Equity Market Cap: Approximately 31.6 Billion
Enterprise Value: Approximately 22.6 Billion
Although many have left the company for dead, I believe Dell (DELL) offers long-term investors a compelling value at today’s price. Formerly a high flying tech stock with a price over $50 per share at the peak of the tech bubble in March of 2000 and a multiple that remained elevated throughout most of the last decade (as high as 35x earnings in 2004 and near 19x in 2007), Dell has experienced significant multiple contraction, even with an aggressive transition of the business model the last two years that has resulted in vastly improved operating margins, net income back near peak levels, and earnings per share at record levels (due to the firm’s aggressive share buybacks).
The negative opinions and short-term thinking can be seen in many places. Here are some headlines from CNBC from February 22, 2012:
“Dell is Done, But Don’t Discount HP: Analysts”
“Will HP Follow Dell’s Lead Down?”
“Dell’s Earnings Miss”
“Dell Disappoints the Street”
I believe investors who think longer term and take the time to study business fundamentals have a distinct advantage over the so-called “Street,” who tend to focus on one quarter of earnings and shun less exciting stocks.
First I will review Dell’s segments:
Dell breaks sales down into six categories as shown below:
1) Servers and Networking
4) Software and Peripherals
6) Desktop PCs
Desktop PCs and Mobility Segments
Products include desktop PCs, workstations, laptops, netbooks, tablets and smartphones.
Dell does not have a presence in smartphones or tablets; however, that is not where they will add value in my opinion over the long term (more on that below). The bulk of sales from this unit will continue to come from PCs and workstations, as well as laptops and netbooks.
Below is PC shipment data:
Despite many claiming PCs are on their way toward extinction, the data shows PC growth is not dead, only maturing. A three-year CAGR of over 5% which includes one of the worst recessions since the Great Depression and a slow 2011 due to caution related to the eurozone crisis as well as the effects of the Great Recession still lingering, does not represent an industry headed for extinction. Of course the mainstream application of the tablet has cannibalized demand for PCs in certain cases, but PCs will still be necessary for many tasks; try typing a term paper, using Excel, or navigating a highly complicated finance program on a tablet. Future PCs are likely to be smaller with tablet-like features, such as Windows 8 touch screen. PCs will still be relevant the next several years and should grow slowly because of enterprise use, emerging market demand, and the convenience of smaller laptops and netbooks.
The latest PC data shows that Dell has performed well relative to the industry:
Dell posted year-over-year unit shipment growth of an impressive 7.8% the fourth quarter while the industry declined 1.4%. For the full year Dell also outperformed the industry growth rate and slightly increased their market share. Some of Dell’s most recent success is surely due to HP’s indecisiveness regarding its PC unit. I believe HP's share is likely to recover later this year due to the new CEO’s commitment to their PC division; however, some of Dell’s success is due to execution and the firm broadening its products and services.
Although Dell still has some progress to make before they become a full services IT firm like HP and IBM, it is encouraging that management is recognizing PCs are a mature, slow-growth industry generating thin margins and have begun focusing on higher margin segments such as servers and networking, storage, IT services and even software. This can be seen in the numbers as the firm is much less reliant on PCs than they were in the past:
Nearly 63% of revenue generated was derived from PCs in the fiscal year ended Feb. 3, 2006, with nearly 38% of revenue from desktops. During the last quarter only 53% of revenue was derived from PCs and only 23% from desktops, which is clearly the most mature, slow-growth, lowest-margin segment.
Investors are currently pricing Dell as a company solely reliant on slow growth desktops, but even if desktops are in secular decline, they represent less than one quarter of Dell’s revenue. Below I will describe Dell’s other segments and why they can thrive even if PC demand remains weak.
Servers and Networking
Description from last year’s 10-K dated 1/28/11:
“Our standards-based PowerEdge line of servers is designed to offer customers affordable performance, reliability, and scalability. Options include high performance rack, blade, and tower servers for enterprise customers and value tower servers for small organizations, networks, and remote offices. We also offer customized Dell server solutions for large data center customers. During fiscal 2011, we expanded our networking product offerings and introduced our PowerConnect J-series. These products serve as part of our mission to help companies of all sizes simplify their IT environments."
Compare this with the 10-K dated 2/3/06:
Servers & Networking. Dell provides customers with standards-based PowerEdgetm line of network server hardware and PowerConnecttm networking solutions.
