Mason Hawkins and Carl Icahn versus Dell

Outside shareholders upped their pressure on Dell's board of directors this week, arguing that the proposed go-private transaction is unfair to all shareholders not named Michael Dell.  Southeastern Asset Management’s Mason Hawkins, who has been arguing for several weeks that the deal being promoted by the board undervalues the company, sent a letter to Dell restating his case, and requesting information about Dell's shareholders, which will enable him to persuade other owners to join his cause.    

In the letter, Hawkins points out that the special committee charged with assessing the proposed transaction - and soliciting alternative offers - is composed of board members who themselves own very little of Dell’s stock, meaning that their interests may not be fully aligned with the interests of all shareholders.  In addition, he questions the fact that Dell has long argued that its sizable cash hoard was "trapped" overseas - since repatriating it would involve paying tax - yet is now using that very same cash to fund part of the buyout.  Further, Hawkins wonders aloud about the way management presented recent earnings results, and suggests that they were arranged in such a way as to emphasize the declining PC segment, rather than highlighting the rest of the business, which surely has a brighter future. 

Hawkins was joined by the formidable activist investor Carl Icahn, who reportedly owns up to 6% of Dell.  The significant size of his stake, combined with Icahn's experience and reputation engaging in proxy battles, adds immense weight to the growing list of dissatisfied outside shareholders.  It's unclear if their efforts are coordinated, but Icahn contends that Dell is worth around $23 per share, almost exactly the same number that Hawkins has put forth, and recommends a deal that is similar to one of the scenarios that Southeastern favors.  Icahn would like to see the company pay a special dividend of $9 per share, funded by a combination of cash, receivables and new debt.  In addition to the $9, ongoing shareholders would own a "stub" that could be expected to be worth nearly $14, based on Dell's cash flows.

But Icahn goes further than Hawkins.  If Dell shareholders vote against the go-private proposal, and if the company doesn't then implement his preferred deal, Icahn stated his intention to run a slate of directors who will.  In effect, the annual meeting where shareholders are given the choice between the two competing boards would amount to a vote between Dell's deal and Icahn's.  In a bold and clever move, Icahn pledges that he will personally provide financing, on commercially reasonable terms, which would allow for the prompt payment of a special dividend.  

Taken together, Hawkins and Icahn are making a multi-pronged attack on the go-private offer.  They make a sound business case that the proposed deal undervalues the company; they raise hard questions about the interests and fiduciary duties of the board, questions that will not fade away quietly as they proceed to rally the support of additional shareholders; by offering financing of his own, Icahn has pre-empted management, if they were planning to claim that the cash for a special dividend was unavailable; and management was reminded that matters that can't be settled agreeably in the boardroom can be settled disagreeably in the courtroom, as legal options remain available.

If reports of Icahn owning about 6% of the firm are accurate, then together he and Hawkins control 14-15% of the company, about the same proportion as Michael Dell.  It will be fascinating to watch which side prevails, though this writer's guess is that shareholders will not approve Dell's existing offer.  Whether the transaction that is ultimately agreed to is a sweetened version of the go-private deal, or a different transaction altogether, remains to be seen, however.

Sources: The letters referred to above can be found in Dell's SEC filings.

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Valuing a Business - Mason Hawkins on Dell

Valuing a business is part art, part science.  Since determining a business's true worth is subtle enough to resist any hard-and-fast formula, it's always useful to learn how successful investors do it.  After all, investors who have outperformed the market over an extended period of time must know how to identify undervalued assets.  The consensus these days is that most of a business's value lies in the free cash flows that it will generate in the future, albeit adding on surplus assets, and subtracting long-term liabilities.  

Warren Buffett pegs the value of a business on the earnings that will be generated "from now to kingdom come," though he's deliberately vague on specifics.  It appears that he doesn't employ any standard discounted cash flow model.  In fact, biographer Alice Schroeder, among the most well-informed and shrewdest of all Buffett-watchers, has suggested that when gauging a business's value he looks forward mostly by looking backward, focusing on a business’s past ability to generate profits as a predictor of future results.  If he's confident that the business has an enduring competitive advantage, and the industry it's operates in is unlikely to undergo major change, he assumes that tomorrow will look much the same as yesterday and today.  

However, there are other valid ways of assessing a company's worth.  One of North America's foremost investors is Mason Hawkins, of Southeastern Asset Management.  He is currently campaigning on behalf of Dell shareholders, maintaining that the proposed leveraged buyout, led by founder Michael Dell, "grossly undervalues" the company.  In fact, he argues in a recent publication that the tech giant is worth nearly twice what's being offered.  Given that Southeastern is the largest outside shareholder, owning 8.5% of Dell's stock, the business world will be watching closely as events unfold.

Happily for investors and students of investing, Hawkins not only makes explicit what he thinks Dell is actually worth - $23.72 per share - he offers details about he arrives at his conclusion.  Essentially, Hawkins breaks Dell down into its constituent parts - no longer merely a purveyor of low-priced desktops, the company now sells servers, software and services, in addition to its financing operation - and attaches a multiple to current operating income.  The multiples applied are different for each business, reflecting the going rate for comparable companies in their respective industries.  He sums up these numbers, adds net cash plus an estimate of the value of recent acquisitions, then subtracts unallocated financing and corporate expenses.  While Hawkins doesn't attempt to quantify it, he notes that Dell's distribution network offers the company a competitive advantage, adding further value.

Number-loving investors will be fascinated by Hawkins' analysis, but the important work is actually qualitative.  Taking apart Dell piece by piece forces Hawkins to carefully consider each of its component businesses, and how they compare to competitors in their respective industries.  While this analysis focuses on today's earnings, rather than attempting to predict what may happen tomorrow, it has one crucially important thing in common with a future cash flow estimate: it places a company's value in its ability to sell products and services to customers.  Hawkins goes on to suggest several scenarios that may unlock latent value, but the value itself resides in the quality of the business.

Source: http://www.longleafpartners.com/downloads/dell-board-letter.pdf

Here is an earlier article on Dell.

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

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.


Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.