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Dell: Value Trap?

September 07, 2010 | About:
Henry W. Schacht

Henry W. Schacht

13 followers
Dell is the definition of a fallen angel. This former tech darling has fallen to earth after years of flying high. It is also a company that bedevils me. Is it ridiculously undervalued or a value trap that will ultimately burn shareholders?

At year-end 2009, Dell had approximately $11 billion in cash and $4 billion of debt. Add in $2 billion or so in annual free cash flow and there is something to get excited about. This is especially true considering the company’s $25 billion market value. Not surprisingly some of my favorite value firms are among the largest owners of Dell shares, including Southeastern (Longleaf), Brandes, and Harris Associates (Oakmark).

Earlier this year, I too was seduced into owning Dell. It didn’t last long. A talk with investor relations woke me up. In discussing uses of cash, we covered buybacks, special/regular dividends, acquisitions and more. It became very obvious that acquisitions were to be the focus. In closing, the investor relations rep said my opinions were similar to those of Mason Hawkins. I took that as a huge compliment, but it wasn't meant to be. Dell clearly has no intention of listening to either of us.

This is a company that doesn't speak our language, to say nothing of their "new math".

I've seen companies fritter away billions and have nothing to show for it thanks to this attitude, so my Dell shares quickly found new homes. Given the continued decline in Dell shares, I should be grateful, but I keep revisiting this company and its odd capital decisions.

Given Dell’s track record on share repurchases, one can understand if the company swore off buybacks. Shares have declined from nearly 3 billion shares to below 2 billion in the past 15 years and the stock has fallen nearly the entire time. In fact, since the shares peaked in 2000, shares outstanding have dropped from 2.6 billion to 1.9 billion. Hindsight tells us that they should have been more patient. Ironically, the cheaper the shares have gotten the less attractive they’ve become to Dell management as a use of excess cash. Buy low? No thank you.

As for dividends? Just like real men don’t ask directions, real tech companies don’t pay dividends. This is especially so for "growth" companies. And that is how Dell sees itself, even if the world no longer does. And paying dividends sends the wrong message. And here I thought dividend payments were about using capital wisely?!?

Instead Dell has decided to hold the cash and use it to “invest in the business”. For the uninitiated, that’s code for acquisitions. In this, Dell looks like a desperate company. Margin compression in Dell’s core business helps explain why this may be the case. Of more concern, everywhere Dell wants to be there seems to be a superior company occupying the space.

Whether large integrated firms like IBM and HP or specialized firms like storage giant EMC, Dell seems caught in the mushy middle strategically. This 2009 headline speaks volumes: Dell to Buy Perot in Catch-Up Deal.

Perhaps in response to Hewlett Packard’s purchase of EDS, Dell bought Perot Systems a year ago for $3.9 billion, a 68% premium to Perot's public market price and 30x its earnings.

Shareholders should be relieved in a way. The Perot deal was relatively cheap compared to the attempted purchase of 3Par. Whether it’s the $18 a share bid in August or the final one at $32 (or $2.4 billion), it is a hefty bid for a company that is barely profitable. The financial press must have been feeling nostalgic about the Internet Bubble because they were again able to use the price-to-sales multiple to explain the deal instead of price-to-earnings. In fact, HP “won” the day with a bid valuing 3Par (PAR) at 8 times sales. Congratulations!

I’ve been told many times that as a value investor, I just don’t understand growth, that I am incapable of understanding the world of possibilities that opens up because of such strategic acquisitions. I admit that I hate the word “synergy” and have no imagination! I will only say that growth is a variable to be valued not an end. Growth at any price does not benefit shareholders.

If this was a make or buy decision, both companies are admitting something by the price they were willing to pay for PAR. By ignoring other uses for cash, Dell is admitting still more.

A value trap is a company that may be undervalued, but where intrinsic value is falling. Margin of safety is eroded and there is no guarantee of upside. Some companies do this by losing money and burning up asset value. Others do it through poor capital allocation decisions.

If the competitive environment and value were static, Dell would be a buy. But these are dynamic forces. Dell’s reaction to their competitive positioning is eating away at intrinsic value. Dividends and aggressive share repurchases (at current prices) would be vastly superior to acquisitions at ridiculous prices.

