Why Smart Money Should Buy Dell

I have a healthy respect for the stock market as a short-term, forward-looking indicator; it does provide an excellent vision of about six months down the line. But today, I hold the market in contempt. This is a time when smart money is behaving dumb; even if the market-wide story is true, opportunity is created from sheer stupidity at an individual stock level. At present, the market is stupid and lacks vision. For an investor willing to look beyond his or her nose, there are some amazing opportunities. Dell (DELL) is one of them.

Look at Dell's balance sheet: if you add up its cash, short/long-term investments and short-term notes receivable, and subtract long term and short term debt, you get $9.5 billion. This is over $4.87 per share. Shares outstanding are down from 2,485 million shares at 1/28/2005 to 1,960 million at the end of the most recent quarter closed; that means over 21% of the company has been bought back.

During the past five accounting years, based on 1,960 million shares now outstanding, the company has generated free cash flows of $1.12 (Year end 1/30/08), $2.54, $4.54, $2.11 and $0.44 (1/30/04). During the past 6 months, it has generated $0.99 in free cash flows. In total, over the last 5 1/2 years, the company has generated $11.74 in free cash flow. Since it still holds $4.87 per share, roughly $6.87 has been invested in principally in buy backs and acquisitions. This is a pretty amazing record of the ability to create free cash flows.

Consider this: if Dell were to start with $4.87 per share in cash and shut shop in 20 years, generating only $0.80 per year, growing at an annual inflation rate of 3%, in free cash flows during those 20 years; using a discount rate of 12%, we would arrive at a value of $12.09. If you use a 6.5% discount rate (long-term market returns), then value is $16.01.

If you look for $2.13 per year (average free cash flows over past 5.5 years) for the next 20 years growing at 6.5% and demand a 20% annual rate of return, the price to pay now is $19.20. Now, I think Dell will do growth well over 6.5% per year long term, so this valuation is depression economics.

If I were Michael Dell, at this point in time, I would ratchet up share buybacks with a view to a leveraged or management buyout. Listing back after the turnaround is complete would make a second fortune. If this did occur, I would be a sad man; as a shareholder, I would lose out on a magnificent opportunity.

Disclosure: Author holds a long position in Dell

Comments

[basehitz:]

You apparently didn't get the memo. No analyst is allowed to say anything positive about any stock, especially tech. Instead, you're supposed to sit with CNBC and emphasize why the world will end and when. Of course, a year ago there was only blue skies ahead from that same propaganda machine. I have 4 possible theories:
1) They're right. Go find a bomb shelter. The end is here.
2) The talking heads find sensationalist headlines are good for ratings.
3) CNBC and the analysts are jawboning down tech stocks because they know what you are saying is true and their Wall Street buddies are today buying what they are telling you to sell.
4) Most of the media is liberal, and they want you to believe the worst about everything until "The Chosen One" gets elected and the Dems have a supermajority in Congress. Then Pelosi will generate some useless refund checks like the $160B, and miraculously, the media reports will turn positive and The Chosen One will be given credit.

Today, I will be looking to buy chip ETF shares. I have waited a very long time to buy this where it troughed in Oct '02. Today, that will happen. My preference is USD, an ultra ETF.

Thanks for your post. A moment of sanity in the midst of the chaos is refreshing.

2008 Oct 24 08:08 AM

[Walt17:]

Dell could well be a good long term investment. But your balance sheet numbers ignore the fact that payables are about 2x receivables. You should also consider the other liabilites and deferred long term debt. Add those in and the balance sheet picture isn't as good as you paint it.

2008 Oct 24 08:40 AM

[Shiv Kapoor:]

Walt17 - the value of Dell's supply chain is of prime importance in understanding why Dell creates value and free cash flow. This will deteriorate somewhat as Dell enters the traditional sell through retail segment; however, the deterioration is built into lower expectations of future free cash flows.

This post is not really about Dell's balance sheet, it is about Dell's ability to generate free cash flows. They are succesful because of incredible supply chain management which is perhaps second only to WMT's supply chain. Using the balance sheet to determine liquid reserves is just to identify what they have today which could be invested or distributed; what remains on the balance sheet & payables is a maintainable structural advantage Dell possesses.

2008 Oct 24 09:00 AM

[H.J. Huneycutt:]

(1) Dell's balance sheet isn't in nearly as good shape as you paint it out to be. They have a 91% debt-to-value ratio in what has basically become a commoditized industry.
(2) The book value of their equity is a paltry $1.41 per share
(3) Their free cash flows are deceiving in '07 and '06 because they sold off a lot of investments. This does not imply anything about their future FCFs.
(4) Quite frankly, Dells are crap. Dell used to be the standard of PC quality and now, they are pieces of junk. Dell has shifted to a low-cost strategy and has abandoned their high-quality/reasonabl... price strategy that helped make them the market leader.
(5) A low-cost strategy could theoretically work, except that others have undercut Dell and I have a hunch that some will succeed with the strategy of selling low-cost PCs with Linux-based operating systems.

While I felt like Dell was significantly overpriced at $15, it has at least dropped to $12 and will probably drop a little further. I still think it's not a very good value even at $10. Given their future prospects and the nature of their industry, I wouldn't even consider them a buy target till they hit $6 or $7 and I'd still keep away from them on the basis that I think their business model will get beat out by others in the next decade.

2008 Oct 24 09:48 AM

[Frank Waddell:]

I have to agree. Any value investor, that has a lick of analytical skills, can see that there is tremendous value here. I only hope the share price stays low long enough to buy back a good portion of the outstanding shares, while maintaining a good cash cushion.

