Dell Is Ripe For a Leveraged Buyout

Aug.17.11 | About: Dell Inc. (DELL)

Dell is a cheap stock.

Computer maker Dell (NASDAQ:DELL) reported its second-quarter earnings on Tuesday, with analysts apparently disappointed with the top-line number of $15.66 billion, which was lower than estimates of $15.75 billion, and also disappointed with revenue growth guidance of 1% to 5%, which is down from 5% to 9%.

To which I say, "Who cares?"

I don’t invest in companies based on what is going on in the current quarter or the next quarter. I’m investing in a company if I think the value of that company’s cash flows over the next 20 years are being offered to me at a discount.

And if you ask me, Dell looks pretty cheap at current prices. Consider the numbers (yes, I’m rounding):

Market Capitalization: 1.87 billion shares x $15 share price = $28 billion
Less: Cash and Short Term Investments: ($16 billion)
Add: Net Debt: $8 billion
Equals an Enterprise Value of: $20 billion

On that enterprise value of $20 billion, Dell had $5.2 billion in cash flow from operations over the last four quarters. My math isn’t great, but that appears to be a $5.2B / $20B = 26% operating cash flow yield. And this is not a capital expenditure-intensive business, folks. That is cheap by anyone’s measuring stick.

And the last 4 quarters are not an aberration. Dell has had operating cash flow of at least $3.9 billion in 4 of the last 5 full fiscal years. A repeating cash flow machine.

Dell Has Been a Cheap Stock for a Long Time

A cheap and predictable cash flow stream and a terrific balance sheet. What isn’t to like? In a word, I’d say a catalyst. Or more accurately, lack thereof.

While Dell is moving from computer end users to higher-end enterprise solutions (servers, service, software), the likely truth is that this move is going to help hold cash flows at current levels or growth them slowly. With the new business being much higher margins, Dell can offset revenue declines in the PC business fairly comfortably. But the reality is that there is just not going to be the growth from Dell at a rate that will catch the stock market’s attention. The stock market just doesn’t have anything to get excited about when it comes to Dell, and the earnings and cash flow multiples have long reflected this.

In some circles, Dell might be referred to as a classic value trap. I think Dell shareholders might be able to relate to the feeling of being trapped -- as in the share price of Dell being trapped under $20 since 2008. But trapped Dell shareholders are at least in good company.

I refer you to the year-end annual report for venerable value investors Longleaf Partners, in which you will note that the largest position in the fund is Dell, with a 9.4% weighting. Then I would refer you to the most recent semi-annual report for Longleaf Partners, in which you will note that again the largest position is Dell, with an 8.8% weighting.

Make no mistake, Longleaf is a first-class outfit. They have soundly trounced the performance of the S&P 500 since inception in 1987 (11.39% annualized returns vs 8.8%). But they have long been in a value trap with their Dell position. Their 2010 report to shareholders explains in simple terms why they are attracted to Dell:

While the company repurchased discounted shares in the year, much larger opportunity exists to do more. Michael Dell increased his own personal stake in the company by $100 million in December. Dell’s adjusted free cash flow yield is over 20% and the top line is growing, yet the market multiple on the stock implies a business in decline.

I’m with you boys. Dell is cheap, but that isn’t news at this point.

Ripe For An Old-Fashioned LBO

So what we have here is:

  • A stock dirt-cheap based on free cash flow
  • That cash flow has been extremely steady, even during the Great Recession
  • A major shareholder in Michael Dell, who owns almost 13% of the company
  • Historically low interest rates

Do I need to paint a picture? It is time for a good, old-fashioned 1980s-style management-led LBO to take advantage of this ridiculous valuation and bring some closure and reward to long suffering shareholders?

With $4 billion to $5 billion per year in predictable cash flow funding, such a deal shouldn’t be a problem. With Michael Dell on board, the fundraising is even that much easier, as that is 13% of the shares that do not have to be acquired.

Every few months I get tempted by this cash flow yield and consider buying Dell. The lack of a catalyst keeps me from pulling the trigger. But sooner or later, something has to happen -- doesn’t it? I mean, the market over time is supposed to be efficient. Maybe an LBO is the answer for Dell.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.