The media is currently focused on the saga of Michael Dell's battle with existing shareholders to take "his" company private. Many investors that have owned Dell (DELL) over the past five years have been disappointed in stock performance. Likewise, with the current news stories, many investors are probably glad they did not "buy a Dell" share in the past five years.
But the past is not always correlated with the future. The question is whether there is an investment opportunity in Dell today. Obviously it is not in the equity because assuming the deal is closed, it will be taken private. But there are more than just equities in the investment universe. A thorough credit review of Dell produces a unique high yield investment opportunity, assuming the LBO is not completely derailed by activist shareholders such as Carl Icahn.
The analysis in this article shows that the worst case scenario for Dell shareholders now is that the deal falls apart because activist shareholders come in, block the private equity transaction and then lever up to pay themselves a big dividend. That would put the shareholders in valuation purgatory where the ability to unlock value from the existing assets is left in limbo - and in a technology driven company this is the "kiss of death."
Assuming the Dell merger deal is closed, a quasi-equity credit opportunity in the long-term Dell bonds is available with a high coupon, moderately aggressive cash flow coverage (contrary to fears in the market presently) and most of all, long duration equity partners that align with Michael Dell's vision for the company, and with deep enough pockets to mitigate downside risk of long-term creditors.
Entering this type of investment position with any confidence requires critical analysis of Dell from a credit perspective, including:
- Bond Pricing - what is the risk reward pricing of Dell bonds today?
- Credit Analysis - what condition will Dell be in post LBO?
- Down-side Risk analysis - what happens in the worst case?
- Icahn Factor - what happens if the leveraged buy-out deal blows up?
Bond Trade Analysis - Bottom Formed for Longer Term Dell Bonds
On February 5, 2013 it was officially announced that Michael Dell and Menlo Park's Silver Lake Management, the nation's largest technology-focused private-equity firm, agreed to pay $13.65 a share to take Dell private in a $24.4 million dollar deal. But the information was in the market well prior to the official statement. My review of market buzz identifies that the transaction was first rumored as early as mid November 2012. Over the time frame dating from November 16, 2012 to the February 5, 2013 closing, the Dell stock increased in value from $9.33 to the $13.64, a 46.1% increase.
Over the same time period, the Dell long bonds in the market declined steeply. Using the 4/15/2038
Dell's 6.50% bond as a proxy for the impact of the buy-out announcement on bond investment value, the price fell from over $120 to approximately $90, a 33% decline.
Since a major gap down in early January, the Dell long bonds have formed a bottom. Examining the actual bond trade, it appears that the longer dated bonds are being liquidated on an orderly basis by Institutions that cannot hold non-investment grade bonds. The demand for the longer dated bonds is steady, and in recent days has shown a stronger bid, even as long-term risk free rates have risen. Since the middle of January when the bond gapped down to 90, Treasury rates have gone up approximately 20 basis points.
Credit Analysis - Structure of the Leveraged Buy-out
The following table summarizes Dell's pre and post LBO capital structure:
The structure of the announced plan of merger, as detailed in the Dell 8-K dated February 6, 2013, places clear boundaries between the big banks lending in the deal and the existing debt-holders who have been crammed down in the new capital structure. However, the existing debt holders have been given some important buffers in the LBO transaction - 1) $750M in new cash equity from Michael Dell, 2) $1,460 in new cash equity from Silver Lake, and 3) $2,000M in preferred equity from Microsoft.
The pro-forma structure will raise the leverage of Dell's capital structure significantly. The pro-forma interest bearing debt to equity as shown in the table above is 2.49x. The news media and Fitch ratings are reporting an "expected" 3.5x-4.5x leverage ratio on the deal. This is an overstatement, maybe because it does not account for the cash source of funds in the transaction. If you read the merger plan 8-K dated February 6, 2013, the debt committed to the deal adds up to $10,650. The gap between the $24.675M merger agreement and the amount of source of funds reported in the 8-K has to be filled in order to close the transaction. The fill comes from the cash equity infusions and the cash on the Dell balance sheet. Dell's cash balance as of February 1, 2013 was $12,569M.
The real interesting aspect of the merger transaction is that post LBO, the net impact to the on-going Dell cash-flow is projected to be $0. Dell has publicly stated that the financial impact of the new interest burden assumed by the company will not exceed what Dell currently pays in debt interest today plus shareholder dividends.
Here is the math, which backs up Dell's statement:
(Note: Dividends now is an annualized figure, Dell only paid 6 months in dividends of $279M in 2012, after declaring the 1st dividend in June 2012)
In reality, with the proposed merger the primary credit risk change relative to cash flow for existing bondholders in the company is what happens in the event of a default. This is because post-LBO the existing bondholders will no longer be in a senior tranche with superior asset coverage. Currently Dell has $12.5B in cash on its books - more than it actually has in debt outstanding. Post-LBO the cash balance will be reduced by an estimated $6B, and senior debt with specific liens against company assets will come onto the balance sheet, severely diluting existing bondholders' effective collateral.
In a high-technology business with rapid change being the norm, asset coverage is an important consideration. In the case of Dell's existing bondholders at least in the initial years post IPO, if Dell has a big financial problem, recovery of investment could be severely reduced. However, as detailed in the section below, because of the stakeholders in the equity positions of the capital structure, risk of such an event is greatly mitigated for the near term.
