Description

SUMMARY

Dell is no longer primarily a PC company.  PC sales combined with associated higher-margin software and peripheral sales will contribute only 40% of Dell’s operating profit in the current year and 44% of adjusted free cash flow[1].  While this is still a significant portion of Dell’s free cash flow, this earnings stream is deserving of a lower multiple than the rest of Dell’s business.  If valued based on industry multiples, the PC business makes up only 25% of the total value of Dell Inc.  Despite its relatively minor importance to the overall value of Dell, a severe 14% YoY revenue contraction in the PC business in the second quarter of this year has caused many observers to believe that the overall Dell business is in decline.  This is a false assumption.

The more valuable portion of Dell is the “Solutions and Services” business, which provides networking hardware and software as well as support, security, IT outsourcing, and other services to business and public customers[2].  This business boasts higher-margins, recurring revenues, and has been growing the top line at a CAGR of 7% for the last four years.  Faced with a difficult macro-environment, this business still posted a 6% YoY revenue gain in the most recent quarter.

Dell’s adjusted enterprise value of $10.1 billion is equivalent to just 3.6 times this year’s adjusted free cash flow before changes in working capital.  This valuation suggests Dell is either in terminal decline, will destroy a great deal of value in capital allocation, or the market is being very short-sighted.  Recently lowered sell side estimates expect Dell’s EBITDA to remain flat at this level through 2015.  Not only is this not indicative of a business in decline, but the portion of EBITDA contributed by the non-PC business should grow during this time.  I believe the major concerns about this business are inaccurate or short-sighted.

“Face up to two unpleasant facts: The future is never clear; you pay a very high price in the stock market for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values.”

–Warren Buffett in Forbes, 1979

Dell has all of the attributes of a great company.  It has a leading global brand, is led by its capable founder, and is solidly profitable.  The company has a strong balance sheet and management is committed to returning free cash flow to shareholders.  In addition, Dell has long-term relationships with its customers, an industry leading cost structure, and an increasing amount of differentiating IP.  Expectations have now been dramatically lowered for the future performance of this company, and it is repurchasing its own shares. 

BUSINESS OVERVIEW

Dell positions itself as a global provider of “IT solutions and services”.  This branding is not simply an attempt to distance itself from the profitable but low-margin PC business, for which Dell is known.  It is a very real transition for both Dell as a company and the IT landscape, in which Dell operates.  With the increase in connected devices, big data, and the transition towards “cloud computing”, information technology is becoming less of a simple hardware need for business and more of a vital service – akin to legal or accounting services.  These changes are rapidly moving down the food-chain from huge enterprises into Dell’s core constituency of small and medium business customers.  Through its many acquisitions, Dell has created a full suite of offerings and positioned itself as the premier mid-market end-to-end IT solutions provider.  These new capabilities should both protect and complement Dell’s valuable PC and server hardware franchises.  (Note: Dell’s fiscal year ends in January, so Fiscal 2012 refers to 2011)

Dell refers to its legacy PC business as “Core Dell”, which encompasses the client business and software and peripherals reselling business.  The enterprise solutions and services business as well as Dell’s new proprietary software business – built around the $2.4 billion acquisition of Quest Software – are classified as “New Dell”.  

The Core Dell/New Dell model is a useful way to look at the company because it separates out the declining PC business - which few investors want to own - and the rest of Dell’s businesses that are growing and have attractive margins.  Many investors are currently fixated on the PC business particularly Dell’s consumer PC business.  For this reason, it is worth looking at the “Core Dell” and the “New Dell” separately.  

CORE DELL:

• Lower margin transactional business producing  2/3 of revenue and ~45% of gross profit
• Projected revenue CAGR of -5% to +2%
• Designs, develops, manufactures and distributes PC-based notebook, desktop, tablet and thin client workstations
• Resells third-party software and peripherals 
• Direct distribution model is now coupled with worldwide sales channel participation
• Third largest global PC manufacturer with 11% share; down from 18% in 2005
• Overall revenue and share of the market has been shrinking as Dell exits unprofitable lower-end business like netbooks
• 30% of Core Dell revenues are from the consumer segment, which is most at risk
• Transition to lower-cost contract manufacturing model nearly complete, with plans to cut an additional $1 billion in supply chain costs by 2015
• End-markets are highly competitive; Dell operates at roughly breakeven in the consumer segment and margins have been falling across the board
• Enterprise PC business is more insulated from competition and is solidly profitable, but double-digit revenue declines in the current year highlight an uncertain future
• Strong cash flow generation is augmented by a negative cash conversion cycle of roughly -30 days
• Management has suggested further costs could be cut in an industry contraction and expects this business to remain solidly profitable even if macro conditions are unfavorable
• Business-oriented Windows 8 tablets and thin client systems provide avenues for growth

        Core Dell revenue has fallen by almost 10% in the first half of this year, as compared to the first half of last year.  This has precipitated a 35% YTD decline in the stock price, as investors are concerned that the profitability of this business could disappear in an industry-wide PC contraction.  The preceding chart from Evercore Partners shows the diminished industry outlook as of September of this year.  It is worth noting that overall PC unit sales are expected to rebound, although it is likely the ARPU will continue to fall. 

