- Long: Dell Inc (DELL)
- Current share price: $15.30
- Potential Upside: $13 to $18
- Market Capitalization: $26.3B
- Cash: $15.10B; Upcoming debt: $1.3B
- Shares Outstanding: Approximately 1.8B
- Sector: Technology Industry: Diversified Computer Systems
- Net Cash per share: $8.25 ; FCF/Share:$2.5
- Trading timeline: 15 to 18 months
- Situation – Business model restructuring and turnaround after settlement of SEC investigation
- Main Catalyst: Implementation of Phase II restructuring beginning 2H- 2011; Major share buybacks, Extremely selective and smart Board Appointments; Venturing into Analytics & Business Intelligence, focus on enterprise business, Strong and disciplined management, Fundamentals
- Inflection points:: Uptick in margins and FCF, a possible uptick in macro drivers due to 2012 being election year leading to beginning of IT replacement cycle in medium size business markets, coming online of cost initiatives
2H-2011 might present one of the best opportunities to buy Dell as the firm moves from near completion of its Phase I restructuring onto the implementation of Phase II strategy. Phase I, which started in late 2007, has finally ended and the thesis rests around what are believed to be the possible catalyst in the medium term that will help shareholders realize the intrinsic value of their investments.
What happened so far - Turnaround Story - Phase I
After undergoing SEC investigation for accounting gimmicks earlier during the decade resulting in a substantial decrease in its stock price, the year 2007 saw the return of Michael Dell, the firm’s founder, as Dell’s CEO and Chairman of the board. Michael Dell still holds 12% of the firm’s equity. After Michael Dell took over, the company announced major strategic changes. In retrospect, the turnaround was structured in one of the worst markets the US was going to undergo since the 1920s. But so far, management has shown determination and focus in the implementation of strategic objectives that have been executed as planned. There were three main objectives from what I understood that the management had set to achieve as part of this Phase I:
- Change the company's toward selling complete solutions instead of just PCs by bringing dramatic changes in the product mix
- Focus on cost cutting
- Maintain margins and free cash flow.
Looking at the presentations over the past three years, conference calls and speaking to certain people I personally know, the research concluded that the management has delivered on 85% - 90% of what it had set out to do since 1Q-08 to date. This augurs well, especially for investors trying to bet on Dell’s future. It tells us a story of strong management committed to turning around the company and of disciplined execution – qualities that will benefit shareholders in the medium term. So how well has Dell executed on the above mentioned objectives so far?
Change in Product Mix – The change in product mix was made possible by a slew of smart acquisitions that Dell has made starting in 2007. Not only were the acquisitions focused on the strategy that dictated complete change in Dell’s service offerings, but these acquisitions were also scalable onto Dell’s current platforms. This made integration of new products much faster and highly increased their likelihood of being accretive to earnings in 2012. Examples being Force10 Networks (Server space for virtualizing and automating conventional datacenter and cloud networks); Compellent Technologies (Storage & cloud computing); Boomi (Cloud Computing); SecureWorks Inc (Information security services); Exanet (Storage); Kace Networks (systems management); Ocarina Networks Inc (Storage); Scalent Systems (Scalable and efficient data center infrastructure software; Perot Systems (Services), to name a few. In addition to the acquisitions, Dell also redefined its business in 2007 and implemented initiatives to grow organically. First step was to break down the reporting by product types in 2008, namely Enterprise (servers & Networking, storage, Services, Software & peripherals, which includes security) and Clients (PC desktop & Mobility). Another segmentation was by business lines - Large enterprise, Public, SMB (small & medium business) and Consumer. The change in the product mix since FY-2008 to date is evident with the increase in revenue and operating margin as Dell moves steadily toward high margin product offerings. From 1Q-08 to 2Q-11, the change is as follows: Networking (10% in 1Q-08 to 13%in 2Q-11, Operating margins: 10%+); Storage (4% to 4%, operating margins: 10%+ ; here Dell moved from being a reseller to selling its own product, therefore no growth yet in percentage terms!); Services including cloud, (8.3% to 13%, Operating margins: 20%+); Software ((17% to 16.4%, Operating margins: 5%+). On the client side, Mobility (laptops, ect) has remained flat at 30% with operating margins of 5%, while Desktop PCs decreased from 30% to 23% of revenue with operating margins of 5%. Furthermore, business segments as of 2Q-11 as a percentage of total revenue and operating margins, respectively, are Enterprise (30% of total revenue & 32% of total operating profit), Public (29% & 34%), SMB (24% & 29%) while consumer is at 19% & 5%. Some fret about exposure to the public sector, however I would say to the contrary. Within public, in addition to exposure to the government, the major focus has been on healthcare and education - growth areas that I consider a positive. The strategy seems to be working and here is why - despite major M&A and ongoing business restructuring, margins, FCF and EPS have all been either flat or on the rise from 2007 to date, a time period when the US underwent one of the worst economic recessions. The execution of Phase I bodes well for medium-term shareholders wanting to play the stock now as the next round of initiatives are beginning to get implemented adding to Dell’s bottom-line and growth.
