Catching a bottom is never easy, and recent investors in Dell are learning that the hard way.
The drop in Dell's (DELL) YTD share price has been relentless; the stock is down more than 50% as of last Friday's close. Anytime a stock's valuation gets cut in more than half, I at least get interested in the story.
Dell's story is a bit unclear, and Wall Street clearly has not been buying it. With the PC market largely commoditized and saturated, Dell's desktop and mobile businesses (responsible for 50% of revenues) have slowed markedly. Lenovo and Acer's offerings have compressed margins and revenues at the ultra-cheap end of the PC market, while Apple has been the clear leader in "luxury" computing. This has left Dell with little differentiation to offer and no cost advantage; a poor combination to say the least.
Worldwide PC sales reflect a tough reality for producers, with sales expected to grow less than 1% this year. This figure is the result of saturated developed markets and slowing demand within Asian economies, specifically China. With neither of these headwinds posed to ease, the obvious conclusion is that Dell's PC business is largely unexciting.
Dell's PC Business
Let's take a look at what value we can conservatively assign Dell's desktop and mobile businesses.
For fiscal 2012, Dell's desktop and mobile businesses (D+M) generated $33.2 billion in revenues. This was roughly in-line with 2010's results. Dell's most recent 10-Q indicated deterioration in both businesses; H1 2012 results showed sales down 5 and 14% respectively YoY.
The main catalyst for this revenue weakness has been sustained losses in final sales prices; a trend that is likely to continue.
Over the next five years, as Dell continues to transition away from the D+M businesses and towards enterprise solutions, annual revenues could, in an aggressive scenario, decline 10% annually. This would result in 2017 D+M revenues of $19.5 billion. Assuming that today's margins of 22% continue, these segments would generate about $4.3 billion in gross profits, compared to today's $7.4 billion. Over those five years, the segments will have generated several billions in cash flows to aid Dell's transition into enterprise solutions.
While this exercise illustrates Dell's steady cash generator, another interesting situation to consider is if we send the value of these businesses to zero, leaving us with the ES, services, and software segments.
Those three higher-margin segments generated $28.7 billion collectively in fiscal 2012, at an average gross margin of about 29%. While Dell doesn't plan on making large investments in their server business, it does expect its ES and software to grow markedly over the next several years. Dell expects a 10% growth rate in the solutions business, along with a 13% operating margin. Assuming a conservative 7.5% annual revenue growth rate, Dell will receive over $41 billion in annual revenues from these segments. At a 13% margin, Dell will earn $5.33 billion in 2017. This figure does not include any D+M revenues.
Conclusion - Huge Margin Of Safety, Asymmetric Return Profile
Dell is positioning itself to be a vendor of enterprise solutions to individual businesses, and to attach high-quality software to its hardware offerings. While this is by no means an easy transition, Dell has a $3.5 billion cash cushion, which is unlikely to be burnt via acquisitions given Dell's recent close on Qwest software.
Furthermore, the valuation offers a significant margin of safety. At less than 6 times earnings, meaningful downside is only plausible if EPS takes a surprise turn downward. Given the above, conservative scenario for $5.33 billion in net income by 2017 excluding any D+M income, Dell would be trading at a market cap of $32 billion, compared to today's valuation of $17 billion.
This model calls for 20% annual returns, without accounting for share buybacks or annual dividends (which are currently 3.20%), and assumes a conservative growth rate of 7.5%, no multiple expansion, and a worthless PC business.