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Henry Blodget is pulling on exactly the right thread with respect to why the Dell (NASDAQ:DELL) leveraged buyout deal is so amazing for Michael Dell and his private equity partners and why it's not so great for existing shareholders.

No matter what you think of Dell's products, growth trend, competitive landscape, etc. - this company prints a LOT of cash. So much cash that it's made over $8 billion in acquisitions AND over $3 billion in repurchases and dividends over the last three years, while maintaining a large $5 billion net cash position (as of the 11/2/2012 10-Q).

Why aren't more people actually talking about the deal structure here and what it means for how much actual "at risk equity" both MSD and SLP are needing to put up to take the whole company private?

Sources and Uses:

Uses: It's a $25 billion deal, give or take, after including fees. Let's estimate the company has $3.5 billion of onshore cash and LT investments available to use in the transaction, which counts as a negative use of cash because it can be used to buy shares at the LBO price. That figure is approximated by the company's own recent statements that 25% of its cash flow is generated in the U.S. That leaves $21 billion, give or take.


Let's just take the low end of the $13B-15B reported bank financing, to be conservative ($13B). Then let's add the $2B borrowed from Microsoft (NASDAQ:MSFT) in the form of some kind of note. Ok, that's $15B of total sources before you get to the new/rollover equity required to fund the deal. So the new/rollover equity required is then $6B ($21B minus $15B), of which $3.3B or so is simply a tax-free rollover of Dell's existing shares. That leaves a $2.7B equity "hole" to plug from a combination of MSD Capital and SLP (and whatever other co-investors they manage to corral into the deal). It has been reported that SLP will need to kick in anywhere between $1-1.5B for its equity portion of the deal. That looks like a lot of equity to commit, even for a big fund like SLP.

What are we ignoring? Why is this such a good deal from Dell & SLP's point of view when that much equity is apparently at risk?

So, this company had something like $14.2B of balance sheet cash and LT investments at quarter end 11/2/12. We already "used" $3.5B of estimated onshore cash above to reduce the total purchase price to the LBO investors. So that's $10.7B of presumed offshore cash that looks like it's just sitting stranded out there, unavailable to use in the transaction. But is that true? What if the company decided to repatriate all that cash at some point in the near future and use it in this transaction or to fund a post-LBO dividend to the investors? So, they'd pay a big penalty of say, 35% to repatriate the funds. That's still close to $7 billion of after-tax coming back into the U.S.

Compare the new/rollover LBO equity estimated above at $6B, to the $7B of after-tax cash that *could* be repatriated back to the U.S. at some point. Based on this back of the envelope calculation, LBO investors could take the entire company private for virtually free *AND* fund a $1B dividend to themselves rather quickly? Oh yeah, and this doesn't include whatever future dividends come from free cash flow from the business which, although it appears to have declined quite meaningfully in 2012 YTD, is *still* on the order of $3-3.5B+ per year (yes, down from ~$5B in 2011 but still...).

So, with the new debt that the pro forma (post-LBO) balance sheet would appear to have ($15 billion of new bank debt and MSFT note payable), the interest expense on this debt is probably on the order of $1 billion per year (company says in its 8-K on the deal: "The cost of servicing the debt in the proposed structure over the next three years is projected to be approximately the same or slightly less than Dell's dividend and share repurchase costs over the past three years."). That still leaves $2-2.5B of *annual* free cash flow that accrues to LBO equity which, as we saw above is basically better than nothing.

It's like me and you agreeing to buy a $250,000 house from a seller where banks are willing to lend us $150,000, leaving us to come up with $100,000 to close on the house. But during our pre-closing walk-through of the house, we find a briefcase tucked in the hallway closet that contains $35,000 in cash that the seller hasn't yet discovered and reflected in the contract price. Then when our home inspector goes into the crawl space, they find a chest buried under the house that contains another $100,000 of gold coins - again the seller doesn't know this. It's just that this chest is buried really deep and it will cost $30,000 to get it out of the ground, and technically we don't own the house yet so we can't actually go and extract it. So, initially we had a $250,000 deal where we had to put down $100,000 equity to close on the house. We "found" the $35,000 in the hallway closet so we only need to put up $65,000 of our own equity now. And we hired some really good soil experts who think they can extract that $100,000 chest of coins (net $70,000 after we pay for it to be dug up) in a reasonably straightforward manner, without damaging the house, although it can't happen until after we close on the house, obviously. Would we want to take this deal - where we can basically pay $65,000 of our own equity at close, and get it all refunded back with an extra something on top ($5,000) after we extract the chest? Oh yeah, and turns out the house can cash flow something like $25,000 per year, meaning rent *after* mortgage interest, and repairs & maintenance. Are you kidding me, why wouldn't we take that deal?

Multiply this house example by ~100,000x and that's basically the proposed Dell LBO in a nutshell. The risk here is that after initially "overfunding" the deal with out-of-pocket cash and rollover equity, MSD and SLP cannot get to that overseas cash in any reasonable time frame. That outcome is not so bad either; they put up $6B in combined equity and get a business that does free cash flow of $2-2.5B per year. That's 33-42% equity yield every year, far in excess of the typical LBO target 15-20% IRR. The beauty of it is also, on a pro forma basis, this company is not levered that severely at all - $15B of total debt on a business that does $3.5-4B of EBITDA is only 3.8-4.3x levered on a total basis, and far less on a net basis when you include the cash stashed overseas (even with a 35% repatriation penalty).

The last question I'd have is, why can't the company execute this kind of dividend-recap and share repurchase deal as a public company, rewarding shareholders who have stuck with the company for so long despite its disappointing performance?

Disclosure: I am long DELL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.