At the beginning of the year, I recommended Dell (NASDAQ:DELL), then trading at $9.97 a share, in an article which also suggested that it might be a potential take over candidate. My methodology for evaluating stocks crudely tries to approximate private market value and so, while it may not tell you much about where may prices will move in the short term, it probably is useful in identifying potential LBO candidates.
My methodology is based on a combination of balance sheet analysis and cash flow analysis. First, I try to determine what a buyer is paying for the operational company itself by backing out net balance sheet cash. I generally credit the company for financing receivables as a "cash like" asset and therefore often calculate net cash at a higher level than some other analysts. Then, I try to determine the earnings and cash flow of the enterprise itself by backing out net interest income or interest expense. Finally, I subtract capital expenditures (Capex) from depreciation and add the remainder to income to determine owner cash flow. I do not subtract tax payments because these are not truly avoidable. I take Capex into account on the assumption that the stream of earnings requires constant investment of capital. The ratios of EPEE and EPEC represent the relationship between the price being paid for the enterprise and its respective earnings and cash flow.
This methodology identified DELL as very inexpensive at $9.97 and an LBO proposal ensued which would pay shareholders $13.65. There has been widespread concern among shareholders and analysts that $13.65 (roughly 37% over the $9.97 price) is too low a price for the buyout. I have written an article suggesting that a higher price would be appropriate and DELL is now trading at $13.92, presumably on the impression that the LBO price may move up.
I have looked at a group of tech stocks which I believe are attractive and have applied my methodology to Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT), Cisco Systems (NASDAQ:CSCO), Western Digital (NASDAQ:WDC), and Kulicke & Soffa (NASDAQ:KLIC). In each case, I have provided Friday's closing price, cash per share, EPEE and EPEC. I have also included data for DELL at the $9.97 pre-LBO price and at the proposed LBO price. The cash per share and share count data is based on the most recent SEC filings of each company. Depreciation and Capex (used to calculate EPEC) are based upon the most recent annual financial report as filed with the SEC. Current-year earnings (used to calculate EPEE and EPEC) are based on consensus estimates as set forth Yahoo Financial.
A few initial points. My cash calculation for DELL and CSCO includes financing receivables and is, thus, higher than conventional numbers. This higher cash calculation has the effect of reducing the price being paid for the enterprise itself, which in turn produces lower EPEE and EPEC numbers. I believe I am correct in this matter but readers should be aware of the divergence. AAPL is the only company in the group with Capex higher than depreciation and that is why its EPEC is higher than its EPEE. The pre-LBO price of DELL was extraordinarily cheap but the LBO gives shareholders quite a large premium over that price. The price being paid for DELL in the LBO (which is being widely attacked as considerably too low) certainly makes WDC and KLIC look cheap here. Are their businesses so much worse than DELL's that the low multiples make sense? I don't think so but apparently the market does. Finally, All of these stocks look cheap with mid-single digit multiples that are usually characteristic of companies in declining industries.
It has been widely noted that DELL's LBO is going to be largely financed with DELL's own cash and that raises the question of what is going to happen to the rest of the companies in the table. WDC and KLIC are small enough to be privatized or taken over; the others are considerably too large. On the other hand, if DELL's own cash can be used to take it private, the same result can be achieved - at least to a degree - through share repurchases for these larger companies. Share repurchases are really "slow motion" LBOs in the sense that publicly held shares are being slowly withdrawn from the market and the ultimate result would likely be ownership of the company by a small number of insiders willing to hold onto their shares. I would expect to see aggressive financial engineering, including share repurchases, in the coming months. It is also a good time to look for smaller tech companies with EPEC valuations below 5 on the assumption that the DELL deal may serve as a kind of benchmark. In this regard, both WDC and KLIC look interesting at these price levels.
A broader issue is raised by the low valuations in the tech sector. My own theory is that this is an "echo" of the Year 2000 Crash. There are many, many investors who lost a ton of money with some of these stocks. I confess to having thought myself brilliant when I bought some CSCO at $29 and Intel (NASDAQ:INTC) at $48 on the way down and promptly got my head handed to me on a platter. Like the experience of a carjacking after driving through a sketchy neighborhood, the losses experienced with some of these stocks and in the tech sector have made investors very, very gun shy.
On the other hand, we have very, very few folks now who have ever lost money in the bond market. I can remember some pretty bad experiences back in the 1970s, but I am 68 and a lot of investors have never really had to take a big loss on bonds. Perhaps, this is what sets the stage for a kind of "bubble."
At any rate, I have been long with a number of these stocks for some time and I am getting impatient. Perhaps, we are reaching the point in time at which the private market value of some of these companies will assert itself and draw the stocks higher. Stranger things have happened.