In case you haven't come across it yet, I would listen to Mason Hawkins' recent conference call for shareholders in its LongLeaf Partners Fund. He briefly mentions his reasons for his bullish stance on Dell, in which is his largest holding in the fund at near 10% of Fund assets.

2008 Oct 24 02:36 PM

[Frank Waddell:]

I have to agree. Any value investor, that has a lick of analytical skills, can see that there is tremendous value here. I only hope the share price stays low long enough to buy back a good portion of the outstanding shares, while maintaining a good cash cushion.

In case you haven't come across it yet, I would listen to Mason Hawkins' recent conference call for shareholders in its LongLeaf Partners Fund. He briefly mentions his reasons for his bullish stance on Dell, in which is his largest holding in the fund at near 10% of Fund assets.

2008 Oct 24 02:36 PM

[brewer:]

I'd agree with Jake, Dells are crap, plain and simple. What value to do they add that you can't get in any generic PC? Nothing. Just buy the least expensive motherboards you can, put them in the most unbelievably ugly case you can find (be sure it doesn't quite fit) and you have the same computer for a lot less money.

Michael Dell should close the company and return the money to the shareholders. I mean, if they can't manage their business, it would be the prudent thing to do! It's not as if they ever did anything original to begin with. Any one who's ever 'built' (and I use that term loosely) their own computer (from completely assembled parts, naturally, you have to have the genius mentality to plug them together) has done as much as Dell has to further technology.

2008 Oct 24 04:45 PM

[ppgreat:]

Dell has proven to be a poor long term investment. It has only made ends meet by laying off about 9,000 people recently. They are trying to sell off their manufacturing plants. Their profits are razor thin.

They are quickly going the way of Gateway.

2008 Oct 24 05:12 PM

[Shiv Kapoor:]

Dell has been an incredibly poor long term investment. It has managed a pathetic 20 year return of near 28.5% annualized over the last 20 years and that is a shameful performance; it has only outperformed the broader indexes by some 438% during this period.

2008 Oct 25 02:34 AM

[mannheim:]

What definition of "FCF" are you using with those numbers? If I use FCF = Net Inc + Depr&Amort - CapEx - Cost of Stock Options, I get $1.81 (1/30/08), $1.70, $2.04, $1.71, $1.47 (1/30/04), which puts the 5-yr avg at $1.75...am I missing something here? (all share counts are 1,960 million) This might be mice-nuts, but "inquiring minds want to know"...

I'm torn on Dell, because it does have tremendous FCF growth potential. However, the present and future of the PC business is increasingly laptop-driven, which diminishes the value of Dell's marvelous supply chain. At the same time HP has improved their supply chain, further eating into Dell's moat, so much so, that I think these companies for all intents and purposes are at parity. (from the manufacturing perspective) In addition to altering their business model, they need to improve the quality of their consumer products, to Jake's point. They have a lot on their plate...

Longer term, I'm also concerned about any competitive advantage they could re-establish. If you look out 10 yrs, there's a good probability of multiple emergent Asian suppliers that could become the lowest cost producers in an increasingly commoditizing business.

Given these risks, it seems that any valuation would have to discount appropriately. I don't know if the probabilities can realistically be well-estimated. This might be a case of "too hard"...

2008 Dec 05 08:36 PM

[Shiv Kapoor:]

The main difference on FCF between your calc and mine will come from the working capital adjustment in each historic years and use of the actual share count each year. No doubt Dell has a hard job ahead of it; I think they have an executable turn around plan which is progressing well, though the economy turn makes it difficult. In terms of Asia competition; this is a real threat - my view is that any company no matter of what incorporation can in the global world do what the Asian competitors do, where they do it. Since Dell has embraced globalization, it stands to benefit greatly. Over an emergent Asian competitor, Dell will have (a) better management (b) better intellectual property (c) better supply chain (d) better access to capital; this coupled with the ability to source and produce in EM's will allow them to stay ahead.

Mind you since I wrote this post the market has created a fair few opportunities with better FCF growth potentials in basic materials and energy. Provided of course that EM's continue to grow long term.

On Dec 05 08:36 PM mannheim wrote:

> What definition of "FCF" are you using with those numbers? If I use
> FCF = Net Inc + Depr&Amort - CapEx - Cost of Stock Options, I
> get $1.81 (1/30/08), $1.70, $2.04, $1.71, $1.47 (1/30/04), which
> puts the 5-yr avg at $1.75...am I missing something here? (all share
> counts are 1,960 million) This might be mice-nuts, but "inquiring
> minds want to know"...
>
> I'm torn on Dell, because it does have tremendous FCF growth potential.
> However, the present and future of the PC business is increasingly
> laptop-driven, which diminishes the value of Dell's marvelous supply
> chain. At the same time HP has improved their supply chain, further
> eating into Dell's moat, so much so, that I think these companies
> for all intents and purposes are at parity. (from the manufacturing
> perspective) In addition to altering their business model, they
> need to improve the quality of their consumer products, to Jake's
> point. They have a lot on their plate...
>
> Longer term, I'm also concerned about any competitive advantage they
> could re-establish. If you look out 10 yrs, there's a good probability
> of multiple emergent Asian suppliers that could become the lowest
> cost producers in an increasingly commoditizing business.
>
> Given these risks, it seems that any valuation would have to discount
> appropriately. I don't know if the probabilities can realistically
> be well-estimated. This might be a case of "too hard"...

2008 Dec 06 11:32 PM