The fickle nature of market participants is always an extremely interesting study into human nature and greed. Back in 2000, there was no price high enough to pay for the stock of the high-flying Dell Computers (DELL). Times have changed quite dramatically with the advent of new form-factors such as tablets and smartphones, while the development of the Cloud has elongated the refresh cycle for P.C.'s and notebooks. In 2007, Michael Dell finally saw that trends were shifting from hardware to cloud services and came back to the company as CEO, going on a nearly $10 billion acquisition spree to acquire businesses that would allow Dell to become a highly competitive end-to-end IT solutions provider. While the strategy was sound, the prices paid on acquisitions destroyed shareholder value, eventually causing the stock to trade at some of the cheapest P/E and EBITDA/EV levels in the S&P 500 (SPY). In response to the stock's precipitous fall below $10, Michael Dell and Silver Lake have teamed up to attempt a roughly $24 billion buyout at $13.65 a share, which is a 25% premium to where the stock was trading at prior to the rumors. We are going to update our investment thesis on Dell from our article last August, and we will weigh the pros and cons of the proposed management-led buyout. I'm not going to touch on Dell's 4th quarter earnings released today, as I'll save a more detailed valuation for if the buyout fails.
One of my favorite Warren Buffett sayings is "price is what you pay and value is what you get." When I wrote the first article on Dell and when positions showed up in client accounts, I was often questioned as to what I could have been thinking giving the obvious headwinds facing the P.C. market. The reality however, is that Dell is a highly profitable business with a strong balance sheet, and the company generates prodigious free cash flows, which if properly allocated could create significant shareholder value well in excess of recent implied enterprise values. Dell was late to re-align its operations towards services from hardware; therefore the company has been more exposed than its models for the business structure change, IBM (IBM), and to a lesser extent Hewlett-Packard (HPQ), which have more diversified revenue streams. The beauty of Dell's hardware model was that from the very beginning its growth was funded via a cost-advantageous, direct-selling method that was revolutionary for the fast-growing P.C. industry. This second iteration of Dell has been predicated through milking the free cash flows of the P.C. business to invest high multiples to earnings and sales on I.T. services businesses that have the potential to make Dell competitive in the modern day I.T. business environment. Michael Dell's capital allocation strategies have likely increased the risk profile of Dell, but the decision to leverage its enterprise server install base to pitch a platform of higher margin services has shown signs of long-term success. Because the stock price already reflects the costly acquisitions and the questionable return on investment that were inherent in the pricing of the deals, the decision for Dell to attempt to take the company private at $13.65 per share gives the buyout group 100% of the upside from the depressed expectations priced into Dell's stock.
$1 invested with a 30 year-old Warren Buffett, is worth many multiples more than that same $1 invested with a Steve Ballmer or Leo Apotheker, whom have both proven to be dismal capital allocators. Dell has had the option to use its cash to pay dividends, buy back stock, or make expensive acquisitions and it has chosen to do the latter. Now that the stock is extremely cheap, the CEO and largest shareholder is willing to pay taxes on repatriated cash, and leverage up the company to bet on its future. I would do the same thing if I were Michael Dell and Mr. Market was valuing this business at absurdly low prices, but for long-term and loyal shareholders, this is obviously extremely upsetting because the company is not allowing them to participate in the upside after suffering the drop in share price. Michael Dell's capital allocation resume is still up in the air, but at the current juncture Dell has a real chance to succeed with a strong presence in the declining P.C. market, a profitable and growing services business, and a balance sheet that prior to any buyout is in wonderful condition. Keep in mind that 2012 was a horrible year for IT spending, as Dell's key markets in Europe, Asia and the governments it sells to were extremely weak. If Dell were to buy back stock using foreign cash while remaining a public company, long-term shareholders would likely be quite happy and eventually assign the stock a higher multiple on the perception of less risk from poor capital allocation. The same businesses, which Dell paid large multiples for are available to Dell or any other investor, as part of the overall package of the company, at one of the lowest forward p/e multiples a large and well-financed technology company has ever traded for.
At the same time, I certainly understand the desire for Dell to once again be a private company. The company does not need additional equity capital to fund its operations or growth objectives, and to achieve its goal of being an end-to-end IBM-like I.T. provider for small and mid-size businesses, the company needs to sacrifice shorter-term margins for long-term investments such as R&D and expanding the service suite package via acquisitions. Also, many of those outraged by Dell's decision to take the company private on the cheap seem to be recent investors in Dell that see an opportunity to squeeze out a higher bid on a short-term trade. Moving forward, I expect the deal to get done at a higher price than $13.65, possibly as high at $16.50. There are enough large and motivated shareholders that are willing to take the risk of the deal falling through to force a higher price.
In an absolutely terrible economic environment for IT, Dell generated nearly $3 billion in free cash flow over the last 12 months. This is down substantially from recent years and I believe that as the services investments bear fruit, Dell could get back to generating $3.5-$4 billion in free cash flow quite easily. As tablets and ultrabooks become more commoditized, a low-cost manufacturer like Dell has a great chance to squeeze out reasonable margins, prolonging the cash flow generating capabilities of the terminally declining hardware businesses. Dell ended the 4th quarter with $5.242 billion in long-term debt and $15.342 billion in cash and investments, much of which is held outside the U.S. The company ended the quarter with 1.748 billion diluted shares outstanding; therefore, the company has net cash per share of $5.77.
At $13.65, Dell is being acquired at roughly $23.86 billion. If you take the adjusted implied enterprise value of the acquisition of roughly $13.76 billion, and divide it by even the marginal trailing 12 months free cash flow of $3 billion, you get a free cash flow over enterprise yield of 22%. Now this is not a perfect way of calculating the implied value on the deal because there are tax and financial implications depending on how the deal is being structured, but I don't need a spreadsheet to tell me that is extremely cheap. The fact that Dell has paid roughly $10 billion for its spate of services acquisitions and has not written them down highlights what a ridiculous multiple is implied for the rest of Dell's legacy businesses, which still generate most of the free cash flow. With interest rates so low, Dell could really hit a home run if the current price holds up but strong execution will be paramount. Any improvement in the global economic backdrop could provide just the tailwind needed to allow the company to reduce debt, clearing the path for the free cash flow to be paid out to investors, or to be used to grow the business for the long-term, with the end-game being a likely IPO in a more favorable environment for Dell's evolving business. At T&T Capital Management (TTCM) we have exited a good amount of Dell short put options and long common stock at excellent profits, and are currently engaged in an arbitrage betting that the stock will not drop significantly, which we could exit at any time.
Additional disclosure: We could potentially exit the remaining Dell positions at anytime, as they are now intended as an arbitrage.