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Dude, Are You Getting a Dell?

August 13, 2012 | About:
Joseph Byrne

Joseph Byrne

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In the wake of disappointing earnings news at Apple, another computer hardware firm is becoming attractive from a value-perspective: Dell (DELL). While DELL’s share price has taken a beating in the last 12 months – down almost 26% – an in-depth analysis shows that perhaps DELL was kicked around more than it deserved. And for a value investor, there is often no better time to make a move on a stock than when no one else wants it.

No doubt DELL faces significant pressure in its PC business from competitors as well as consumers expecting a lower purchase price. DELL appears to be aware of this issue and has addressed it. As a result, DELL is making a sound effort to push further into the services area such as servers and cloud computing. Currently, services and storage represent only about 17% of total revenue,[1] a figure that should grow rapidly with DELL’s commitment to this segment. Furthermore, while true DELL largely missed on the tablet-craze, it could expect at least a small lift to product growth should they decide to enter this segment (especially if the product runs the new Windows operating system).

From a quantitative standpoint, DELL is a promising investment opportunity based on a discounted cash flow model. To accurately perform a DCF, an appropriate discount rate had to be chosen. As of the end of the first quarter 2012, DELL had an obligation to just under $9 billion of debt with an original amount of $9.5 billion. Interest rates on these various pieces of debt ranged from 27 basis points (commercial paper) to 6.5% for a 30-year note due in 2038. A weighted average cost of capital debt was calculated at 3.06%.

Different from investors like Warren Buffett who prefer to simply use the 30-year Treasury rate, investors like Seth Klarman elect to choose a discount rate based on how an individual investor values present vs. future cash flows.[2] In this model, 8% was chosen to represent this premium reflecting the relative uncertainty of cash flows for tech companies (as opposed to more non-cyclical businesses such as utilities). Klarman generally may choose a much higher figure in order to be conservative, but generally accepted practice is a 4% to 6% addition. Eight percent seemed a reasonable middle-ground estimate for a well-established tech brand but with a significant amount of debt; these two figures were added to reach a discount rate of 11.06%. An income statement was projected out through 2017, and Free Cash Flow to the Firm figures were calculated. DELL management has kept CAPEX spending near or above depreciation and amortization for each of the last five years. To reflect the potential commitment to infrastructure investment in the future (particularly to the services business), CAPEX was assumed at 120% of projected D&A expenses. Conservative revenue estimates of an 8% increase in services and a 2% increase in products were applied (implies overall revenue growth of a modest 3.2% to January 2013). This takes into account management’s desire to bolster service growth and temper expectations on product growth, with strong competition from the likes of Apple. A fair value price was calculated to be $18.21 based on the full $9.5 billion market value of the debt and an even more attractive $19.01 when using the balance sheet par-value debt figures. This represents a 53% and 60% premium to the current stock price, respectively.[3] Based on projected 2012 EPS, the P/E multiple is 13.43 – more in-line with competitor multiples. (Note: using a Free Cash Flow to Equity model, the calculated fair value is an even more impressive $20.87.)

It is interesting to note that these figures were calculated using a very conservative 0% terminal growth rate. Sensitivity analyses for target price and P/E based on varying discount and terminal growth rates were constructed:

101927_1344871935W1w5.png

The main concern in the analysis of DELL is their ability to transition to, or at least partially transform into, a solutions-based business as opposed to a strictly hardware business. Famed short-seller Jim Chanos announced in April that his fund, Kynikos Associates, was shorting DELL citing “the death of the PC” and concern DELL missed a huge opportunity in tablets.[4] Interestingly enough, Chanos admits DELL is extremely cheap and is largely playing a bet that DELL cannot effectively evolve their business.

David Einhorn of Greenlight Capital takes the opposite view of Chanos, applauding DELL’s expansion of product offerings and going long DELL at around $15.53, over 30% higher than current price.[5] Ultimately, I believe the healthy cash flow and established management team at DELL will successfully guide the firm to a business model less dependent on hardware products.

For investors looking for a solid name to add to their portfolio with an appealing cash flow, DELL should be strongly considered. Even scaling back services revenue growth to 6% still produces a fair value price of $14.65, an over 18% increase from the current DELL price. DELL’s acquisition of software companies such as Quest Software should bolster their commitment to services growth and contribute greatly to this investment thesis. Potential buyers could also look at purchasing call options on DELL. The current February 13 calls with a strike price of $15 are trading for about $0.20. This could be a savvy, albeit risky play for an investor who does not want to jump into the stock immediately but would rather wait to see how the debut of Windows 8 plays out and DELL’s services growth through calendar year 2012. Whatever the strategy, with the continued move into services and the announcement of Windows 8 potentially giving a small boost to product growth, investors could stand to gain a healthy profit with DELL in their portfolio.


Disclaimer: Author does not own DELL or any of its derivatives.



[1] Holt, Michael. DELL Morningstar research report. 7/2/12

[2] Klarman, Seth. Margin of Safety. Pg 125-128.

[3] Price of $11.85 as of 7/30/12

[4] Chanos, James. CNBC TV Interview. April 2012.

[5] Greenlight Capital. Investor Newsletter pg 4. 1/17/12.

About the author:

Joseph Byrne
I am a current 2013 MBA candidate at the Kellogg School of Management at Northwestern University. Before entering Kellogg, I worked in wealth management in New York and, more recently, a commodities broker at the Chicago Board of Trade. I can be reached at jbyrne2013@kellogg.northwestern.edu.

Rating: 4.1/5 (26 votes)

Comments

cubsfan
Cubsfan premium member - 1 year ago
I think Einhorn said in his last letter he sold all of his DELL, as he didn't like the direction

the business was going.

cubsfan
Cubsfan premium member - 1 year ago
Einhorn's latest comments on DELL:

Dell (DELL) proved to be a disappointment. We had thought that the growth in the non-PC business would be enough to offset the deterioration in the PC business. The non-PC growth was smaller than we'd hoped and the PC deterioration was worse than we'd anticipated. While DELL has a good balance sheet, it appears likely that management will try to use much of the cash to try to buy its way into better businesses. At a minimum, this will erode some of the value cushion that the cash balance creates. We exited with a loss.
Cowboy77
Cowboy77 - 1 year ago
The PC business is dead and/or dying. I've always bought my PC's from Dell...until now. Just had to buy 3 PC's. Went to Best Buy and paid $299 each for 3 new PC's and they're all great. Why hassle with 1000 options, toll free numbers and then wait on the shipping. I went, looked, bought and was up and running in an hour and was less confused.

Sorry but I just don't see the point in Dell anymore.

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