Servers. Dell’s standards-based PowerEdgetm line of servers is designed to provide customers affordable performance, reliability and scalability. Options include high performance rack, blade and tower servers for enterprise customers and aggressively priced tower servers for small organizations and networks. Dell ranks Np. 1 in the U.S. and No. 2
worldwide in shipments of x86 servers (based on standard Intel architecture). During calendar 2005, Dell maintained its number two position in the category.
Networking Products. Dell’s PowerConnecttm switches connect computers and servers in small- to medium-sized networks. PowerConnect products offer customers enterprise-class features and reliability at a low cost.
The statement “We also offer customized Dell server solutions for large data center customers” is a newer area of focus for Dell as they transition to a full services IT firm. Through their acquisition of Force10, Dell has become a player in the data networking market.
Below are quotes from an article written by Larry Walsh from channelnomics.com dated July 20, 2011:
“Force10 is a small-but-tenacious competitor in the data networking market. It’s been squarely aiming to rob market share from Cisco with high-performance switches and routers. Under the channel leadership of Michael O’Brien, it’s made steady progress in building a niche among partners and the marketplace.
Dell’s acquisition of Force10 is a clear indication that it intends to continue building out its enterprise IT capabilities and compete with the likes of Cisco, Juniper, IBM and Hewlett-Packard.”
In addition to Dell’s push into the higher margin data networking market, Dell has consistently been a top provider of servers. Below is the latest data from Gartner:
Dell grew server revenue year-over-year 6.3%, faster than the industry average of 5.2%, increasing their market share slightly. The interesting thing is the numbers show Dell’s mix of servers has shifted more toward the high end, as their revenue growth increased 6.3%, almost twice as much as the increase in their server shipments of 3.2%. Unlike PCs, server demand is still healthy and likely to grow rapidly because they are necessary for enterprises and data centers.
Update: IDC just released worldwide server market revenue data for Q4 2011, as well as finalized 2011 figures. Despite a decline in server revenue worldwide during Q4, Dell continues to impress, growing revenues year-over-year and increasing its share of the worldwide server market. The link to the IDC press release is below:
According to IDC, as of the latest data (third quarter 2011), Dell ranked fourth in total storage disk systems revenue with a market share of 11.6% and experienced year-over-year growth of nearly 5%. Data shown below:
IDC - Press Release
Industry Year-over-Year Revenue Growth: 8.5%
While this bodes well for Dell, with storage demand likely to continue to grow, due to more internet traffic and the need to store more electronic data over the next several years, this does not tell the full story. In the past Dell sold many third-party storage systems. From the 10-K ended Feb. 3, 2006:
Storage. Dell delivers a comprehensive portfolio of storage solutions with services, including DellIEMC and Dell’s PowerVaulttm lines of storage devices to help customers address today’s most significant challenges — growth, backup and compliance. To meet customers' mission-critical requirements, Dell offers a broad range of cost-effective tape backup products, direct attached storage, network attached storage and storage area networks. Total storage revenue grew 38% during fiscal 2006 and continues to be supported by Dell’s long-standing partnership with EMC Corporation.
This highlights the firms partnership with EMC. However, with the acquisitions of EqualLogic in 2008, and more recently Ocarina Networks and Compellent Technologies, Dell is shifting toward more self-branded storage systems, which should improve margins. As the latest press release highlights, storage revenue is back on the rise after experiencing a decline for several quarters due to Dell’s move from third-party to self-branded storage. Below is the new description from last year’s 10-K dated Jan. 28, 2011:
Storage — We offer a comprehensive portfolio of Dell-branded and third-party advanced storage solutions, including storage area networks, network-attached storage, direct-attached storage, disk and tape backup systems, and removable disk backup. With our advanced storage solutions for mainstream buyers, we offer customers functionality and value while reducing complexity in the enterprise. Our storage systems are easy to deploy, manage, and maintain. The flexibility and scalability offered by our Dell PowerVault and Dell EqualLogic (“EqualLogic”) storage systems help organizations optimize storage for diverse environments with varied requirements. During Fiscal 2011, we expanded our storage portfolio by adding a variety of increasingly flexible new Dell PowerVault, Dell EqualLogic, and Dell DX Object storage choices that allow customers to grow capacity, add performance and protect their data in a more economical manner. We are shifting towards more Dell-branded storage offerings. In addition, our recent acquisitions of Ocarina Networks Inc. in Fiscal 2011 and Compellent Technologies Inc. in early Fiscal 2012 will enable us to expand our storage product offerings. We believe that along with our solid position with the EqualLogic product line, these acquisitions allow us to expand our customer base for mid-range and high-end storage solutions and deliver integrated data management solutions to our customers.