Credit Risk Analysis of Dell's Cash flow
An equally important perspective to consider in the credit risk of Dell is whether the company can continue to generate the same level of cash flow from an "aging PC market" that it has in the past. This "aging" connotation in the present press about Dell is actually the best rationale, ironically, for taking it private.
The metrics from a Trailing 12 month perspective on Debt / EBITDA and Interest Coverage in the table above show the deterioration that can be expected post LBO. The numbers are aggressive, but not "flashing red." The aggressive part of this deal is actually levering up a technology business, which has shown volatile changes in cash flow year to year. Most large technology companies since 1999 have moved to holding large cash balances and shedding debt to protect their "empires." But this transaction actually is doing the opposite, and it may be for a very good reason.
The cash flow at Dell, as shown on the pro-forma EBITDA figure, pre-and post merger is not expected to change because of the change in the capital structure. This points to the fact the real credit review risk post LBO will remain whether the Dell business model can continue to generate cash flow at historical levels, and improve post LBO.
If you review the financials at Dell over the past 3 years, the company has generated generous cash flow. The interesting change in the use of cash in recent history is the aggressive stock buy-backs and the declaration of a dividend (June 2012). This has re-directed cash from business investment, to shareholder buy-backs and dividends - "Yea" for shareholders. But from a credit analysis standpoint, this is a constant drain on creditworthiness if it affects / distract from the ability of the company to invest longer term. You can imagine the board room dynamics of an institutional shareholder base demanding pay-off, and a founder that sees a need to keep investing long-term for the good of the business.
My personal career experience on the battlefield in the high technology computing industry is that management execution and constant revitalization is critical to success. The whole industry runs on the concept of "planned obsolescence." The half life of computing based technology is short. This means there are ample opportunities for Dell in the computing space currently driven by enterprise computing, consumer video and mobility, not just desk-top PCs. The key to cash flow growth at Dell will be Michael Dell's leadership in successfully re-directing resources to the highest return markets in the rapidly changing computing technology marketplace. It appears that recent demands from a portion of the shareholder base may be directly at odds with the long-term needs of the business.
Down-side Protection - What is the worst case exposure?
The LBO structure proposed in the plan of merger has a unique backstop that is important in evaluating the credit risk in the transaction. The Microsoft preferred stock position is important because it places a major market partner as an equity stakeholder in the success of the deal.
Since Dell is a major channel partner for computing devices that run Microsoft based software, the symbiotic relationship means that post LBO, the goals of all the major equity owners will be aligned. Barring a cyber blow-up in which Dell goes into complete failure mode, it is reasonable to expect that Microsoft would choose to continue support for Dell in the future prior to any re-IPO of the company, even if it entailed more preferred equity being required in the interim. This "buffer" greatly reduces default risk of Dell for the medium term as the LBO proceeds.
The Icahn Factor - What it means to Dell Bond Investors Right Now
Dell stock gapped up around noon of Wednesday 3/7/2013 when information became public that Carl Icahn was getting a look at the books to assess whether he is interested in structuring an alternative bid for the Dell's shares prior to the go-shop time period expires.
I have examined the bond trades during the time that this information was made public. There was a slight, but perceptible dip in the prices buyers were willing to pay during this timeframe, stretching from the announcement through 3/11. It has since trended back up and the price level in the bond trade shows strength.
A structure like the one being proposed by Carl Icahn is unlikely to be successful if it does not have the following components: Equity holders with deep pockets that are not looking for dividends and buybacks going forward, a willing Michael Dell to lead the revitalization effort, and a coalition of major banks who are willing to see the company through the next five years.
If the company simply rotates from its current capital structure and leverages up to pay a big dividend to existing shareholders, the company is likely to struggle. The Michael Dell-led LBO structure puts a major onus for producing Dell growth on equity stakeholders who are not in the deal for near-term pay-back, and can afford to stay in the position long term.
Essentially any LBO structured by a Carl Icahn coalition which cannot maintain the net cash flow position as neutral going forward would be a credit market nightmare.
One of my major credit analysis principles is, if the equity holders cannot afford to stay in the position they are creating, why should I be in the deal? Structuring an LBO to create a big cash pay-off to existing equity owners while not tending to the real needs of the business would be a cut and run scenario, and a good rationale for getting out of any bond position.
Adding it all up
Currently the Federal Reserve is forcing investors to move capital out on the risk curve through the continued policy of QE combined with zero short -term interest rates. I have written articles which explain the impact these policies are likely to have on investors (see S&P500 Driving to All Time High - Buy, Sell or Hold in Your Portfolio) and the strategies they can adopt to advantage their portfolio.
One of the strategies is to find investments in the bonds of companies that have equity-like characteristics and near equity returns.
The Dell bond play, assuming the publicly traded equity shares are taken private by Michael Dell and Silver Lake partners, is a unique example of this type of opportunity in the current market.
As always, I recommend strict discipline in exposure limits for any unique investment. For a non-investment grade high yield bond, my recommended limits are .5% to 1.5% of the your total portfolio.
Additional disclosure: I am long DELL.GB - 7.1% 4/15/2028 Senior Debenture