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And therein lays the key to Dell’s undervaluation and its appearance on the magic formula screen.
Dell trades like it’s the same company it was in the '90s. Investors view it as exclusively a PC and laptop consumer business. A one trick pony, if you will. And that one trick (PCs and laptops) is steadily losing ground to smart phones and tablets. While they’ll likely never completely go away, it’s likely PC and laptop sales will be much lower five years from now than they are today as they continue to be replaced by things like the iPad.
As if that wasn’t enough, as the PC and laptop become more and more of a commodity, cheap imports from foreign companies like Acer are slashing prices, and with PC companies already squeezed on one side by powerful suppliers of critical components like Microsoft (MSFT) and Intel (INTC), all of the profit from the space is rapidly disappearing.
All told, any company exclusively dependent on PC sales deserves to trade at a discount, as they face serious headwinds in the near future.
However, the Dell of today is so much more than just PCs and laptops.
As a matter of fact, Dell’s consumer division will be most affected by the shift to tablets and smart phones. It accounted for just 20% of revenue and 1% of operating income in their last fiscal year.
And that misperception has created an incredibly compelling valuation that is attracting both value investors like Mason Hawkins and Staley Cates of the Longleaf Funds and insiders like their CEO and founder, Michael Dell, who’s purchased over $250 million of shares in the past 12 months.
Magic Returns
Let’s start by taking a look at how great Dell’s returns are, and how traditional metrics like ROE and earnings per share might actually understate Dell’s cash generation ability.
At their most recent quarter end, Dell had just under $40 billion in assets and $33.2 billion in tangible assets. With operating income coming in at ~$4.1 billion, return on assets comes in a bit above 10.25% and return on tangible assets around 12.3%. Those are good numbers, but by no means outstanding.
But then consider that Dell employs a shockingly conservative balance sheet. Against $7.6 billion in total debt, Dell has total cash of $14.5 billion cash, another $9.4 billion in receivables, and almost $2 billion in long term investments and financing receivables.
All told, the core business employs ~$25 billion in capital and the other $8.3 billion represents excess dry powder that the company can use to weather any economic slowdown, continue their massive share repurchase program, or make further acquisitions. And it employs that $25 billion at a juicy 16.4% return.
But even that may understate Dell’s true economic returns. Dell’s famous for changing the way PCs are sold. Instead of building PCs and then selling them to consumers, Dell has consumers build and purchase a custom PC. Dell then orders the inventory, builds the PC, and ships it to consumers.
Because Dell has already taken on the cash before creating the product, Dell can actually employ negative working capital in its business (meaning it can basically run the business on interest free loans from customers and suppliers).
Negative working capital creates giant excess cash flow, and as long as the business doesn’t shrink, cash flow will significantly exceed net income. For example, over the past five years, cash from operations has exceeded net income by an average of $920 million per year!
So our 16.4% return on assets actually understates just how much cash Dell can generate from its assets!
Valuation
Dell earned a little over $4.1 billion in operating income in the past 12 months and an average of $3.1 billion over the past five years. At its most recent price of $15.92, Dell trades for a market cap of $30.2 billion and, with excess capital of $8.3 billion, an EV of $22 billion.
So you can buy one of the fastest growing businesses in American history, headed by its founder (incidentally, one of the best businessmen on the planet), for about 5.5x EV / EBIT and, after adjusting for their excess cash generation, around 4.75x cash flow. That’s absurdly cheap, and it’s why value investors are finding a lot to like in Dell.
Of course, part of the reason why Dell trades so cheaply is all of the “old tech” stocks (think MSFT and HPQ) trade at a discount because of the cloud hanging over them from cloud computing and the tablet movement. All of them are getting some attention from value investors as their stock prices look incredibly cheap given their huge cash flows.
But Dell trades for the widest discount, even though they are most likely the “old tech company” best positioned for the cloud computing and tablet era. Dell’s EV / EBITDA, for example, is at just 4.4x, versus HPQ at 4.9x, IBM at 8.8x, and MSFT at 5.8x.
Summary
It’s true, the future is uncertain, and some of Dell’s product line will undoubtedly look much, much different three years from now than they do today. But Dell’s strong segments, specifically the storage, servers and services segments, account for 75% of revenues today and are poised for years of strong growth.
With great returns on capital, a fortress balance sheet and a dirt cheap valuation, Dell makes a wonderful magic formula pick at today’s prices.
Looking for more Magic Formula Stocks? What about unrecognized and unloved microcaps with outstanding return characteristics? Maybe ones that, like Dell, generate even more cash than their earnings would lead you to believe? Then check out the Microcap Magic Formula Newsletter! Each month, we find one undiscovered microcap with magic formula characteristics, do in-depth and detailed research, and add it to our microcap portfolio. It’s early, but our first pick is already up 15% in just more than one month, and our second pick has almost 100% upside to fair value.
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One of my biggest positions. Just wished they paid a dividend....but as long as they are buying back tons of shares, I am happy. How do you say double your money in three years? Dell!