Michael S. Dell, Dell's (DELL) Founder, Chairman and Chief Executive Officer, in partnership with the global technology investment firm Silver Lake Partners, has entered into a binding agreement to acquire Dell for $13.65 per share in cash. The price represents a premium of 37 percent over Dell's 90-day average share price, based on the last trading day before rumors of a possible going-private transaction were first published.
However, as we will show below, this offer price of $13.65 is grossly under the most pessimistic intrinsic value of $23.56 that we got from a solid economic foundation. Based on our analysis, we can only agree with Carl Icahn when he says:
To us it seems that no one has less confidence in Dell than Dell itself ... I can't help ask myself why, if Dell is so awful, do Michael Dell and Silver Lake, both very astute investors, want to buy it?
Dell, Inc. is a global information technology company that offers its customers a range of solutions and services delivered directly by Dell and through other distribution channels. Dell is a holding company that conducts its business worldwide through its subsidiaries. The Company operates in four segments: large enterprise, public, small and medium business, and consumer. Its large enterprise customers include global and national corporate businesses. Its public customers, which include educational institutions, government, healthcare, and law enforcement agencies, operate in their own communities. Its SMB segment is focused on helping small and medium-sized businesses by offering products, services, and solutions. Its consumer segment is focused on delivering technology experience of entertainment, mobility, gaming, and design.
The Basis for our Intrinsic Valuation
One of the keys to finding superior long-term investments is to buy companies that will be able to stay one step ahead of their competitors. Companies that have generated returns on their capital higher than their cost of capital for many years of operation usually have a competitive advantage, especially if their returns on capital have also increased over time. This line of reasoning is fundamental. In other words, having an unexpected or a temporary competitive advantage is not enough for a business to be able to declare that it has a competitive moat. As mentioned by Mr. Warren Buffett in a November 22, 1999 Fortune interview:
The key to investing is determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.
Simply put, you cannot expect to obtain abnormal return (alpha) as an investor if the business you invest in does not have a sustainable competitive advantage. This is the economic reasoning behind our intrinsic valuation.
Performance Spreads of DELL Inc.
We define moat or competitive advantage as the difference (the performance spread) between the return on capital and the cost of capital (correctly measured, that is after transforming GAAP numbers into a rigorous computation of economic profit, after deducting the full cost of capital, and eliminating the accounting distortions). The higher the performance spread, the bigger the competitive advantage.
Performance Spread (Trailing 36 and 12 months as of April)
|Dell (trailing 36 months)||4.0%||5.4%||8.2%||7.9%||6.8%|
|Dell (trailing 12 months)||9.4%||4.7%||9.6%||7.7%||3.4%|
Based on the evolution of the performance spreads, it is clear that Dell has a respectable competitive advantage which slightly eroded recently. However, we should keep in mind that Dell has spent $9.6 billion since 2007 to acquire software and service providers and built out end-to-end solutions for enterprise customers that generate higher-margin sales. These investments affect negatively and transiently the return on capital because they have first an effect on the denominator (the Capital), before impinging on the numerator (the NOPAT, net operating profit after taxes). By comparison, IBM (IBM), a close competitor, has spreads (trailing 36 months) of 7.8%, 8.5%, 10.2%, 11.3%, and 11.8% respectively for the same years. Hewlett-Packard (HPQ), another close competitor, has spreads of 4.8%, 5.3%, 5.7%, 5.7%, and 2.3%respectively for the same years.
Equipped with the above information on the performance spreads of Dell that permit us to have a serious fundamental view of its value creation potential, we have calculated the actual intrinsic value (the base case) and simulated the intrinsic value of a Dell share under three scenarios, which we present in the following table. All our estimates are based on the trailing twelve months data.
In the base case scenario, we assume that Dell will obtain a return on capital in 2014 equal to the average obtained during the last five years and maintained it thereafter. In the first scenario, we suppose that Dell will obtain a return on capital in 2014 equal to the lowest return obtained during the last five years and maintained it thereafter. In the second scenario, we suppose that Dell will obtain a return on capital in 2014 equal to the second lowest return obtained during the last five years and maintained it thereafter. In the third and final scenario, we suppose that Dell will obtain a return on capital in 2014 equal to the highest return obtained during the last five years and maintained it thereafter.
Intrinsic Value (IV) of Dell Share based on Base Case and 3 scenarios:
|Base case (based on the average return on capital of the last five years)||36.01$||13.65$||22.36||164|
|Scenario 1 (based on the lowest return on capital of the last five years||23.56$||13.65$||9.91||73|
|Scenario 2 (based on the second lowest return on capital of the last five years)||30.06$||13.65$||16.41||120|
|Scenario 3 (based on the highest return on capital of the last five years)||45.23$||13.65$||31.58||231|
What can we conclude from our analysis? That the offer price of $13.65 is grossly under the most pessimistic intrinsic value of $23.56. What additional fundamentals can come in support of these intrinsic values? First, Dell is already a value creator: the difference, the market value added, between the market value of its total capital (100%) and its invested capital (84%) is 16%. So, we are not talking about a value destroying business that we would had first to simulate alternative strategic plans before calculating the intrinsic value of the business. Second, if we subtract the current operating value of Dell (116%) from the market value of its total capital (100%), we obtain the future growth value of Dell which, in our case, is a negative number of minus 16%. What it says? Simply, that at the actual market price of $13.03 (July 5, 2013), when you buy Dell, you obtain the future growth options of Dell for nothing. In other words, the current operating value of Dell is higher than the market value of total capital. The market price underestimates the intrinsic value of a share of Dell.
Based on our analysis, we believe that the price of $13.65 is unfair, and we can only agree with Carl Icahn when he says:
To us it seems that no one has less confidence in Dell than Dell itself. I can't help ask myself why, if Dell is so awful, do Michael Dell and Silver Lake, both very astute investors, want to buy it?