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By Joseph Morrison

Dell LBO Overview

In Pulp Fiction, Uma Thurman's character sagely observes of a group of gossiping gangsters, "When you little scamps get together, you're worse than a sewing circle." The way that Wall Street has handled the speculation of a Dell (DELL) leveraged buyout is in the same vein. There has been no confirmation that these talks are even underway but so far we have all witnessed two firms put in bids, one firm withdraw, and Microsoft (MSFT) join in the game. All the while, the share price for Dell has skyrocketed to one of the suspected buyout levels and has maintained that level.

I keep running through a scenario in my head where on the 2/19 earnings call, Michael Dell does not even address the chatter or worse, flat out dismisses all of the rumors about Dell going private. Given the year-over-year trend in the company's fiscal 2013 quarterly earnings, things could get ugly fast for the stock. If this occurs, I look for this stock to plummet to the lowest level of support at around $8.95 if this buyout does not occur.

Dell is trading on rumor and hope right now. Anytime I see a stock trading on hope, I am reminded of the quote which is popular in the trading world which starts, "hope in one hand" For this reason, I am staying away from trading Dell or Microsoft. I have many trading strategies, but hope is not one of them.

Discounted Cash Flow Overview

Discounted cash flow [DCF] is a popular way to measure the efficacy of a given project. The abridged explanation is that the user takes the project cost and estimates the growth rates of future revenues and costs. From that, using a discount rate to account for the time value of money attains a net present value [NPV] of the project, internal rate of return [IRR], payback period and so on. As an MBA student learns, the only measure that truly matters in this analysis is the NPV since IRR bears the reinvestment rate assumption, whereas NPV measures net benefit/loss to the firm.

What should now be apparent is that doing a DCF analysis requires many assumptions particularly in regards to growth rate. Even using an historical growth rate is a flawed method since past performance is not a measure of future results. What the following analysis is attempting to do is take into account multiple possibilities and recommend the best course of action for Dell as a firm. Additionally, whenever possible, the projections are taken from established sources. Many DCF analyses will pull a growth projection from seemingly thin air.

One constant assumption in the DCF analysis is that it will be conducted over 5 years. This is because the forecast from Fitch Ratings that Dell would need 3-5 years to have a higher enterprise multiple.

DCF Does Not Go Private

If Dell does not go through with any leveraged buyout, we just have to work the NPV of the projected cash flows over that 5-year time frame. This will provide us with a baseline from which to evaluate any buyouts. For the earnings growth, this analysis uses the forecast on NASDAQ which is 2.80% per year over the next 5 years. For weighted average cost of capital [WACC], this analysis uses the sector average which is 9.16%. Under these assumptions, the NPV for the cash flows for Dell over the upcoming 5-year period is $11.323B.

Dell Projections No LBO

Figures in Millions $

Projected Year Ending

2012

2013

2014

2015

2016

2017

Revenue

57,428

59,036

60,689

62,388

64,135

65,931

% growth rate

-8.0%

2.8%

2.8%

2.8%

2.8%

2.8%

Less: COGS

46,481

47,782

49,120

50,496

51,909

53,363

Gross

10,947

11,254

11,569

11,893

12,226

12,568

Less Op Exp

7,753

7,970

8,193

8,422

8,658

8,900

Less SG&A

6,913

7,135

7,363

7,598

7,841

8,091

EBITDA

4,034

4,119

4,206

4,295

4,385

4,477

Less Depr & Amor

839

835

830

824

817

809

EBIT

3,195

3,284

3,376

3,471

3,568

3,668

Less Taxes

744

765

786

808

831

854

NOPAT

2,451

2,520

2,590

2,663

2,737

2,814

Free Cash Flow to the Firm Analysis

Add Back D&A

839

835

830

824

817

809

Less Cap Ex

625

642

660

678

697

717

Less WC Investment

337

(117)

(120)

(123)

(127)

(130)

FCF

2,329

2,829

2,880

2,932

2,984

3,036

WACC:

9.16%

IRR:

N/A

NPV :

$11,323.21

As you can see, there is no IRR since there is no initial investment in this project. Now there is a basis for comparison as to whether or not to go forward with any buyout.