Making reasonable growth assumptions for business-oriented Windows 8 tablets, thin client workstations, and accessory sales, Dell plans to add $3.5 billion to Core Dell revenue by F2016.[3]  Core Dell is projected to grow to $47 billion in revenue by F2016 from $43 billion last year, with the acknowledgement that investors should “expect some volatility”.  This acknowledgement looks to be a significant understatement, as current year Core Dell revenue is on pace to come in at only $38 billion.

 Acknowledging the headwinds to the PC business, Dell is cutting $1 billion in direct costs from its supply chain as well as an additional $1 billion from SG&A (attributed to Core Dell) over the next three years.  As seen in the slide below from its investor day, management expects to maintain operating income of “almost $2 billion” even if Core Dell revenues decline to $35 billion.  I estimate that Core Dell operating income will come in at $1.7 billion this year with an operating margin of 4.4%.  This is actually a very good result in a year that revenues for this business will decline 13%, and I believe this lends credence to Dell’s assertion that it is maintaining profitability at the expense of share. 

NEW DELL:

• Higher margin service and solutions business producing 1/3 of revenue and ~55% of gross profit
• Projected revenue CAGR of +8% to +12%
• End-to-end IT solutions business that encompasses servers, networking hardware, storage, security, virtualization, business process automation (BPO), financing and a number of services and software capabilities. 
• Large sales force with over 6,600 solutions specialists
• $12.7 billion spent on nineteen acquisitions since 2007, including leading technologies in security, storage, networking and cloud computing
• Ability to build, deploy, secure and support physical and virtual networking and IT solutions worldwide
• Significant recurring revenue streams; current backlog of $16.3 billion for contracted services and deferred extended warranties
• Dell does not break out the term of its recurring service contracts, but the backlog has risen 17% from the beginning of F2012 and represents almost two years of service revenue
• Includes highly lucrative “support and deployment services” (extended warranty) business for both the “Core Dell” offerings as well as the many offerings of the “New Dell”
• Server business is a key strength and competitive advantage as the industry shifts towards x86 architecture, where Dell is a leader
• Leader in growing field of healthcare IT

                The New Dell is built for the transition to cloud computing, which is at its essence the outsourcing of IT hardware.  Rather than purchase the hardware necessary to build and maintain a network, businesses can now have a virtual network.  For instance, Netflix’s entire technology infrastructure is essentially just a software program running on spare capacity in Amazon’s data centers.  Enormous cost savings can be had from moving to the cloud; businesses no longer need to purchase, maintain, and upgrade their own hardware.  This obviously presents a challenge for Dell’s server business, but the company has met this challenge by taking a leadership position in private clouds as well as catering to the public cloud providers.  This is evidenced by the continued growth and market share gains for Dell’s server business.  In the first half of F2013, the servers and networking segment is up 8% YoY and results are expected to improve in the second half due to the September release of the Windows Server 2012 operating system. 

The outlook for specific technologies and predictions as to whether Dell will be able to meet its goals in the Enterprise Solutions or Software business is beyond the scope of this report.  However, the Services business, particularly the extended warranty component, is worth examining.  Dell does not break out this business or discuss its extremely high margins in anything but oblique terms.  Much like an insurance company, for accounting purposes, the company defers revenue recognition for extended warranties and accrues a liability for future costs to service these contracts.

                An examination of Dell’s current period revenue and cost recognition for past extended warranties clearly shows that this is the company’s best business.  This segment produced $2.7 billion of gross profit at 72.2% margins for Dell last year.  This was 19% of the corporation’s total gross profit and came without the need for any real capital investment.  Of course, this business could not exist as a stand-alone without Dell’s huge sales force or products on which to sell extended support services on.  There is a real concern that declines in the PC business will have a negative effect on this high-margin cash cow.  Looking at the last eight years, extended warranty sales have increased as a percentage of primary hardware[4] sales.  PC sales peaked in F2008 and have declined 11% since then, yet warranty sales have actually grown 13% since that year.

