In the past 12 months Dell's (DELL) stock has plunged by ~24% but the rumor of LBO has given some momentum to the stock price. The potential deal looks good on paper but, with my in-depth analysis I feel it to be the nail in the coffin for the company's already declining PC shipments.
Dell has all the attributes required for a typical LBO, like hoards of oversees cash, modest leverage and handsome free cash flow. Additionally, the fact that Michael Dell owns 16% stake in the company will presumably reduce the capital required to complete a transaction assuming that he is involved and could make the deal easier. Going private may allow the company to revamp itself outside the public market, reduce its obligations and repatriate its offshore earnings. But my point of concern is whether going private will really help Dell, when its core business is already on the floor.
What's going on in the PC Market?
With the growing usage of cloud computing devices, large number of vendors has jumped into the emerging markets by providing cheaper computing devices. This shift in the computing environment combined with the emergence of Tablets and Smartphones will continue to threaten Dell and HP in their PC business. In fact, Dell's PC revenue fell by 9% year over year last year.
In spite of the headwinds in the PC business where the sales have been sluggish, Hewlett Packard Company (HPQ) has beaten Lenovo and Dell by capturing 16.7% of the global market share during the 4Q12. In a report by IDC, HP has also beaten Apple Mac which was reported to be relatively successful in the US market during the Q4 of 2012. HP is under a 5 year process to reinvent the brand and to develop innovative products that are more inclined to modern technology. But in my opinion, the heaving trend of tablets will ultimately dethrone Hewlett from its top position.
Market share of another PC player Lenovo Group Ltd. was 15.7% in the fourth quarter in comparison to 13.6% a year earlier. This is its highest market share since its inception due to its aggressive pricing which has left it with thin margins. Lenovo is also improving in the enterprise and consumer space but is fully devoted to the PC market for the long term. Meanwhile, it will continue to invest in innovative products that will help drive the convergence of technologies and services across - Smartphone's, Tablets, PCs and Smart TV. Recently Lenovo enhanced its non PC business by unveiling a new Smartphone Portfolio in order to offset the declining PC demands. Seeing the affinity towards Windows 8- it has also introduced a new lineup of consumer and business Windows 8 touch-optimized devices. And at this stage it would be very challenging for Dell to surpass Lenovo.
Currently there has been an increase in the number of traditional window-based vendors looking at a substitute OS to make their devices more attractive for lower end customers- like Samsung Chromebook. So, it is very likely that this competition will go higher in the near future. In addition, shifting towards Windows 7 and virtual desktops will also taper off the PC demand. In such a scenario, a leveraged buyout of $ 20 billion is highly cynical as Dell will also be restricted with limited free cash flow. Though Dell has around 11.3 billion cash to defray the deal's cost added to its overseas free cash flow but we shouldn't forget that bringing it back could cost a heavy tax penalty.
Hurdles on the way
Dell LBO isn't an easy game as there are several obstacles in front of it. On one end, Dell is already in $4.9 billion in long term debt and on the other side, the company is continuous in metamorphosis of its PC business to Enterprise business. The company has been acquiring smaller companies to expand into new markets. Seeing the growing demand of Enterprise products, what I am thinking is whether a private Dell would have the capital to pay for these acquisitions.
The deal is one of the largest for a technology company since 2007. The buyout is also the largest for a computer company since 2003 when HP took over Compaq Computer Corp. for $19 billion. Therefore, with the burden of its large debt, it would become more challenging for Dell to go for further acquisitions which in return may again hinder Dell to diversify away from the PC market. To get this deal go through-Dell will require heavy contribution from private equity investors (Potential PE investors-Silver Lake Partners and TPG Capital). And I assume that each of them have to pour around 10% of the deal in order to get it done which sounds crazy. The steepness of the deal implies it would be too large for single financial investors, so any deal would be likely involve multiple partners and we have seen in history that clubbed deals related to technology LBO were not successful. Unless the private equity investors are willing to continue injecting capital to support strategic decisions, Dell's transition to be more enterprise focused could become even harder.
Post effects of LBO
By going private, Dell will be relieved from public scrutiny. In addition, Michael Dell will be legally responsible to gain the elasticity required for rescuing lost ground and market share. On the services /solutions front, Dell will strive with Cisco Systems, Oracle Corp. and International Business Machines.
A leveraged buyout will make the firm unstable considering that Dell's EPS is going down - it has come down to 39 cents per share from 51 cents per share in the last four quarters. Dell is currently in the stage of transition from a personal computer company to a services firm and trying to take on the role of IBM for SMEs. A leveraged buyout at this stage might make the transformation more difficult.
The strategy of transition and LBO will not improve its competitive position against the popularity of Apple and Samsung in basic tech markets-tablet and Smartphone. In terms of broader takeaways, I don't think Dell LBO will create any harm to other PC vendors as the market is likely to continue favoring Asian manufactures that are focused on strengthening their market share.
Added to it, how Dell would exit its investment in the future is still doubtful.
This deal seems a legion as the company is shifting from the PC to other business operations, so I am expecting more investment on R&D for the fast evolving mobile market. And as a result, this stock may remain neutral for the upcoming 8 to 12 months. Apart from that, if its PC maintenance revenue follows the same trajectory, its earnings outlook will come under pressure. Dell will need free cash to continue the ongoing shift of its business toward enterprise IT and away from PCs. This in return would make it harder to bring down the sizeable debt burden that an LBO would require. I believe that LBO makes sense only if Dell's would have been backed by real recurring revenues, but unfortunately it is not like that. Therefore, with the burden of large debt, it would become more challenging for further acquisitions which in turn may again hinder Dell to diversify away from the PC market.