Dell (DELL) is a global information technology company operating in four main business segments:
1) Large Enterprise: Provides solutions and services to large global and national corporations. Represents 30% of total revenue.
2) Public: Services government, educational institutions, health care, and law enforcement agencies. Represents 27% of total revenue.
3) Small and Medium Business: Provides solutions and services for small and medium sized businesses. Represents 24% of total revenue.
4) Consumer: Provides consumer products such as desktops and notebook computers. Represents 19% of total revenue.
A common misconception about Dell is that it's mainly a consumer PC company. Consumer products make up less than 20% of Dell's revenue, with almost a third coming from the enterprise. Dell has made a slew of acquisitions recently, including Make Technologies, Clerity Solutions, and Wyse Technology. All of these acquisitions suggest that Dell is looking forward to a business model more like that of IBM, and it seems to be on the right path. Competitor HP (HPQ), which I've written about here, is attempting a similar transition.
(click to enlarge)
Dell's stock has remained flat over the last two years, currently trading at $16.49. Here's what the financials look like:
| (In Million $) | 2008 | 2009 | 2010 | 2011 | 2012 |
|---|---|---|---|---|---|
| Revenue | $61,133 | $61,101 | $52,902 | $61,494 | $62,071 |
| Operating Cash Flow | $3,949 | $1,894 | $3,906 | $3,969 | $5,527 |
| Capital Expenditure | $-831 | $-440 | $-367 | $-444 | $-675 |
| Free Cash Flow | $3,118 | $1,454 | $3,539 | $3,525 | $4,852 |
Revenue has grown slowly over the past 5 years, and free cash was flat for 2010 and 2011 with a significant increase in fiscal 2012. According the financial reports this was due to increased margins on products and 6% growth in the enterprise solutions segment.
Owner Earnings
Owner Earnings is a better measure for valuation purposes than free cash flow. Warren Buffett defines Owner Earnings as follows:
These represent (1) reported earnings plus (2) depreciation, depletion, amortization, and certain other non-cash charges... less (3) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume... Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (3) must be a guess - and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes.
I'll calculate Owner earnings by taking the 5-year average capital expenditure and subtracting that from the operating cash flow. I'll also subtract stock-based compensation from the operating cash flow since it has a dilutive effect on the company but is routinely included in the cash flow figure. I'll also add interest payments adjusted for taxes since interest is tax deductible.
| (In Million $) | 2008 | 2009 | 2010 | 2011 | 2012 |
|---|---|---|---|---|---|
| Operating Cash Flow | $3,949 | $1,894 | $3,906 | $3,969 | $5,527 |
| Interest Payments | $45 | $93 | $160 | $199 | $279 |
| Stock-based Comp. | $0 | $418 | $312 | $332 | $362 |
| Avg Capital Expenditure | $-552 | $-552 | $-552 | $-552 | $-552 |
| Owner Earnings | $3,432 | $993 | $3,155 | $3,242 | $4,843 |
Owner earnings smooth out capital expenditures and provide a clearer picture of the profitability of the company. Let's use the Owner Earnings figures to determine Dell's Cash Return on Invested Capital, or CROIC. This is the cash return generated by the company on invested capital, and is simply the Owner Earnings divided by the total invested capital. This is a better measure than ROIC because ROIC relies on earnings, which is a poor measure of profitability.
| (In Million $) | 2008 | 2009 | 2010 | 2011 | 2012 |
|---|---|---|---|---|---|
| Owner Earnings | $3,432 | $993 | $3,155 | $3,242 | $4,843 |
| Invested Capital | $27,561 | $26,500 | $33,652 | $38,599 | $44,533 |
| CROIC | 12.45% | 3.75% | 9.38% | 8.4% | 10.88% |
Dell had a CROIC 0f 10.88% in fiscal 2012, which means that given, say, $1 million in invested capital (reinvested earnings for example) the company generates $108,800 of cash on that investment. CROIC has increased over the last three years, which is a nice trend, and Dell seems to be capable of generating substantial owner earnings. Here's the balance sheet.
| Cash and Cash Equivalents | $14,818 |
|---|---|
| Investments | $3,404 |
| Debt | $9,254 |
| Pension Obligations | $0 |
| Minority Interest | $0 |
| Net Cash (Debt) | $8,968 |
| Diluted Float | 1,828 |
| Cash/Share | $4.91 |
Dell's balance sheet is incredibly strong, with almost $5 per share in net cash. This represents nearly 30% of Dell's market capitalization. This cash should allow more buybacks and acquisitions. Interest expense was less than 6% of owner earnings last year, so the debt levels are perfectly safe.
Valuation
I use a discounted cash flow analysis to calculate the fair value of a company. I use a discount rate of 15%, and you can read about my view on discount rates here. I'm going to assume that the huge increase in owner earnings in fiscal 2012 was a bit of an outlier, so I'll project owner earnings of about $3,800 for next year (the -21.5% in the table below). After that I will use a growth rate of 3%. This may very well be a pessimistic view, and I think the chance that Dell exceeds these projections are quite good, but let's see what these pessimistic projections give us. The growth table is shown below.
| Year | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 |
|---|---|---|---|---|---|---|---|---|---|---|
| % | -21.5% | 3% | 3% | 3% | 3% | 3% | 3% | 3% | 3% | 3% |
| Year | 11 | 12 | 13 | 14 | 15 | 16 | 17 | 18 | 19 | 20 |
| % | 3% | 3% | 3% | 3% | 3% | 3% | 3% | 3% | 3% | 3% |
Using these parameters I put the fair value of Dell at $22.24 per share. As you can see from the margin of safety table below, Dell is currently trading with over a 25% margin of safety from this fair value. This should be viewed as a low end estimate and could very well be much higher if Dell can grow faster than these pessimistic projections.
| Margin of Safety | Buy Target |
|---|---|
| 10% | $20.01 |
| 15% | $18.90 |
| 20% | $17.79 |
| 25% | $16.68 |
Conclusion
No matter how you slice it, Dell is an absolute steal at these prices. Even under fairly pessimistic assumptions Dell is trading well below fair value. If Dell succeeds at expanding more and more into services and the enterprise like IBM has, Dell could be poised for strong growth for years to come. Dell doesn't pay a dividend but at these prices the planned share buybacks are a far better option. I'll be looking to open a position in Dell soon.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in DELL over the next 72 hours.