                In addition to growing revenues, this business has displayed interesting counter-cyclical trends with regard to overall hardware sales.  When hardware sales suffered in 2009 (Fiscal 2010), warranty sales rose, partly because consumers who could not afford to replace their laptops purchased more premium warranties.  In the first half of this year, hardware sales are down 5.3% YoY, but warranty sales are down only 2.5% YoY.   Profitability of the warranty business is also improving over time, as the Core Dell business becomes higher-end and the server and storage business grows.

                The gross margin accrued for in new extended warranty sales is higher than the margin on revenue recognized in the current period, even after taking into account the timing differences between accrual and recognition.  Clearly, some portion of these contracts is longer-term and carries a much higher margin.  The current amount of deferred warranty revenue on the balance sheet is $7.2 billion, and the implied gross margin on this revenue is approaching 90%.  The amount of deferred revenue has been growing at a CAGR of 13% since 2005, outpacing the growth of even Dell’s fastest growing segments.  One implication is that Dell is selling more long-term service contracts on critical equipment that doesn’t break, such as its networking and storage equipment, a hardware business that has grown at a 9% CAGR over the same time period.[5] 

                The extended warranty segment is clearly benefitting from Dell’s transition into more mission-critical solutions and away from commoditized hardware.  Looking at quarterly trends and particularly the most recent quarter in which PC sales fell by 14% YoY, warranty sales were actually up slightly YoY.  Fears that declining PC sales will kill this golden goose appear to be unfounded.

Key Positives to this investment:

• Core Dell is still very valuable: While this business has become largely commoditized, Dell is the most efficient operator and has some minor moat-like qualities to its franchise.  70% of Dell’s PC’s are sold directly, which gives it a margin advantage.  When coupled with Dell’s increasing capabilities for end-to-end solutions and longstanding customer relationships, it should prove difficult for competitors to capture Dell’s existing enterprise PC customers, even if they were to sell at a lower price point.  This business is increasingly scalable with the move to contract manufacturing, enabling Dell to generate significant free cash flow even in an unexpectedly bad year like the one it is currently experiencing.  The most recent forecasts from IHS now estimate the global PC market will fall 1.2% this year, with expectations for next year ranging from -1% -+7%.  Even in a further contraction, this business could grow FCF from this level due to the high-grading of its revenue base and substantial cost cutting initiatives.
• Management: Michael Dell is a proven innovator and appears to be a strong leader during this transition.  This stands in stark contrast to the situation at H-P, Dell’s biggest competitor.  Additionally, Michael Dell owns almost 16% of the company and spent $250 million to purchase stock at $14.04 per share in late 2010 and early 2011.  This serves to align his interests with shareholders.  The company also has a deep and capable bench of managers.  Earlier this year, Dell hired John Swainson, who is credited with turning around Computer Associates in the 2000s, to run their new software business.  In August of this year, Dell hired Marius Haas to run the servers, networking, and storage hardware business.  Hass is a Hewlett Packard veteran who successfully turned that company’s flagging networking business into a growth leader.

• Balance sheet and free cash flow: Dell appears to have almost $7 billion in excess cash on their balance sheet and generates $2.8-3.8 billion in annual adjusted ongoing FCF.  This provides the company with substantial flexibility as well as the opportunity to generate a very high return on investment by buying back its own stock at current prices.  While not expected, a $2 billion buyback in the second half of this year is very possible and would have a meaningful impact on future per share results. 

• Synergies between Core Dell and New Dell: When H-P announced plans to spin off their PC business last year, Cisco put out an internal marketing update detailing the problems this would cause for H-P.  According to Cisco, this move will “have a major impact on H-P’s ability to generate economies of scale – impacting other products such as low-end servers – and would undermine its ability to gain a competitive advantage by positioning itself as an end-to-end IT supplier.”  Cisco believed that if H-P divested its PC business, they would suffer a 2-5% margin loss in servers due to the negative supply chain implications (Dell’s server business has operating margins of 5-8% for comparison).  This document also suggests that loss of the PC business would cause H-P to lose $0.6-$1.0 billion in essentially free marketing and 50% of their face time with potential clients for their non-PC products.

Key negatives to this investment:

• The PC business could decline more rapidly than expected: The risk exists that content creation will shift to lower priced thin client workstations, while content consumption moves to tablets built by Apple and others.  While it is unlikely that this transition destroys the PC market or moves into the enterprise in the near term, the potentially large effects of such a transition make it a risk.  If the PC market shrinks and Dell is unable to cut costs in a timely fashion, FCF from Core Dell could disappear.

