By Thomas E. Sobon
On November 21 I wrote an article entitled "Is Dell (DELL) a Buy Idea Whose Time Has Come." In it I concentrated on the transformational change taking place in the personal computer space and commented on historical examples of such change to provide perspective. The stock then was trading below 10 and, inasmuch as I rely on both fundamental and technical analysis, preferred to avoid the stock until there was some indication on the chart that its downtrend was coming to an end. Shortly thereafter, the news flow showed that a leveraged buyout was being planned and the stock broke to the upside and now trades at about 14.
I really don't have an opinion about the investment (speculative?) merits of the stock at this time except to say that there is substantial operational risk involved. So why, then, did I take time to write this article? I wrote it because the drama in the story is intriguing and shareholders should be apprised of a risk which others have not yet addressed here on SA.
Carl Icahn has jumped in with both feet and he threatened to initiate a prolonged legal battle if Dell's management doesn't abandon its plan to go private and thereby eliminate current shareholders from participating in the benefits that the privateers expect to realize from the leveraged buyout. After all, Michael Dell and his select few are not doing what they are doing for altruistic purposes. Icahn has proposed that a dividend of $9.00 per share be paid to shareholders from funds raised through a debt offering. There are now about 1.74 billion shares outstanding. So that would add $15.7 billion to Dell's balance sheet which would bring the total debt on the books up to $25 billion. Icahn would then have management do what it would have done if it had gone private.
Inasmuch as management was forced to seek additional bids, it let Hewlett-Packard (HPQ) and Lenovo (OTC:LNVGY) look at its books to see if either of them would be willing to make a competing bid. With regard to market share, Hewlett-Packard and Lenovo rank one and two, respectively, with Dell third and it is questionable as to whether or not the DOJ would let either of them acquire Dell's PC business.
I could ramble on, but I will now cut to the quick as to why I think Dell could be a disaster begging to happen. Many years ago Safeway (SWY), the supermarket chain, was expanding by acquiring regional chains from which it could then increase its market share in the newly entered region. Giant Foods (now a division of the Netherlands based Ahold) was the dominant operator in the Washington D.C. market. Safeway acquired a marginal chain in that market and financed the acquisition with debt. The management of Giant Foods knew what Safeway was up to, so it decided to defend its turf. As soon as the aforementioned acquisition was completed, Giant Foods cut prices and ran specials like never before. Safeway's management was blindsided and found itself in a lose-lose situation. If it cut prices it would cut into an already thin profit margin and if it didn't, it would lose market share. With its debt heavy balance sheet and weak competitive position, it incurred heavy operating losses in that marketing area. Fortunately for Safeway, it had extensive operations outside of that market so it was able to survive.
In commodity markets such as supermarkets or personal computers, competitors usually try to adhere to "community of interest" pricing policies whereby the company with the largest market share is the price leader and the others follow without seriously undercutting on price to gain market share. (That could trigger a price war where all participants would suffer.) This has long been the case in breakfast cereals where Kellogg was the dominant firm. The management of Hewlett-Packard has already stated that it intended to compete for Dell's share of the PC market.
It seems to me that it would be foolish for Hewlett-Packard or Lenovo to acquire Dell when its share of the PC market can be had for a pittance. All they have to do is sit back and wait for Dell to leverage its balance sheet and then launch an aggressive marketing campaign by way of a generous rebate program (say $100 per computer or whatever it takes) directed against competing models of Dell's product lines. This would put Dell in a lose-lose situation: It is counting on cash flow from its PC business to finance its diversification program. If Dell decided to defend its turf, it takes a big hit on its profit margin or else it loses market share. With heavy debt charges compounded by a squeeze on profit margin or a loss of market share, Dell's cash flow from PC sales could slow to a trickle.
The genie is out of the bottle. If Dell goes private or goes the way Icahn has proposed, leveraging of the balance sheet could be disastrous for the company. The real winners could be Hewlett-Packard and Lenovo. Competition is what simulates executives to do things that they otherwise might not want to do. The two PC companies cited may not choose to compete the way I suggested. But if they do, Michael Dell need have no fear of being under stimulated in the years to come. I think he has painted himself into a corner from which it will be difficult for him to escape unscathed.