How Much Would Dell Be Worth If It Never Sold Another Desktop PC?

| About: Dell Inc. (DELL)

In just about every corner of the investing world, you can hear commentators crowing about the post-PC era. Despite the fact that Apple (NASDAQ:AAPL) received much fanfare for the Retina Macbook Pro, everyone seems determined to write companies like Dell (NASDAQ:DELL) off because tablets have supposedly killed the personal computer.

This assumption is, of course, erroneous for multiple reasons. But let's run with it just to show how ridiculously undervalued Dell really is.

According to Dell's Consolidated Statement of Operations, Desktop PCs generated $14,144M in revenue for FY12. Trefis estimates that Dell's gross margin for desktops is 21%.

So what I'm going to do is shutter Dell's Desktop PC division entirely. That's right - kill it. Zap, zilch, zero, no more desktops will ever be sold again.

Given $14.144B in desktop PC revenue and a 22% gross margin, we can conclude that Dell would lose roughly $3.11B in gross margin. Let's back this out of Dell's stats. (For the sake of demonstration, I'll assume that other costs scale proportionately. While this assumption may be a little inaccurate, it's okay given that we're working with a pretty preposterous presumption to begin with.)

Dell As-Is, FY12 Dell Without Desktop PCs, FY12
Gross Margin $13.811 B $10.7B
Operating Income $4.431B $3.43B
Net Income $3.492B $2.70B
Diluted EPS $1.88 $1.45
Click to enlarge

Now, there's just one problem with my analysis. I used FY12 data for ease of calculations, but in reality, Dell is about to report Q2-FY13 results. In Q1-FY13, Dell had some problems and EPS dropped to $0.36 from $0.49 in Q1-FY12. Let's assume this trend continues throughout the year, and further scale down our EPS by 25% to compensate. Our final FY13 EPS, if Dell never sells another desktop PC, is $1.08.

At a share price under $12, our very battered Dell is selling at a FY13 P/E of 11. And guess what? At that valuation, I'd definitely still buy Dell, even without them ever selling another desktop computer. As I've examined in previous articles (The Future For Dell), Dell's enterprise services solutions already account for 50% of gross margin, and the industry has strong secular growth trends: with the rise of the "cloud" and Big Data, enterprise cloud spending is projected to double to over $200B by 2016. In addition to the increasing adoption of Intel (NASDAQ:INTC) Ultrabooks, that's one of the reasons why Trefis is modeling a fair price of $19.22 for Dell.

In conclusion, Dell is certainly facing some challenges during the transition period from PC provider to enterprise solutions provider. Nonetheless, it's easy to see why Dell is a huge value at the current stock price. It would be a pretty good buy even if we knew that Dell would never sell another desktop. And given that it will still continue to sell desktop PCs to businesses, emerging markets, and even the occasional old-school consumer, the desktop PC segment is more of icing on the cake. Even with draconian assumptions about future EPS and the complete elimination of the desktop PC unit, Dell would still be a good buy. With Dell's recent initiation of a dividend, it's really hard not to like the stock at current valuations.

For investors who agree with my thesis but don't want to tie up a lot of capital in Dell stock, LEAPS present an interesting opportunity. I generally don't recommend buying "speculative" OTM options, but since I believe Dell's plunge in May was completely unwarranted, I think they might be a good way to play the stock's rally. $15 strike Jan '14 call options currently trade around $0.80-$0.90. Given that Dell was trading in the $16-$18 range earlier this year, I have complete confidence that Dell will be in that range again sometime between now and Jan '14, giving the trade a lot of profit potential.

To me, what happened to Dell looks a lot like what happened to Seagate Technology (NASDAQ:STX) - the market overreacted to the downside on a bit of bad news, giving investors a great buying opportunity. (I'm up nearly 25% on Seagate since buying it in June)

As for me, I hold the aforementioned calls as well as several hundred actual shares of Dell. At the current valuation, especially with the 2% dividend, it's a great way to play the growth of Big Data and the Cloud. I'm planning to hold the shares for several years and reinvest the dividends, while I'm looking to exit the calls when Dell fills the gap and once again trades in the $16-$18 range.

Disclosure: I am long DELL, INTC, STX.

Additional disclosure: I am long Jan '14 Dell $15 calls in addition to actual Dell shares.