• Reduced balance sheet flexibility and acquisition risk: More than half of FCF is generated oversees, and the majority of the excess cash is domiciled outside of the US.  Dell has already taken on US debt to provide domestic liquidity, and it may be forced to sell financing receivables at a discount, pay taxes on foreign cash, or sell more debt if the company is to continue buying back stock and making large acquisitions.  The company could also potentially make a large acquisition that would substantially reduce its financial flexibility.

• Potential for empire building by Michael Dell: Despite his large shareholding and open market purchases, Dell stock represents less than 20% of Michael Dell’s $16 billion net worth (according to Forbes).  Michael Dell seems fully committed to the future of his eponymous company, but his financial future is not dependent on the stock price.  Dell has an internal IRR target of 15% for acquisitions, which Dell claims to be hitting, but this is impossible for investors to evaluate.  The recent dividend announcement and high level of share buybacks make it unlikely that Dell is attempting to grow at the expense of shareholders, but it is a risk to be aware of.

• Past Accounting Scandal: From 2001-2006, Dell used accounting gimmicks like over/under-reserving for warranty costs in order to smooth earnings.  More disturbingly, Intel paid “rebates” to Dell in return for Dell using Intel chips exclusively, despite AMD occasionally offering better products.  Intel’s “rebates” included lump sum payments, which were also used to smooth earnings.  These issues were settled with the SEC in 2007 and some minor restatements were made, including to F2005 and F2006 warranty accruals and recognitions.  While not directly involved, it is clear that Michael Dell had knowledge of these strategies to smooth earnings. 

• Dividend: While considered a positive by many, I believe that Dell’s recent announcement of a dividend is a sign that the company is still more concerned with Wall Street perceptions than with the long-term value of their business. Dell has ironically chosen to show financial strength to Wall Street during this time of transition by making a move which actually limits their financial flexibility.  I believe that this is one of the biggest reasons for which David Einhorn chose to sell his Dell position.  Einhorn came up with a brilliant strategy for cash rich companies like Dell, in which the company would dividend out a perpetual preferred share to each of their shareholders.  Based on Dell’s creditworthiness, a perpetual preferred share issued by the company would trade at a yield of 5%.  If Dell had issued (directly to shareholders as a 1-1 dividend) a perpetual preferred with a $0.32 annual dividend rather than issue that dividend on their common stock, that preferred would be worth $6.40 per share.  Because the preferred share would be perpetual, the value of the common stock should only be discounted by the value of the FCF spent on the preferred dividend, rather than the liquidation preference of the preferred share.  Einhorn’s strategy[6] or large current buybacks would have been much better uses of these funds than a dividend.

VALUATION

                Both the company and analysts who follow it use adjusted Non-GAAP financials to remove unusual and one-time items that have resulted from shutting down the manufacturing facilities and making many large recent acquisitions.  While these expenses have not been infrequent in the last few years, going forward they should not be a large factor on a cash basis, so this treatment is appropriate (large amortization charges from acquisitions will continue).  Over the last three years, the negative impact to net income of these items has ranged from $460-621 million, with more than half of this adjustment stemming from non-cash amortization charges. 

One way to value Dell is to split it into the “Core Dell” and “New Dell” as the company suggests.  While not perfect, readily available publicly traded comps exist for both sides of Dell’s business.  Dell does not break out the gross margins or cost allocations for these segments.  However, by making some educated assumptions based on statements the company has made in the past, it is possible to get a rough estimate of the FCF and EBITDA for each segment. 

I believe the valuation of comparable companies gives a reasonable estimate of where these two businesses would trade in the market.  For New Dell comps, I have chosen NetApp, Symantec, and EMC.  These are three companies operating in the storage, networking, security, and data management

For Core Dell, Lenovo makes for an ideal comparison as a stand-alone PC business[7].  Because other device manufacturers like Asustek, Acer, Sony and Toshiba have lower margins, these businesses are valued at much higher metrics currently, so I have chosen not to include them.  I have also included Seagate, as an example of a completely commoditized device maker.  Seagate is currently able to generate high profits due to the concentrated nature of the hard disk manufacturing business as well as the result of
flooding in Thailand.  For this reason, I believe Seagate presents a good example of a device manufacturer whose profits are expected to decline in the near term.

If valued as suggested by the above table, Dell’s equity would trade at $17.72 - $21.19 per share.  The estimates of FCF above are net of stock based compensation expense and capital expenditures but do not include changes in working capital.  I would also note that the Core Dell business has declined significantly in the current year for both cyclical and secular reasons.  Results are currently at the level at which management has suggested they can hold the line through F2016, even in a more adverse PC environment.  For this reason, I think this valuation has some conservatism baked into it.