Dell Goes Private

It has been discussed in prior articles that the only way for CEO Michael Dell to realize his vision for Dell's future is to take the firm private. In order to do this, this analysis will apply the strategy which Dell has laid out to each business segment and project growth rates for each segment to comprise the earnings growth projections. First, we must look at the cost of this investment. Michael Dell owns approximately 15% of the stock and this will be thrown in so that can be deducted from the outstanding shares. The price per share is estimated at $15-16 which I support given a 20% premium when the deal was first rumored. Adding in existing debt and using the Lehman Formula for the banking costs, the total cost of the deal is $19.7B.

Price per share=

15.06

Debt outstanding currently (MIL)=

35.269

# shares outstanding =

10.61565

Other costs (Investment banker etc.)=

2.04

Total cost of the deal=

197.1807

Now there is a basis upon which to measure the cost of the deal. This analysis will use industry projections for growth in each segment in conjunction with the strategy laid out by Dell. In addition, it must be taken into account that the company will come public again. In order to parse this, this analysis uses the buyout investment except the investment banking costs are deducted rather than added.

Dell Projections W/LBO

Figures in Millions $

2013

2014

2015

2016

2017

Servers & Networking

7,968.22

8,278.98

8,601.86

8,937.33

9,285.88

Growth Rate

3.90%

3.90%

3.90%

3.90%

3.90%

Storage

1,928.78

2,081.15

2,245.56

2,422.96

2,614.37

Growth Rate

7.90%

7.90%

7.90%

7.90%

7.90%

Services

8,000.77

8,360.81

8,737.04

9,130.21

9,541.07

Growth Rate

4.50%

4.50%

4.50%

4.50%

4.50%

Software

9,968.49

10,566.60

11,200.60

11,872.64

12,584.99

Growth Rate

6.00%

6.00%

6.00%

6.00%

6.00%

Mobility

19,315.67

21,324.50

23,734.17

26,344.93

29,119.93

Growth Rate

9.90%

10.40%

11.30%

11.00%

10.53%

Desktop

13,233.69

13,498.37

13,687.34

13,783.15

14,017.47

Growth Rate

1.70%

2.00%

1.40%

0.70%

1.70%

Revenue

60,416

64,110

68,207

72,491

77,164

Less COGS

48,899

51,889

55,205

58,673

62,454

Gross Profit

11,517

12,221

13,002

13,819

14,709

Less Op Exp

8,156

8,655

9,208

9,786

10,417

Less SG&A

7,301

7,778

8,307

8,862

9,470

EBITDA

4,215

4,443

4,695

4,956

5,240

Less Depr & Amor

855

877

901

924

947

EBIT (oper profits)

3,361

3,566

3,794

4,033

4,292

Less Taxes

782

830

883

939

999

NOPAT

2,578

2,736

2,911

3,094

3,293

Free Cash Flow to the Firm Analysis

Add Back D&A

855

877

901

924

947

Less Cap Ex

657

697

742

788

839

Working Capital

(4,384)

(4,652)

(4,949)

(5,260)

(5,599)

Less WC Investment

(240)

(268)

(297)

(311)

(339)

FCF

3,016

3,184

3,367

3,540

3,740

WACC:

9.60%

IRR W/LBO

15%

NPV W/LBO

$3,833.81

LBO Price

-19,718

Public Offering

19,310

With the return to the stock market in 5 years, this is a NPV positive project. In addition, the firm is now in a better position to capitalize on higher growth markets for future profitability.

Final Analysis

There are many assumptions as well as factors that go into any analysis of projections. What this analysis shows is that if Dell can go private and restructure to keep up with growth in the various market segments, when it reemerges as a public firm, it can profit from this transition in the firm. For the long term investor, this could serve as a template upon which to base Dell as a firm when it reemerges from going private.

Source: How To Evaluate The Dell LBO