Shares of Dell (NASDAQ:DELL) have caught a strong bid over the last month, up 10% since news broke of Goldman Sachs' buy recommendation and subsequent price target of $13. GS initially rated Dell as a sell.
I generally don't place much emphasis on analyst actions, but the event was significant as it appeared to finally get some investors interested in the stock after a dismal 2012 in which the shares fell nearly 30%.
When I recommended Dell's shares as recently as October 1st, I emphasized Dell's apparent valuation and growth estimates as a PC maker, rather than the enterprise solutions firm it's in the process of becoming. Trading at a 6.4 times Enterprise Value/Net Income ratio, it's clear the market is still not buying Dell's ability to successfully make a major business transition, or investors are still not aware of that the relevance of the firm's PC operations in the context of the bottom line is on the decline.
This article will approach the logistics of Dell's transition in the context of competitive advantages and disadvantages. I'll reiterate the quantitative aspects of my projections for Dell at the end of the article,
How Can Dell Be Successful In The Transition To An Enterprise Solutions Company?
One of the first questions investors should be asking themselves when they hear that the management of any company is attempting to enter a business that seems foreign is, "what makes management confident in their abilities to succeed?"
Warren Buffett has written several times about the folly of business diversification outside of a firm's traditional circle of competence. Noted examples are Coca-Cola (NYSE:KO) growing shrimp in the 1970s and Gillette exploring for oil. The takeaway is that diversification of revenue streams for the sake of diversification or quick profits is an excellent recipe for disaster.
In Dell's case, the company doesn't have much of an option. The aggregate 2012 PC market saw the biggest decline in shipments since 2001, with Dell's shipments down 14%. With the mobile computing revolution well underway, traditional PC makers are in quite a precarious situation. To make matters worse, Dell is getting squeezed at all price levels in the PC market by firms like Acer (OTC:ASIYF) and can't compete very much at the "luxury" end given Apple's (NASDAQ:AAPL) dominance.
Given this dynamic, management's motivation for the transition is at least better then the Coke shrimp example.
The move to enterprise solutions isn't exactly original, as IBM (NYSE:IBM) pulled it off well before companies like Dell and Hewlett-Packard (NYSE:HPQ) began to ramp-up investment in the space. For me, the biggest question has been, what exactly gives Dell a competitive advantage in the enterprise solutions business? In other words, Dell has been getting crushed in the PC market due to the double-edged sword of an overwhelming transition to mobile computing and a largely commoditized market; Dell needs to offer an array of differentiated products that allow it to build a niche. This is the only way Dell will remain relevant and produce above average economic long-term returns for its shareholders.
The answer appears to lie in the acquisition led strategy of acquiring attractive businesses, made possible only by the practice that led to Dell's struggles: excessive free cash flow as a result of low R&D spending.
Dell had nearly $5 billion in FCF in fiscal 2012 (almost one-third of the firm's enterprise value), and will probably do almost $4 billion in fiscal 2013 free cash flow. This generation of cash in conjunction with exceptionally low CAPEX has created a lean balance sheet that allows for strategic purchases.
Since 2008, Dell has spent $13 billion on making itself a vendor for companies that are producing their own data centers. Enterprise solutions, services and software (ESS&S) are the main bright spot, closing in on $20 billion in annual revenues. Within this segment are servers, which make up about 13% of Dell's revenues. Servers and networking enjoyed 11% sequential growth. ESS&S now make up more than 50% of Dell's annual revenues. Software acquisitions, most notably that of Quest Software, have resulted in meaningful overall margin expansion even in the face of a struggling PC business; gross margins are above 23%.
Valuation Provides Significant Margin Of Safety
Given the transitional stage that Dell is in and the inherent uncertainty regarding the durability of the company's revenues, I'd have a difficult time recommending Dell as a good long-term investment. Thus, there's not much convexity in buying shares with a 3-5 year time frame.
That being said, Dell appears very attractive as an investment over the next 1-3 years. At 6.5 times net income and FCF generation that makes up 20-35% of the enterprise value, the poor prospects of Dell's PC business is well reflected, and the uncertainty regarding the future success of the business transition also appears to be well discounted.
ESS&S generated almost $29 billion in FY 2012, at an average gross margin of 29%.
According to its Q3 conference call, Dell expects mid-single digits growth in Enterprise Solutions & Services. While software sales (which are reported along with peripherals such as keyboards) have struggled in FY13, their long-term importance as attachments to ES&S offerings will continue to grow extensively over the next several quarters. Quest Software will contribute meaningfully to software revenues in FY14.
Focusing solely on Dell's three higher margin businesses (ESS&S), operating at the aforementioned gross margin of ~29% currently producing roughly $30 billion in sales, Dell is generating about $9 billion of gross profit.
As I calculated in my previous article (using a 13% operating margin):
"Assuming a conservative 7.5% annual revenue growth rate, Dell will receive over $41 billion in annual revenues from these segments. At a 13% margin, Dell will earn $5.33 billion in 2017. This figure does not include any D+M revenues."
It's my expectation that by FY 2015 Dell will be earning $1.90-$2 in EPS and trading at an expanded earnings multiple. Downside appears limited to about $10.20 (current EPS of $1.70 with shares trading at an ultra low 6 times earnings, not excluding cash) with a two-three year upside of $16 based on expectations for $1.90 to $2 of earnings and modest multiple expansion. At current prices, investors would be risking about $1 for $5.