From the last 10-K:
Our services include a broad range of configurable IT and business services, including infrastructure technology, consulting and applications, and product-related support services. Our customer engagement model groups our services with similar demand, economic, and delivery profiles into three categories of services: transactional, outsourcing and project-based.
Transactional — We offer services that are closely tied to the sale of our servers, storage, and client hardware. These services include support services, managed deployment, enterprise installation, and configuration services.
Outsourcing — Our outsourcing services business is designed to reduce customer costs and help to increase the efficiency and improve the quality of customer business operations. Our outsourcing services include data center and systems management, network management, life cycle application development and management services, and business process outsourcing services. A significant portion of the revenue we derive from our outsourcing services contracts is typically recurring in nature.
Project-based — We also offer short-term services that address a wide array of client needs, including IT infrastructure, applications, business process, and business consulting.
Although still a long way from IBM (IBM) and HP (HPQ), acquisitions of Perot Systems in November of 2009 and Secure Works in February of 2011 has enabled Dell to become a broader IT services and solutions provider. The IT services market is a large, highly competitive market, nearly $850 billion in 2011 worldwide according to Gartner, and is also less concentrated with lower barriers to entry. IBM’s top market share (approximately 7% in 2010) is a much lower share than the top share in other areas like servers and storage systems. Dell’s growth of service revenue shows they have executed relatively well so far, is helping to forge stronger IT relationships, and also partially responsible for the improvement in operating margins over the past couple of years.
Certain acquisitions mentioned above also recognize the importance of the cloud, such as Compellent, which provides storage solutions for cloud computing environments and Secure Works, which provides cloud security services.
Software and Peripherals
The peripherals market, which consists of items such as printers, monitors, keyboards, mice, etc., is likely to be a slower growth market. According to IT Candor, as of July 2011, Dell had 5.3% of the worldwide peripherals market and increased share slightly from one year previously:
I would expect this market to grow slowly and nearly in line with the PC market, as their will be a need for printers and other peripherals, but much less so than many years ago with the move to electronic data and tablets. Although this should remain a small piece of Dell’s business going forward.
Dell’s software segment is small relative to the company. However, they recognize this is a higher margin and growing area, especially software-as-a-service. Dell has made several acquisitions but still remains a marginal software player. But according to an article by Forrester Analysts, this is about to change:
According to the article, Dell has recently formed a new software group led by John Swainson who was appointed president. John led a turnaround at CA and has extensive experience with IBM. John’s turnaround of CA was based on two key areas: customer obsession and embracing partnerships. Dell’s choice of Mr. Swainson shows they recognize that not only are products important, but also relationships. Dell can make software, whether enterprise or software-as-a-service part of their business by establishing and maintaining good relationships and combining software with other products and services such as storage and data center solutions. If successful, growth of Dell as a software player should also improve margins and enhance profitability.
It was announced this past week that Dell acquired AppAssure, which develops backup software for virtual, physical and cloud storage, continuing its expansion into the software arena.
In addition, according to the latest 10-Q, Dell will continue to reduce participation in non-strategic areas of the software business.
SEC Settlement, Negatives, and Conflicts
Below is a link to a good article on the subject:
Quotes from article:
“On July 22, 2010, the Securities and Exchange Commission announced an agreement with Dell and its founder, chairman & CEO, Michael Dell to settle charges of repeatedly "failing to disclose material information to investors and using fraudulent accounting to make it appear falsely that the company was consistently meeting Wall Street earnings targets and reducing its operating expenses."
Dell ( DELL - news - people ) agreed to pay a $100 million penalty and Michael Dell agreed to pay $4 million. Six other Dell employees, including the former chief executive officer and chief financial officer, were either part of the settlement or have been sued by the SEC.
Why is the Dell case so instructive? Simply put, according to the SEC's charges, for 20 straight quarters Dell would have missed consensus quarterly earnings estimates but for receiving payments from Intel ( INTC - news - people ). The SEC findings clearly state that for many of those quarters Dell asked for and received payments in the exact amount needed to meet or beat its earnings estimates.