Dell’s GAAP FCF will be affected negatively during the transition to services by a slow reversal of Dell’s 30+ days negative cash conversion cycle.  In order to account for this, the cash associated with this “float” has been discounted by 50% in the calculation of adjusted net excess cash per share.  Cash and equivalents have also been discounted because ~85% of it is oversees and will be taxed at 10% even in the event of a tax holiday.  This amount is not discounted further because Dell has found other ways to use this cash in a tax-efficient manner over time.  Financing receivables are discounted by 15% under the assumption that the company could sell these securitizations for a 15% discount.  This would be one way for Dell to raise additional domestic cash for accelerated buybacks in the current environment.

                It is likely that the New Dell will continue to make $1-2 billion or more in acquisitions for at least the next few years.  Some investors on the short side have suggested that this should be counted as capex.  This would make sense if Dell was simply replacing lost revenue with unrelated new revenue streams with no end in sight, but this is not the case.  Dell has a cohesive strategy to build an end-to-end IT solutions business.  This will require more acquisitions to fill in gaps in their technology and capabilities, but it appears that most of this business is now in place.  New Dell is expected to grow at double the rate of its peer group above, which suggests these acquisitions will add a lot of value as well as fit overall business needs.  If one wishes to express a negative view of Dell’s acquisition strategy, both as it relates to the value of the New Dell and to overall capital allocation, I believe it is more appropriate to remove the excess cash from the balance sheet, rather than adjust FCF.  It is unlikely that Dell will actually spend $7 billion on acquisitions anytime soon, or that they could do so without materially improving the outlook for new Dell.  Even so, I believe that a valuation based on FCF and not including the value of excess cash presents an appropriate low-case valuation of $13.74 per share.

The above three methodologies suggest that Dell is worth somewhere between $13.74 and $21.19 per share, or a 41-117% premium to the current stock price, depending on whether management can execute on its strategy.  This valuation range represents an EV/EBITDA multiple of 3.6-6.3, net of excess adjusted net cash.  The low-end of this range is still a premium to Dell’s closest peer, Hewlett Packard, which trades at 3.1 times EBITDA.  Considering the myriad problems H-P is currently facing as well as that company’s inferior financial and strategic flexibility, I think this comparison demonstrates that this valuation range is reasonable for Dell.  H-P itself is currently trading at an all-time-low valuation due to internal problems as well as some of the same external headwinds that Dell is facing.  Some of the most respected and successful value investors currently own H-P, which suggests that stock is undervalued as well. 

                In addition to garnering substantial comfort from Dell’s low valuation and strong balance sheet, investors in the stock are exposed to substantial upside to this valuation:

• Annual share buybacks of $650 million (well below recent experience and within guidance that 20-35% of FCF will be returned to shareholders, including dividends) at current prices would decrease the share count by 14% and increase intrinsic value to over $30 per share by 2015, assuming current peer multiples and management’s ability to hit the low-end of its goals.  This suggests a compound annual return of 40% over the next three years.
• A tax holiday following the US Presidential election is a distinct possibility.  This would allow Dell to repatriate its foreign cash at a discounted tax rate and accelerate share buybacks.  Selling its financing receivables would also free up almost $4 billion of domestic cash.
• Current projections include interest costs of ~$240 million per year due to the yield differential between Dell’s offshore cash and onshore debt.  A tax holiday would allow Dell to avoid this ongoing cost and add $1.25 billion to the value of the company at an 8X FCF multiple.
• The company repurchased $2.7 billion in stock last year at an average cost of $15.17 per share, and spent $700 million repurchasing shares in the first half of this year.  With the share price currently below $10.00, the company could repurchase 200 million shares for $2 billion in the second half of this year, reducing the share count by an additional 11.5% in just six months.

OUTLOOK/CATALYST

PC sales may rebound next year as businesses upgrade their PC’s to Windows 7 before Microsoft stops supporting Windows XP in early 2014.  Windows 8 could also drive increased sales on the consumer side.

Sell-side projections have been lowered for the next two years.  Consensus expectations are for revenue, EBITDA, and operating profit to stay at the lower F2013 rate through F2015.

Above consensus results would certainly be a catalyst and any overall growth would be above consensus.  Increased share buybacks, which large shareholders are clamoring for, would create growth on a per share basis even if revenues stayed flat.

In the absence of growth, I estimate that New Dell will account for 70-75% of operating profit and EBITDA next year.  The PC business becoming a smaller problem through attrition may be a catalyst in its own right.

Catalyst