Value Investors Club / DELL TECHNOLOGIES INC (DELL)

Description

Dell has been discussed on VIC a few times in the past, but we believe a new write-up is

warranted as we approach September 2021 when Dell can spin VMW tax free. We believe it is

highly likely that a spin takes place and as a result the stock continues to be severely mispriced.

We believe a spin is highly likely for the following reasons:

1. In early January 2021, when the CEO of VMW abruptly left to become the CEO of Intel,

Michael Dell made the following comment: “As it relates to the form 13D/A we filed on

July 15th with the SEC disclosing Dell Technologies is exploring a spin-off of our 81

percent equity ownership in VMware, nothing changes,” said Dell in a statement to CRN.

“Negotiations on the VMware side are being led by a special committee of the Board;

workstreams continue. As both companies have stated, we believe a tax-free spin could

drive shareholder, team member and customer value by simplifying capital structures and

enabling flexibility.”

2. On its Q4 earnings call, Zane Rowe, the CFO and Interim CEO of VMW stated “Before

we go to questions, I'm pleased to tell you that we are making progress on the potential

spinoff of VMware from Dell. While our special committee of independent directors

continues to evaluate the spin-off, we believe that it could be value-enhancing to

VMware and its stockholders. We will not be commenting further on these discussions

until there's more definitive news to share.”

3. VMW is doing a search for a new CEO. I believe VMW is in a better position to attract

the best possible CEO if it is a sperate and independent entity and I wouldn’t be surprised

if the VMW board is approaching the search with that in mind and maybe even

communicating that to potential CEO as a selling point. I realize that even when

separated, VMW will still be controlled by Michael Dell who will own around 40% of

VMW but that’s still a significant difference compared to the current situation where Dell

owns 81% of VMW.

4. It makes sense from a shareholder value perspective since analysts and shareholders seem

to apply a significant discount to the VMW stake when calculating the value of Dell.

The exploration of the spin started around June of 2020 so I would expect the companies to

know by now whether the spin makes sense which makes the comments from Michael Dell and

Zane Row even more relevant. It seems unlikely that they would make these comments at this

stage unless they felt reasonably sure that the spin will take place.

While Dell is a complex business with many components, most of the value resides in the

following three components:

1. The Client Solutions Group (“CSG”), one of the top three manufacturers of personal

computers, laptops and peripheral components with revenues and segment operating income of

$48.4 billion and $3.4 billion, respectively in FY 2021 (that ended January 29, 2021). This

business sells in both the consumer and commercial marketplaces through one of Dell’s

historical competitive advantages, its distribution network with a 40k+ direct sales force

and leading partnership programs.

2. The Infrastructure Solutions Group (“ISG”), a global leader in providing servers,

networking and storage devices with revenues and segment operating income of $32.6 billion and

$3.8 billion, respectively in FY 2021. The majority of this business was purchased as part

of the EMC transaction in 2016 and Dell currently has #1 market position in external

storage, hyperconverged infrastructure and x86 servers.

3. Dell’s 80% ownership of VMware (Nasdaq: VMW), a stake worth more than $47 billion

(at VMW current price of $140 per share). VMware is a software and hardware provider

in the areas of hybrid cloud, networking, and security.

If we assume a spin of VMW, how much are shareholders paying for Dell’s core business?

Dell’s capital structure is complicated. Here is a table from the company’s Q4 2021 presentation

that summarizes Dell’s debt.

When calculating core Dell’s debt, I include the margin loan since it is tied to Dell’s VMW stake

and will have to be repaid when the spin takes place, but I excludes DFS (Dell Financial

Services) debt which is non-recourse to Dell and is serviced by DFS receivables. Using this

framework, I calculate core Dell’s debt of $34.1 billion. Core Dell has $10.6 billion of cash

implying core Dell’s net debt of $23.5 billion.

Using Dell’s market cap of $66.4 billion, core Dell’s net debt of $ 23.5 billion and the VMW

stake, I calculate Dell’s enterprise value of $42.9 billion. We take a one-year time horizon and

assume 2022 FCF of around $5 billion to get an EV of around $ 37.9 billion

in one year.

What do we get for this enterprise value?

• Core Dell generated FCF of $5.3 billion in FY 2020 and $6.5 billion in FY 2021.

• Core Dell generated non-GAAP operating income of $6.9 billion in FY 2020 and $7.0

billion in FY 2021

The company provided some commentary for FY2022.