Intel's payments to Dell were not trivial. In fact — this is all according to the SEC — in the first quarter of fiscal 2007 the payment soared to $720 million, representing 76% of Dell's operating income. Between fiscal 2003 and the first quarter of 2007, Intel paid Dell $4.3 billion. Such payments according to Intel's lead negotiator and Dell executives "saved their quarter" and allowed Dell to "barely make the quarter because of the Intel money."
Certainly there is no guarantee something like this does not happen again under Michael Dell. However, Dell’s actions are reminiscent of a firm’s behavior during a bubble to prop up its stock price. While firms can always feel pressured to meet quarterly earnings estimates, pressure was at an all-time high when every company in the tech sector was a market darling, and although Dell’s superior supply chain should have been recognized by the market, the stock was clearly trading well above its estimate of intrinsic value. Pressure to keep the price propped up as long as possible by meeting quarterly earnings estimates was a major conflict for Dell.
Although Mr. Dell receives no compensation for serving as chairman of the board, it is troubling that he is both the chairman of the board and the CEO. While all but two directors are independent, it would be an encouraging sign if Mr. Dell would step down as chairman of the board and an independent director were to be appointed. It could also be argued that although Mr. Perot is considered an independent director, companies with which he is involved have close ties to Dell, making his board membership far from independent.
Despite these negatives, clearly Dell is a more efficiently run company with Mr. Dell at the helm. During Dell’s absence as CEO from 2004-07, operating margins contracted significantly, from 8.6% in the fiscal years ending January 2004 and 2005 to 5.3% in the fiscal year ending January 2007, and earnings per share growth was essentially stagnant. Another positive is Mr. Dell’s 13% ownership of the firm, which includes recent purchases totaling approximately $250 million, one for $100 million in December 2010 and another for $150 million in March of 2011. Although these purchases alone are not a significant piece of Mr. Dell’s net worth, they take his ownership interest of the company to approximately 13% according to the latest proxy statement, and could be a sign he believes in the company turnaround and to a certain extent align his interests with shareholders.
While the company foolishly repurchased overpriced shares earlier last decade, the company’s large commitment to share buybacks at lower prices along with Mr. Dell’s 13% ownership and Longleaf Partners 9% stake, could provide somewhat of a floor in the stock price. There will be more on share buybacks below when I discuss company valuation.
Financial Health and Other Metrics
Dell has a strong balance sheet according to the latest press release. The company has approximately $5 per share in net cash and investments as measured below:
As of February 3, 2012
Cash and Equivalents 13,852
Short-Term Investments 966
Long-Term Investments 3,404
Short-Term Debt 2,867
Long-Term Debt 6,387
Net Cash and Investments 8,968
Diluted Shares Outstanding 1,796
Net Cash and Investments per Diluted Share $4.99
Note: A small portion of cash and investments are allocated to a deferred comp plan in a rabbi trust, but the amount is a negligible percentage of total cash plus investments
If the latest 10-Q is studied, it is revealed that the majority of Dell’s cash, cash equivalents, and investments are highly conservative and liquid level 1 and 2 assets with the bulk in cash, money market funds, and commercial paper, and a minority in high quality corporate U.S. and foreign bonds. Very little are equities subject to short-term market fluctuations, and derivatives exposure, primarily used for hedging currency risk, is negligible.
Long-term debt is dispersed fairly evenly over the next decade plus and consists primarily of low coupon debt, with over 90% of debt carrying coupon rates lower than 6%.
If net cash is calculated as a surplus of working capital (Current Assets + Long-Term Investments – Current Liabilities) it increases to $6.04 per share; however, I will use the more conservative number of $4.99 to value the company.
The vast majority of financing receivables are paying in a timely fashion, with only 8% 30 days or more past due or $359 million in dollar terms, and less than 2% 90 days or more past due or $79 million in dollar terms, representing a tiny amount of Dell’s assets.
With its acquisition of DFS Canada from CIT as well as another agreement to purchase CIT Vendor Finance's Dell-related assets and sales and servicing functions in Europe, Dell has broadened its ability to support customer’s financing needs worldwide.
Free cash flow has also been impressive over the last decade, exceeding $3 billion in every year the past decade before acquisitions, measuring free cash flow as cash flow from operations minus capital expenditures. Accounting for acquisitions, free cash flow has always been positive, with the exception of a minor negative year in fiscal 2010. Shown below:
Source: Company Filings
Cash flow from operations has almost always exceeded net income due to issues such as stock-based compensation and deferred revenue. However, I want to emphasize that I will not use these items to inflate my valuation of the company.