Luckily for Dell, 3Par found a “greater fool” in HP, but don’t think that another deal isn’t around the corner. Lexmark (LXK) perhaps? Either way, this flailing around isn’t pretty to watch.

If Dell keeps throwing its cash away, their IR department can relax. That phone won’t be ringing as often.

Disclosure: In addition to numerous Dell computers, author owns LXK.


Henry W. Schacht

http://www.lonelyvalue.com/

About the author:

Henry W. Schacht
Henry W. Schacht, CFA is the founder of Schacht Value Investors, an investment management firm serving individuals and institutions. He currently serves as President and Chief Investment Officer. He earned his MBA at the University Of Chicago Graduate School of Business and a BBA in finance from the University of Notre Dame. Mr. Schacht is a member of the Association for Investment Management & Research (AIMR), the Investment Analysts Society of Chicago (IASC), and the National Association of Corporate Directors (NACD).

Rating: 3.7/5 (18 votes)

Comments

jhodges72
Jhodges72 - 3 years ago
I don't understand your "buyback" argument. A stock repurchase program isn't the only way to create shareholder value. If Dell can get a 40% annual return on their capital through an expansion effort and only a 30% return via a buyback, obviously an acquisition would be the more beneficial catalyst. A comparison must be made. A stock repurchase plan is not a one size fits all solution. Regardless, all of this is rather moot as I'm critical of any value investor who dabbles in the rapidly changing technology world. Like Mr. Buffett, it makes no sense to use an investment analysis approach (value investing) that often takes up to three years to come to fruition on an industry that often endures rapid changes every six months. You might as well be a full fledged speculator.
batbeer2
Batbeer2 premium member - 3 years ago
Two thougts.....

1) I think DELL (at least the old Dell) is more of a retailer than a tech stock. A retailer with "no" inventory. Dell does not compete on technology but on distribution network and high inventory turnover.

2) This company is cheap for a company that dominates its niche globally and is consistently profitable; It's not cheap enough for me.

Dell has returned to shareholders, on average, 2.5B per annum. Add/subtract the ammounts used for share and debt buybacks an cash received for shares and debt issued..... devide by the number of years and you get my 2.5 B per annum. YMMV.

dealraker
Dealraker - 3 years ago
Dell has to sell more and more as prices fall and fall.

Coca-Cola for me.
batbeer2
Batbeer2 premium member - 3 years ago
Dell has to sell more and more as prices fall and fall.

So who/what is causing those prices to fall ?

Deflation is not gravity; it's man-made.
dealraker
Dealraker - 3 years ago
Agree
hschacht
Hschacht - 3 years ago
Where did I say that a stock repurchase program is the only way to create shareholder value? I think value can be created with acquisitions, dividends, buybacks, and internal investments, to name a few. And of course they have to compare the returns of the various alternatives!

Do you think that 3Par was a 40% proposition? Come on. Massive price and no current profits.

"A stock repurchase plan is not a one size fits all solution." True. And I didn't say it was. Just that the buybacks would be more beneficial at current prices than 3Par. Or Perot for that matter.

Please read beyond the 2nd paragraph before commenting.
jhodges72
Jhodges72 - 3 years ago
I didn't see anywhere in your write up in which you said "a buyback would be better than the acquisition of 3par."

That's a completely different sentence than what you wrote. No need to get so excited, I did give you 4 stars for your effort but I give one star for this one.
buynhold
Buynhold - 3 years ago
Henry,

If you read "Direct From Dell" by Michael Dell, you will know where the company's growth (at any price) mentality comes from. I remember him saying in that book that he didn't see why he could not continue to grow his business at a 40% clip for the next few decades.

I am surprised that Mason Hawkins in still hanging on, but then his record in tech-related investments has been appalling so far (Dell, Sun Micro, Symantec) - I believe most of these ideas came from Southeastern's Chief Technology Officer (Richard Hussey?).

Dell is cheap, but it's intrinsic value has been falling over the last few years. If management is focused on a high-priced acquisition spree to fuel growth, it'll be tough for them to reverse this trend.

hschacht
Hschacht - 3 years ago
Buynhold,

Your last sentence is an excellent summary of my article. Thanks for writing it.

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