Recently, we shared our thoughts on the Dell (DELL) leveraged buyout, Microsoft's participation and the PC market in general, concluding that the company was terribly undervalued at the suggested transaction price, and that the dynamic character of the PC market made this a poor time to do a deal.
In the interim, it has been a dance of a thousand veils as daily leaks fleshed out, and no doubt tested the waters for, aspects of the transaction. Thus, in the muted light of such published speculation, the contours of this exotic thing have become a bit clearer. Yes, it is a deal that is attractive for its use of private equity, its absolute size (the biggest since the crash), and the fact it involves a major tech company. Still, what concerns us is that it is Dell that is to be taken private through a recapitalization. Thus, it is the nuts and bolts of the deal that matter. In short, is it a good deal for investors? Through a flurry of stories and filings, we can fashion an answer.
A Deal Is Announced
Well, the deal has been announced and we are halfway towards some clarity on the structure of the transaction. Michael Dell and Silver Lake Partners have agreed to acquire Dell for $13.65 per share in cash, generating a transaction value of $24.4 billion. A Special Committee, originally formed to consider strategic alternatives for Dell shareholders at large, will conduct a 45-day "Go-Shop" period to solicit and review alternative bids as the deal documentation is prepared. Any successful bidder during this period will pay a breakup fee of $180 million, an amount that rises to $450 million thereafter.
Regarding the valuation of the transaction: It is indeed incredibly cheap, offering investors a paltry sum. At $13.65 per share, it generates a valuation of $24.4 billion, which is just 0.44x and 8.2x out-year revenue and earnings, respectively. On a cash-adjusted basis, it is an even cheaper 0.35x revenue and 6.6x earnings; indeed, the Free Cash Flow Yield is a rich 13.9%. No doubt at least some current shareholders are deep value investors hoping to ride these metrics up towards more mean-adjusted levels. It will be interesting to see if they vote to fold early and sell their shares. Assuming they do, only Michael Dell, Silver Lake and unidentified others will enjoy the bounty of this severely undervalued deal.
Other aspects of the transaction are highly problematic, as well. The structure of the deal was not disclosed in the press release (linked above) that announces it. It merely specifies that the transaction will be financed through cash and equity from Mr. Dell, cash from Silver Lake, and cash from MSD Capital (Mr. Dell's family investment fund). Also included is the roll-over of existing debt, $2 billion in debt from Microsoft, some sort of committed mezzanine financing from the Deal Bank Group, and (notably) "cash on hand."
Three aspects of this announcement are of particular interest. First, it appears to consider existing Dell cash, to which present shareholders have a claim, as a major funding source for the deal, which is unusual. This, indeed, will be a huge issue for investors. Second, Microsoft is to contribute subordinated debt, which allows it minimal influence in, or access to, operating and strategic matters. It is well down the credit stack with looser covenants than others. This is no doubt to assuage Microsoft's other PC customers. Finally, there is no financing contingency, meaning the Bank Group will underwrite the transaction (no doubt in the agreed amount of debt) to wherever this mezzanine structure ultimately leads.
It's Harder Than It Looks
Given the paucity of initially disclosed information, major questions arise. First, basic math suggests adequate capital is wanting on both the equity and debt sides of the transaction. A primary cause is the fact that, as a private equity transaction, it is woefully undersubscribed. Just Silver Lake is participating, and it is contributing just $1 billion, or a bit more, in equity capital. Indeed, Managing Partner Egon Durban is credited with putting the deal together. Other firms were suggested as participants, but none are to contribute to the deal. Surely, one factor in their reticence is the fact the current CEO Michael Dell is to take a majority stake; typically, private equity investors work as a group to seek a majority stake among them in the event it is necessary to change management or strategy in husbanding their investment. This protection here is wanting. Constraints exist on the debt side as well, despite the banking commitment, mainly because Dell already has a considerable amount of debt.
There is at present a profusion of stories and filings on the deal, more than can be read as we take this to press. Still, it is clear to us this is indeed a tougher deal than many believe. Private equity deals always have a fair amount of drama, mainly because investors do all they can to minimize the equity contribution, so as to maximize returns, in effect off-loading risk onto the creditors. Still, in this instance, many details have been suggested through the press about how the deal may come together. And in fact, they have guided the way to what is an extremely disadvantageous deal to existing shareholders. Simply put, unable to attract sufficient equity capital, the buyout group has elected to claim company cash-in effect, asking existing shareholders to help fund the deal. This seemed too audacious to us to be true, but it has been confirmed in a voluminous 8-K filing and reported in the press. Let us take a closer look at how this has transpired.
We indicated that putative details of the transaction were discussed in the financial press. Indeed, two articles in The Wall Street Journal suggest specific parameters of the deal and its debt financing, though major questions remain. First, in an article that was published as the Board of Directors met to vote on the deal, it was suggested that Michael Dell contribute his stake as well as $700 million from his family investment firm, for a combined $4.4 billion equity participation. Silver Lake was said to invest more than $1 billion in equity, and Microsoft $2 billion in subordinated debt. In fact, as reported from the filing, much of this has been affirmed.