The free cash flow above shows that Dell is in a good position to make strategic acquisitions that will diversify the firm into higher margin IT segments and to add shareholder value by repurchasing shares at lower prices.
Although return on invested capital has declined in recent years, and will most likely never reach past levels between 40-60%, it still remains high. Return on invested capital has declined due to debt taken on over the last few years, as the company has been more aggressive on the acquisition front. However, Dell’s return on capital still remains in the low to mid 20s, significantly higher than its cost of capital.
Every measure above shows Dell is in fine financial health and most financial metrics show solid performance.
When valuing Dell, I will present a bear, base, and bull case.
I will also use earnings multiples of 10, 12, and 14x in each case. Dell’s average multiple the past five years has been slightly above 13x earnings, thus I feel a base valuation of 12x plus net cash is a reasonable multiple.
I will also use GAAP earnings.
Bear Case for fiscal year ending January 2013:
Revenue growth declines 3% overall, driven by a 10% decline in desktops
Gross Margin declines to 20% from 22.3% with declines in both product and service margins.
Operating Margin declines to 5% from 7.1%
Tax Rate is 21% - high end of guidance from latest conference call as the company projects a tax rate between 19-21% for fiscal 2013
Free Cash Flow before acquisitions drops from nearly $4.9 billion to approximately $3.5 billion
10% of Free Cash Flow used to repurchase shares, which is the low end of guidance from the latest conference call
The company forecasts 10-30% of free cash flow will be used for share repurchases during fiscal 2013
GAAP Earnings per share of $1.23
Revenue grows 2% driven by gains in servers and networking, storage, and services, offset by declines in desktop PCs
Gross Margin declines slightly from 22.3% to 22.1%
Operating Margin declines slightly from 7.1% to 7%
Tax Rate is 20% - midpoint of guidance
Free Cash Flow before acquisitions drops slightly from nearly $4.9 billion to approximately $4.6 billion
20% of Free Cash Flow used to repurchase shares
GAAP Earnings nearly steady at $1.89 per share helped by share repurchases and slight revenue growth but hurt by a slight decline in margins
Revenue grows 5% driven by gains in servers and networking, storage, and services. Mild gains from laptops, PCs, and software
Gross Margin improves to 23% from 22.3%
Operating Margin improves to 8% from 7.1%
Tax Rate is 19% - low end of guidance
Free Cash Flow before acquisitions improves to approximately $5.3 billion from nearly $4.9 billion
30% of Free Cash Flow used to repurchase shares
GAAP Earnings improve to $2.29
Consolidated projections and valuation range below:
As you can see from the chart above, Dell's current stock price, adjusted for net cash plus investments, values the company at only 10x my bearish earnings scenario.
Earnings toward the end of fiscal 2012 were slightly affected by hard drive prices according to management’s assessment during the latest conference call. But given that hard drive prices are likely to fall longer-term once Western Digital’s production is back to full capacity and supply again meets demand, and the fact that Dell is diversifying away from being solely a PC company, this is not much of a concern for long-term investors.
The tax rate for fiscal 2012 was slightly lower than the projected range for fiscal 2013. It is possible the tax rate stays lower if more earnings come from abroad. However, for valuation purposes, I used the company’s more conservative guidance.
Dell has recently completed several acquisitions discussed above. I assume the company spends a similar amount on acquisitions during fiscal 2013 as they did in fiscal 2012, $2.5 billion. I expect the firm to focus more on building their software segment this year, which looks to have already started with the recent acquisition of AppAssure.
There were 137 million common shares of stock-based incentive awards excluded from diluted shares outstanding as of Q3 of fiscal 2012 (October 28, 2011) because they are considered to be anti-dilutive. More detail will be given in the fiscal 2012 annual report when released. Although there are some restricted-stock awards, the vast majority of anti-dilutive stock-based incentive awards excluded from diluted shares outstanding are stock options. According to the last 10K dated 1/28/11, exercisable options had a weighted average price of $28.61, far above the current stock price. Given the company’s commitment to share buybacks and the weighted average price of exercisable stock options far above the current stock price, extra dilution is not much of a concern. In addition, I valued the company on a multiple of GAAP earnings rather than by discounted free cash flow because I did not want to inflate my valuation of the company by including factors such as non-cash stock-based compensation.
Based on my analysis above, I believe Dell offers a sufficient margin of safety and significant upside potential for long-term investors, selling for approximately 6.25x my base case forward earnings estimate adjusted for net cash plus investments at the time of this writing.