“We believe the demand environment will continue to improve. Estimates from both IDC and

Gartner see IT spending growing mid-single digits in calendar year 2021, including growth in

our core PC, server, and storage markets. The do-from-anywhere world is here to stay. We

believe the total addressable market is expanding as there are still millions of children around

the world that need PCs. The number of PCs in the household continues to increase. And

additionally, the refresh cycles are accelerating with the shift to notebooks. And we are on the

cusp of widespread 5G connectivity driving real-time, automated and intelligent outcomes at the

edge. This will drive an estimated $700 billion in cumulative spend on the edge -- on edge IT

infrastructure and data centers within the next decade.”

“Now to our outlook for fiscal year '22 and Q1. For fiscal year '22, while the exact timing is

fluid, we expect the global economy to improve as we move through the year. This should benefit

ISG and VMware as the year progresses, particularly as our customers return to the office. We

expect CSG strength to continue through the first half with tougher compares in the second half.

Factoring in VMware's standalone guidance, the divestiture of RSA and the ongoing risks

associated with the macro environment, we currently expect revenue to grow in the low to mid-

single-digit range. We expect to see costs come back into the P&L, though not fully back to

prepandemic OpEx levels. We have reinstated a number of employee-related benefits, most

notably merit, promotions and 401(k) match, and VMware and Dell core businesses are

investing for long-term growth. These expense additions and their full year impact, combined

with VMware guidance for operating income of 28% for their standalone P&L, should be

factored into your operating income models. Also, remember Dell Technologies' VMware

business unit results include additional OpEx that we recognize related to the combined

solutions selling expenses.”

Dell is a large company and the drivers for the ISG and CSG are complex. Overall, we expect the

CSG group to grow over time at low single digit and the CSG group to grow at mid-single digit

group. For 2022 we expect operating income to remain flat with higher revenue offset by higher

expenses and we assume operating income grow 3% in FY 2023 to around $7.2 billion. Putting

ourselves a year from now, we are buying Core Dell for 5.3x operating income.

By comparison HPE and Cisco that have similar growth profile trade at around 10x operating

income. IBM that has worst growth characteristics trades for 12x operating income. We believe

this discount to the comps is due to the VMW stake. Assuming the spin takes place and Dell

trades on par with these comps, what is Dell worth in a year as investors start to value FY 2023

earnings?

2023 operating income 7.2 7.2 7.2

Multiple 8 9 10

Core Dell EV 57.6 64.8 72.0

VMW stake 47 47 47

Core Dell net debt (end of FY 2022) 18.5 18.5 18.5

Dell equity value 86.1 93.3 100.5

# shares 794 794 794

Stock price ($ per share) 108.4 117.5 126.6

Current price 83.6 83.6 83.6

Upside 29.7% 40.6% 51.4%

Apologies for the formatting

From a FCF perspective, we expect Core Dell to generate around $6 billion in unlevered FCF in

FY 2023. A multiple between 10 and 12x would yield an EV between $60 billion and $72 billion

which is consistent with the EV in the above table.

In summary, we believe that Dell’s upside is around 40 to 50%. We hedge the VMW stake by

shorting the equivalent number of VMW stake since our bet is not on VMW (which we consider

fairly valued to a little bit undervalued) but on Dell’s core business rerating following the spin.

We also expect that as part of the spin, VMW will take debt and pay a large dividend to its

shareholders which would allow Dell to accelerate its debt paydown and achieve its investment

grade objective. Therefore, New Dell will have much more flexibility to start returning cash to

shareholders if the stock remains depressed.

The biggest risk to the idea is that the spin doesn’t take place and shareholders continue to value

the VMW stake at a discount. If we assume a 35% discount to the VMW stake, we still see some

but limited upside to the stock.

2023 operating income 7.2 7.2 7.2

Multiple 8 9 10

Core Dell EV 57.6 64.8 72.0

VMW stake 30.6 30.6 30.6

Core Dell net debt (end of FY 2022) 18.5 18.5 18.5

Dell equity value 69.7 76.9 84.1

# shares 794 794 794

Stock price ($ per share) 87.7 96.8 105.9

Current price 83.6 83.6 83.6

Upside 4.9% 15.8% 26.6%

Overall, we believe that Dell is an interesting risk reward situation that is likely to play out over

the next year.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

VMW spin

Cash flow generation

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			2021	2022
Price:	82.80	EPS	0	0
Shares Out. (in M):	794	P/E	0	0
Market Cap (in $M):	65,743	P/FCF	0	0
Net Debt (in $M):	-23,500	EBIT	0	0
TEV (in $M):	42,243	TEV/EBIT	0	0