Focus on cost cutting – Analysis suggests this is an area where Dell needs to focus more. However, what is admirable is that despite a major cash spend on M&A over the last 2 years, organic growth initiatives of more than $1B and continual hiring of a specialized sales force, there has only been a marginal increase in cost since 2007. COGS has actually declined from 81% of revenue to 77% while SG&A as a percentage of total revenue has only increased 1%. I believe that acquisitions will begin to produce synergies in 2012, giving Dell an opportunity to further cross sell solutions to its clients instead of a single product. Furthermore, shifting production to places like India & China will lead to a major cost reduction while maintaining the same quality. The integration results and production initiatives will not only help generate much higher margins but also reduce costs, thereby making the goal of cost reduction achievable in the medium term. Shareholders might begin to see cost- cutting initiatives priced into the share price in the form of increased EPS and higher margin in 2H-2012 - a positive for the current shareholders.
Maintain margins and free cash flow – Since the beginning of the implementation of strategic initiatives in 1Q-08, gross margins increased from 19% to 22%, while Net Margins increased from 5% to 7.3%. Moreover, although revenue has remained flat at about $62B, operating income increased to $ 4.5B in 2Q-11, a 92% increase from $2.3B in 2Q-10. The increase in operating income has been phenomenal, however, margins still need to increase significantly more. What should be noted is margins and EPS still saw an uptick in the midst of major economic recession, an ongoing acquisition cycle and business restructuring phase. Quarter-over-Quarter figures have also reported an increase in EPS, margins and operating income. Furthermore, Dell's ROIC and ROI has been better than the industry standard. Another important focal point of Phase I was to increase the firm's free cash flow. Despite the decline in business confidence and reduced spend by organizations, Dell's FCFF increased by $2.0B since 2009 to $4.7B as of 2Q-11 while FCFE increased to $6.6B from $3.0B– a net positive for shareholders.
A disciplined management, that has successfully executed on its strategy so far has now created a Dell that has a much better hedged revenue model making it less exposed to a recessionary environment. Increased margins, operating income and EPS might suggest that the integration of recent acquisitions might be going well and the acquired firms will become accretive to earnings in 2H-12. As the transition to Phase II happens, it opens a good entry point for investors who want to participate in future upside.
Executing phase II and Dell’s increased focus on cash rich enterprise
Phase II seems to include three major strategy moves in addition to continuing those from Phase I that I believe will not only differentiate Dell but make it a great investment
- Substantially increasing its product mix toward enterprise solutions and foray into cloud and business analytics – a very important add on.
