group over the value of Dell.

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