Why Dell Should Reboot Perot Acquisition

Dell (NASDAQ:DELL) announced that it would acquire Perot Systems (NYSE:PER) for $30 a share, a 68% premium over where PER closed on Friday. What input did Dell’s Board of Directors offer on this deal? While the equity dollar amount of the deal is only “$32.5 Billion”, relative to Dell’s $12 Billion cash coffer and market capitalization of $32.5 Billion, it is still a bet of more than 10% of the company’s value.

While paying a 68% premium for a company is not by definition silly, it is usually not very smart – in this case it will likely lead to significant wealth destruction. The market seems to agree.

Dell lost approximately 4% of its market value (net of market returns) when the deal was announced, representing approximately $1.4 Billion dollars. That loss basically represents the entire premium Dell anted up for PER. In other words, the market is saying the benefit given to PER owners has to come completely from the hide of existing DELL owners. The market clearly does not perceive this as a “win win” type of acquisition. Instead this seems to be a typical “winner’s curse” deal where management overpays to ensure it “wins”.

Is the market always right? Of course not, but unfortunately management teams listening to Investment Bankers trying to drive deals tend to be right less often. How can one tell when the market is likely to be wrong, and thus reap potentially lucrative rewards? The answer is easy: when one can affirmatively say that the price paid for an acquisition reflects reasonable future corporate performance expectations. With that in mind, let us deconstruct the PER deal.

While growing earnings and sales is nice, it is woefully insufficient to ensure shareholder value creation. Understanding value requires a fundamental grasp of: Profits, Investment, Growth, Risk, and Competition. We will utilize AFG’s Value Expectations™ framework and focus on the profit, investment and growth side of the value equation to decompose this deal.

The 3 charts below highlight PER’s value drivers – Sales Growth, EBITDA Margin, and Asset Turnover. In order to frame whether the transaction makes sense or not, we will back into an answer that describes the sales growth Dell must achieve from PER in order to make this deal work out for existing Dell Shareholders. We will first begin by determining a reasonable estimate of PER’s sustainable EBITDA margin and then estimate how much capital PER needs to sustain its sales model. Lastly we will impute the sales growth required to justify the $30 a share price Dell has agreed to pay.

Beginning with PER’s historic profit margins, what can Dell expect from the unit going forward? Looking at the EBITDA Margins in the chart below from 2000 through 2008, PER delivered EBITDA margins ranging from a low of 2.8% to a high of 11.8%. For our analysis, we will use what seems to be a reasonable figure of 11% to represent PER’s normalized long-term EBITDA Margin. In fact, given the volatility of PER’s margin historically, many can argue that 11% is a generous assessment. That said, let us use 11% nonetheless. Next, review the chart depicting PER’s Asset Turn Over ratio, which tracks how much a company must invest in its balance sheet to support a dollar of sales. For PER the figure recently was about 1.4x, or for every $1.40 of sales the company generates, it must invest $1.00 in assets to support those sales. Though PER has been much more efficient historically, its trend has been towards requiring more and more capital to support a dollar of sales. By using the most recent figure, we will assume it will minimally arrest that slide.

So what sales growth PER needs to generate to justify a $30 share price? An astounding 26% each year over the next 4 years. This compares the to the 13% annual growth PER has delivered over the past 5 years, the 6.4% it delivered in 2008, and an expected but rather certain decline of 10% in 2009.

Source (The Applied Finance Group)

Bottom line, Dell’s management team believes it will double PER’s growth rates over the next four years relative to what PER achieved during the past economic boom, while maintaining historically aggressive profit margins. While it is not impossible, it seems very unlikely. In fact, Dell executives did not give any targets for revenue, saying more details would come after the deal closes. They did touch upon expected opportunities for cost savings, saying the two companies spend a combined $4 Billion in the areas they plan to integrate, and its sees cost savings of about 6-8% in 2 years. If Dell hits those synergies, which justifiably the market rarely pays for, the new Perot would likely have profit margins approaching that of Accenture, arguably the best in class provider of these services. Again, while such an outcome is possible, it is much like betting on the expectation of hitting an inside straight – generally not a very good strategy.

Ultimately, that is the essence of an investment decision – How likely is a company to deliver on the expectations embedded in its share price. During the Tech Boom of 2000, the answer was “not very likely” as stock prices reflected absurdly optimistic future expectations. In March of this year, the answer was “very likely” as so much pessimism reigned, that stock prices reflected absurdly negative future expectations. (See this report for our analysis of the Tech Boom and 2008/2009 Panic).

Dell justifies the deal on the basis of “strategic fit”, as this acquisition should enable Dell to expand into higher margin IT services (increasing its revenues from Services from the current $5.5 billion to $8 billion) and to secure a more stable and recurring revenue stream as computer hardware becomes more and more commoditized. However, any strategically sound growth strategy must have a sound price tag. Overpaying for assets may allow the current management team to claim future revenue and profit growth, and depending on their compensation plans achieve nice bonus payouts. But overpaying for such growth destroys rather than creates shareholder value. Therefore, the real losers are the company’s existing shareholders who paid for the excessive acquisition premium by losing $1.4 Billion of market value.

Dell’s Board should do what every PC user does when its machine acts up – reboot. In this same tech spirit, Dell’s Board should reboot this deal until it creates value for existing shareholders.

Comments

[Vidooshak:]

Dell had a good thing going. And then they go jump off the cliff...
Why??

Sep 22 08:17 AM

[Tom B:]

"Dell justifies the deal on the basis of “strategic fit”, as this acquisition should enable Dell to expand into higher margin IT services"


"Service" and "Dell" in the same breathe-- cognitive dissonance?

Sep 22 10:33 AM

[Tom B:]

You mean-- in the 90's? The low -margin PC is a dead business model. We have no trade protections; the Chinese can export cheap junk sweat-shop PC's for cheaper than Dell can sell theirs in the US.


On Sep 22 08:17 AM Vidooshak wrote:

> Dell had a good thing going. And then they go jump off the cliff...
>
> Why??

Sep 22 02:40 PM

[Hephasteus:]

Dell wants handle all the sensitive private information they can get from nationalized healthcare is the only think I can think of.

Sep 22 10:59 PM