- Sell complete solutions to clients instead of a single product leading to a very well hedged revenue model, increasing recurring revenue stream and earnings predictability
- Increased focus on emerging markets and marked differentiation via use of a specialized sales force that can also act as consultants to clients
Corporations today are sitting on $2T of cash on their balance sheets, an amount stated by some as the highest cash US corporations ever had. As part of Phase II business strategy, Dell has stated its focus in 2011 and beyond to continue to increase its product mix toward Enterprise – a place where the most cash spend is likely to come in the medium term. The directional change can be seen in numbers. For example, from 2005 to 2011, segments as a percentage of revenue have changed as follows: Desktop PCs (from 44% in FY-05 to 23% in FY-11); Mobility (22% to 30%); Software (12% to 17%); Networking (10% to 13%); Services (6% to 13%); Storage (3% to 4%). Furthermore, its unique business model, which focuses on selling complete solutions to clients instead of the past policy of selling a single product, will not only help Dell increase its margins, EPS and revenue, but will create a recurring revenue stream and sticky client base – both good for the profitability of the company. For example, Gross margins for 2Q-11 compared with 2Q-10 increased 6% to 22.5%. Another positive is Dell’s foray into integrating its cloud services with its IT infrastructure business. Industry predicts an annual increase in cloud spend of approx. 30% every year until 2015 - a segment that’s complimented by the server business, which Dell is well positioned to take advantage of. Dell is already the third largest player in the server market (16% market share). Moreover, the management turmoil at Hewlett-Packard (HPQ) and confusion created in its client base, especially enterprise clients, might play to Dell’s advantage and help Dell solidify its position. A point of major differentiation for Dell is its sales force and the continued hiring of a specialized sales force that in addition to serving as experts on a single product can also act as business consultants to Dell’s clients and help their customers lower their IT cost. This can be done by selling clients a complete set of Dell’s solutions & services replacing the existing infrastructure. This helps clients lower their costs and their IT budgets while generating more revenue and higher margins for Dell– a win/win situation. This strategy of a combined sale of hardware and high margin services, including consulting, data center management, business intelligence, cloud and others might make Dell irreplaceable to clients in national and international markets. As Dell has begun to implement this strategy, its EPS increased to 0.48 in 2Q-11 from 0.28 in 2Q-10, operating margins increased to 7.3% from 4.8% while net income increased to $890M from $545M. Additionally, Dell has started to provide business analytics as part of its services, which I believe will be huge differentiators in the future. This focus on personal and specialized services and consulting alone will command a share price premium and hugely differentiate Dell from its competition in the middle market. In addition to focusing on North America, Dell has been increasing its revenue stream and manufacturing in emerging markets, which will not only increase Dell revenue but will help it reduce its costs. SEC filings indicate that the firm has closed some of its high cost facilities and opened centers in places such as India & China. 28% of current Dell revenue now comes from Asia Pacific and BRIC countries. Furthermore, 67% of Dell’s PC sales currently come from these high growth emerging markets, and therefore, contrary to the belief, the PC business still remains profitable for Dell. Furthermore, as Dell moves more toward services and a cross-sale strategy, I believe the decision to keep the PC business is the appropriate one and here is why. Firstly, Dell’s PC business, according to some reports, is 71% Enterprise and only 29% client/consumers as of today. Furthermore, Dell is not just selling PCs to consumers, like its competitors do, but rather an array of solution to its clients along with the PC. In addition, its past PC relationships give it a stronger footprint into SMB space creating high margin opportunities. In essence, Dell is slowly taking over IT departments of mid size organizations by providing a complete solutions set that includes cloud, data management, storage, networking and security, with a focus on cost cutting, which may also make for a great sales pitch. Execution of the Phase II initiatives will play a major role in helping Dell grow its bottom-line in the next 12-18 months.
