The Dell Dilemma

| About: Dell Inc. (DELL)

By now, most investors know about the Dell (NASDAQ:DELL) LBO, but let's quickly recap. On February 6th, Dell filed a Form 8-K to announce that it had entered into an agreement to be acquired by Michael Dell, founder of Dell, and Silver Lake Partners, a California based private equity firm. The deal values Dell at $24.4 billion with a per share price of $13.65, a 25% premium over the close of $11.83 on January 11th, the day before the rumors leaked. The deal is set to close in the second quarter of 2014-that is, if shareholders are convinced that it's in their best interest. So far, a lot of the larger shareholders don't feel that it is.

Most notably showing its concern is Southeastern Asset Management, an 8.5% beneficial owner of the company. Southeastern said in a letter to Dell's Board of Directors on February 8th that it would vote against the deal, stating its reason as undervaluation (yeah, it's a word). The asset management company, which is the largest of Dell's outside shareholders, stated in the letter that they "Believe that the proposed transaction, under which Dell's public shareholders would receive only $13.65 per share, clearly represents an opportunistically timed bid to take the Company private at a valuation far below Dell's intrinsic value, and deprives public shareholders of the ability to participate in the Company's substantial future value creation." In the letter, they go on to state that they believe Dell's true per share value is closer to $24, and that they will "avail [themselves] of all options at [their] disposal to oppose the proposed transaction, including but not limited to a proxy fight, litigation claims and any available Delaware statutory appraisal rights." They even go to the extent of calling out Dell's Board of Directors stating, "The Board of Directors has a fiduciary duty to consider any transaction, and particularly an insider transaction such as this, in light of what is in the best interest of all of Dell's shareholders." Below is a table that was included in the letter to back up their $24 valuation.

Source: Southeastern

All that sounds good, but with only 8.5% of the vote, what can they really do? First of all, they're not alone. On February 12th, T. Rowe Price announced that they "Believe the proposed buyout does not reflect the value of Dell and we do not intend to support the offer as put forward." T. Rowe Price is the second largest outside shareholder with 4.4%. The evening of Dell's announcement, Pzena Investment Management Inc., 1% shareholder, stated that they would vote against the deal, citing the "unreasonable" valuation. These three companies alone hold about 14% of the vote, which still is not enough to put a complete stop on the deal, but Southeastern is already working on a solution to that. The company announced on Tuesday that it has hired D.F. King & Co., the largest proxy solicitor in the nation, to help obtain more votes against the deal.

Dell closed at $13.80 on Tuesday, February 13th, $0.15 above the buyout price that is being proposed to shareholders. Before Southeastern announced that it would be fighting the buyout at the current offered price, the stock was trading at just under the asking price of $13.65. Now however, the market is telling us that it does not believe the deal will go through at the current price, as investors are now willing to pay more than the buyout price to purchase the stock. While Southeastern's analysis, which values the stock at $24 per share, is unlikely to be met, analysts from investment banking firm Jefferies believes Dell could push the deal through with a $15 bid, but they don't believe anything above $17 is likely.

There is significant upside potential and somewhat limited downside potential with Dell in its present situation. If you were to buy Dell at its current price, you would be paying a $0.15 premium with the expectation that the deal will be modified in your favor. The five probable situations and their respective returns are identified here:

  1. Deal goes through as is: $13.65 (selling price) - $13.80 (purchase price) = $0.15 per share loss or 1.1% decrease
  2. Deal goes through at low end of Jefferies' prediction: $15 (selling price) - $13.80 (purchase price) = $1.20 per share gain or 8.7% increase
  3. Deal goes through at high end of Jefferies' prediction: $17 (selling price) - $13.80 (purchase price) = $3.20 per share gain or 23.2% increase
  4. Deal goes through at Southeastern's price point: $24 (selling price) - $13.80 (purchase price) = $10.20 per share gain or 73.9% increase
  5. Deal is retracted and stock reverts January 11th price: $11.83 (selling price) - $13.80 (purchase price) = $1.97 per share loss or 14.3% decrease

Of the five situations listed, the second and third seem the most likely to take place. With the largest outside shareholder threatening litigation and preparing for a proxy fight, and other large shareholders quickly jumping on board, Dell is unlikely to get the offer through at a valuation of $13.65 per share. At the other end of the spectrum, Southeastern is unlikely to see Dell match its $24 per share estimate, which values the deal at about $42 billion. This would mean that Mr. Dell would have to put forward an additional $18 billion. As his current fortune is reported at $16 billion, Mr. Dell would need additional support from one of his partners to make this happen. The last situation listed also seems improbable as Mr. Dell would have to abandon what he believes is the best direction for his company.

Long story short, Dell seems to be a pretty solid BUY right now. With a probable upside in the range of 8.7% to 23.2%, and an unlikely downside of 1.1% to 14.3%, the good definitely outweighs the bad. But buy now while it's still up in the air, because once it's decided there won't be much upside left to capitalize on.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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