First, it is clear that without Dell company "cash on hand," the numbers simply do not add up. Though the Bank Group is apparently prepared to finance up to $15 billion in debt, it is actually contributing $13.75 billion. (For convenience, we cite The Wall Street Journal summary of the filing.) Backing the Bank commitment and Microsoft sub-debt out of the deal consideration, we see that the equity component of the deal is roughly $8.7 billion. Michael Dell is contributing 273 million shares (worth $1.73 billion), as well as $750 million in his own cash and that of MSD Capital. This will give him the majority voting interest (52.8%) he seeks. Silver Lake is contributing just $1.4 billion in equity for a 16.2% voting interest. This leaves a funding gap on the equity side of $2.8 billion, which as a voting interest corresponds to 32.1% -- nearly a third of the new shares. And for this, the buyout group intends to use company cash to fill this equity gap. In effect, in tendering their shares to the buyout group, existing shareholders will cede their claim to this capital, which courtesy of the Banking Group, will be paid to them as partial consideration. Stealing from Peter to pay Paul, indeed!
The situation is even more interesting on the debt side of the transaction, which by its nature involves the terminal, post-deal capital structure and the ongoing level of EBITDA that will allow for the pay-down of the debt. In this case, the addition of $13. 75 billion in new debt to the $9.0 billion that presently exists on the balance sheet appears unsupportable. Dell's EBITDA has fallen over the past couple of years from over $6 billion per year to the $4 billion to $5 billion per year now used on the Street. Hence, the $24.7 billion in apparent total debt, at 5.5x estimated EBITDA of $4.5 billion, seems a stretch. Once again, information leaked to the press, in combination with a closer analysis of Dell's existing debt, will provide additional clarity.
The ever-present "people familiar with the matter" have suggested that the buyout group hopes for a Double-B credit rating, which requires that leverage be less than 4.0x EBITDA they quantify at $5.0 billion. A Double-B is required to satisfy restrictions in place on both banks and the CLO (collateralized loan obligation) managers who mitigate credit risk. These sources say that, in computing leverage, only $15.0 billion in bank debt and $4.0 billion in "legacy" bonds will be included. Obviously, some of the $25 billion in combined debt has to go away in the transaction. And people "in the know" (i.e., the bankers) are apparently willing to exclude up to $6 billion in existing debt. After all, they already have made the financing commitment.
Is a credit bubble so ripe that the new debt holders will disregard such a large amount of debt? In fact, it is not as bad as it seems. First, new debt holders expect to be senior to existing debt holders, and will thus have priority over them if things go bad. More importantly, significant amounts of existing debt will be legitimately excluded. We can see that, of Dell's $9.0 billion in existing debt, $3.3 billion is current and comprises $1.65 billion each of commercial paper and current maturities of long-term debt. The CP program will surely be retired as Dell becomes a highly leveraged company; the maturities will surely be paid down as well. And both will be paid out of existing cash. These retirements will significantly lower post-deal debt to $21.5 billion, or roughly 4.8x estimated EBITDA of 4.5 billion. This is still too high for a Double-B rating.
More of the remaining debt, however, can arguably be excluded from the leverage computations, since $1.4 billion exists to support Dell's Financing business. It is abundantly supported by Financing receivables of $4.5 billion, and is thus allocable to the business unit, even if parent company guarantees are in place. So if we back this out, remaining combined debt is $20.1 billion, or roughly 4.5x estimated EBITDA of $4.5 billion. Indeed, we are not quite to the 4.0x EBITDA required for a Double-B rating, but with more aggressive projections, and a more lenient stance on credit, it may indeed pass muster.
Still, aggressive seems to be the adjective most suited to this deal. Exacted at an extremely low valuation, it is aggressively advantageous to the buyout group. Inadequately funded, to all appearances, on the equity side, it is an aggressively positioned deal, relative to both shareholders and creditors. Moreover, in claiming $2.8 billion in company cash, it is egregiously disadvantageous to existing shareholders. And in creating a large, privately-held Enterprise services company, it uses an aggressive amount of leverage. Indeed, sacrificing a commercial paper program will be a competitive disadvantage to more than the Financing business. And it cannot be stated enough that management will be diverted this year at a key competitive juncture in the personal computing market.
Given these factors, one has to wonder if the Board of Directors is capable of acting as fiduciary to shareholders at large, the silly pantomime of even-handedness notwithstanding. This is always a danger when a founding shareholder retains a key management and stakeholder presence. The fact is that the core PC business has been deteriorating for years, even as the company bulked up through acquisition. Managerial inaction and poor corporate governance have been a problem for some time.
What Are We To Do, Then?
We agree that much of the preceding analysis is fairly speculative. Still, deal information was put into the public domain to guide expectations and facilitate a transaction. And the lengthy S-8 appears to affirm our worst suspicions. (We are eager to read it.) With all of this in mind, then, what are investors to do?
Debt investors can only lick their wounds at present, as values have fallen and spreads (and the cost of insurance) have risen. Nevertheless, covenants on individual issues may allow for some redress through change-of-control provisions. Some holders could be refinanced through the debt funding. Still, for the longer maturities in particular, ratings and valuations are likely to improve over time as the company pays down debt. So, there is light at the end of the tunnel, at least for some.
Equity investors must decide how to cast their vote. And this is a tougher question. We believe many investors view Dell as a deep value play, and have exit points at prices well above the transaction price. The opportunity cost of selling out is thus high. And indeed, major shareholders are set to vote no. That said, there is no way around the fact Michael Dell is CEO and major stakeholder. And this is why no public or private equity holder beyond Silver Lake appears willing to step into the breach. The use of company cash is just salt in a festering wound.
Selling out within this framework may seem to be the best of bad alternatives. With a losing hand, you fold your cards. This is a shame, however. Were management as focused on its operating efficiencies as it is on structuring the buyout, results would likely improve, even with middling execution. Even if it managed to trade at just 0.6x out-year consensus revenues, the stock would be up over 30%, and still incredibly cheap. So, yes, investors have plenty of reason to vote down the transaction. Either way, things will be a mess.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.