Share buybacks authorization equaling 20% of Dell market cap and completion & integration of recent acquisitions along with an important IP portfolio
On 13-Sep-2011, Dell’s Board of Directors authorized the purchase of up to $5B of stock in addition to the $ 2.16B remaining from prior authorizations at the end of the Dell's 2Q-11. Size and timing of stock purchases under the program will be based on factors including price and market conditions. Dell might have already repurchased approximately $8.0B of equity since Dec. 2007. Some analysts estimate that the future buybacks might add approximately $0.65 to the EPS. With a median P/E of 10x for the sector it may add approximately $6.0 to the share price or 40% upside for current investors. Additionally, buybacks will provide a floor to the stock volatility in the current market turmoil that should comfort investors currently buying into Dell’s equity. For 3 months ending June 2011, Dell repurchased 71M shares at an average price of $15.94. Another catalyst for medium-term growth for Dell is the roll out of new services and creating of cross-selling opportunities to new and existing clients in years 2012 and 2013. Dell acquired 11 firms within the past 20 months and has committed another $1B to organic growth and innovations. In addition to being accretive to earnings, the recent acquisitions have brought in an array of patents on acquired technologies for Dell. This IP portfolio not previously available to the firm not only gives Dell unique access to platforms but also places Dell in the markets with a unique advantage to scale out acquired technologies and ability to use the IP portfolio for client benefit. I believe that these acquisitions will help Dell to make headway into the Enterprise client base resulting in higher margins and FCF, thereby benefitting shareholders.
Recent Board Appointments
What many times goes unnoticed and is often very pertinent to share performance is the quality of management and constitution of its Board. HPQ’s share price is a glaring example of mismanagement that has cost shareholders significant losses over the last year. As for Dell, the most recent appointment of 2 of the 3 individuals has especially sparked my interest because of what they bring to the table in many significant ways and what they might be indicative of. First of the three appointments is of Ken Duberstein of The Duberstein Group, former white house chief of staff to the Reagan administration who brings in tons of political experience and contacts – a huge asset given that 24% of Dell’s revenue comes from the public sector. Second is Laura Conigliaro, former Head of Goldman Sachs Equity Research with specialized expertise in the hardware systems sector during her time covering enterprise server and storage companies. Why is this important? I believe among other qualities, she can bring a tremendous amount of experience regarding how the firm should present the right matrix so that it might be valued correctly by the street and what the management can do at best so that investors can realize Dell’s true intrinsic value in the market. Third is Janet Clark, who served as executive vice president, treasurer and CFO at Marathon Oil. Marathon completed a spin-off in July 2011 to split into two separate businesses. Specific qualities Dell’s Board has been focused on are expertise relating to financial experience, technology services, international business experience and mergers and acquisitions. As Dell expands its international presence (28% current revenue from emerging markets), integrates its acquisitions, increases its sale of services with ongoing expansion of current sales force and gears up to make its case to Wall Street analysts and potential investors, these board appointments can be a huge asset for the current shareholders.
Fundamentally undervalued with a much higher valuation for its enterprise business
Dell, which has a float of approximately 1.5B shares has approximately $10 a share in cash and $3.4 a share of LT debt. Dell is positioned for good growth with $15.0 B of cash and $ 4.4B in FCFF as of 2Q-11. Total debt on the balance sheet is $7.7B with 1.3B due in the next 12 months. One of the main fundamental drivers for the share price in the medium term would be an increase in margins for the company – something the management is rightly focused on. Dell trades at EV/EBITDA of 4x compared with 6.6x for competitors while enterprise comps trade at 8.2x. Similarly, P/E ratio for Dell is 8x while competitors is 9.3x and enterprise comps is 14.2x. P/S for Dell is 0.4x, while its comps trade at 1.12x and the enterprise comps trade at 2.5x. FCFx for Dell is 4.9x, while its comps trade at 9x and enterprise comps trade at 9.34x. Looking at numbers and running a competitor analysis on Dell, the company at current multiples should be valued between $28 to $ 30 a share, a median value of price points obtained after performing analysis using EV/EBITDA, P/E, P/S and FCF multiples. As for separately valuing the Enterprise business, the only data available to calculate the Enterprise Business is the revenue multiple. Based on this multiple alone, Dell’s enterprise business can be valued at $40 a share, a $10 premium to the company that includes PCs. As Dell executes its Phase II of business restructuring creating greater margins, higher synergies and greater cost cutting initiatives, it will move closer to realizing its intrinsic value. If the company ever views separating its PC business so that the shareholders can separately trade on enterprise and PC, one possibility might be a CVC type spin-off, where the Dell family retains the voting control over both the PC and Enterprise firms. Another radical thought, which might be unlikely is instilling a dividend for shareholders.