I hadn't researched the company too closely before, so I decided to take a look and see if this was really the case.
Being a value investor, you always have to be on the lookout for "value traps." These are companies that appear very cheap based on past results and typical valuation metrics, but it turns out that the low price is warranted due to a fundamental change in the business.
In this article I will give my thesis as to why I believe that Dell is indeed a potential Value Trap, and not a company that I will be investing in at this time. The company is in the midst of a major transformation to its business model, and due to strong competition and a declining core business, I believe that it is purely speculative at this point as to how successful the company will be in the coming 10 years. If the transformation is successful, the company is extremely cheap and undervalued today. But if is not, the stock will continue to fall -- which way it goes is a guessing game at this point.
Unless otherwise noted, all financial figures quoted in the article are taken from the most recent Dell 10-K.
If you happen to have read some of my previous focus articles, you may know that I use a 10 point system to evaluate companies. Dell I have scored a 7 out of 10 in my system. I advocate to only consider buying a company which scores an 8 or higher.
Note: For more information on my investing philosophy please check out my profile or website linked above. The "Magic Formula" and my "Circle of Competence" are the two most important criteria that I use in my system. Each of these I score a value between 0 and 2. The other criteria discussed in the article are all equally weighted with a value between 0 and 1. A maximum score is 10 points.
For those who are not aware of what the "magic formula" is, this is a stock ranking system created by value investor Joel Greenblatt. The methodology was first described in Greenblatt's The Little Book that Beats the Market. Details about his methodology including the screens can be found at his website. I won't go into detail here on the methods described in his book, but the basic premise is to find companies with a high earnings yield (measured by EBIT/EV) relative to the Return on Invested Capital (ROIC) that they produce. So you are screening for "good" companies at "bargain" prices. If you check out the website above you can sign up for free and view the current screens. Following my philosophy, I check the top 50 stocks over $50 million in market cap and the top 50 over $1 billion in market cap as a starting point for stocks to analyze.
Dell is currently on the 50 over $50 million screen. Using my methodology I therefore give this criteria a full score of 2 points. This tells me that the company has very good internal return rates based on results of the previous year, and also that the market price is very cheap relative to the earnings the company generates. So far, so good.
Score: 100% - (2 out of 2pts)
Circle of Competence
I believe it's important that before diving into the details of assessing any business, you first need to take a step back and honestly evaluate how competent you are to make these judgments. I determine whether a particular business is inside my "circle of competence" by giving this a point value between 0 and 2, using the following methodology:
- First I go to one of the popular finance websites and I read the Profile description of the company. After reading it one or two times, if I still have no clue what the company does or industry is about, then I would score this a 0. In 99% of cases, this lack of understanding that I have of how the business/industry works would cause me to stop looking further into the company.
- If however the profile description is simple and easy to understand from my perspective, I will score this criteria already at a 1 out of 2.
- I'll give a 1.5 if I feel I have some relevant practical experience to have sufficiently developed my own detailed perspective on it.
- A top score of 2 I'll only give if I really have a deep understanding of the company through personal experience with it directly.
In the case of Dell, I will give this a full score of 2 points. I am an IT professional, and I have used Dell products for years. I've owned several Dell personal laptops, and have also been involved with the company's Enterprise division to purchase new servers for a client.
Score: 100% - (2 out of 2pts)
Dell is currently in the middle of a large transformation, where it is trying to shift its core business away from lower margin hardware and PC sales towards higher margin software and IT services. To execute this strategy the company has made a number of acquisitions in the past few years.
This table below shows the breakdown of revenues and growth in the past year (data taken from most recent 10-K):
Percentage of Total Company Revenue
Revenue Growth from FY11 to FY12
Enterprise - Services and Networking
Enterprise - Storage
Client - Mobility
Client - Desktop PCs
Services & Software -
Software & peripherals
I believe there are a couple of things to take notice of here. The traditional hardware business of Dell, where they sell desktop PCs, laptops, and now tablets, makes up 54% of revenue (the Client sections above). This part of the business is under a lot of margin pressure from competition, and growth has been stagnant or even in decline. The same is true for the "software & peripherals", which consists mainly of components such as monitors, printers, keyboards, and other computer accessories. The only parts of the business that are really growing are the IT Services and enterprise server & networking divisions. These however make up only 26% of revenue as of early 2012. The enterprise division is also coming from the lower margin part of the business. We can see in the gross margin column that the profits are higher in the software & services divisions.
The company basically has a strategy similar to what IBM Corp (IBM) did a number of years ago, where they transitioned from the lower margin hardware business to focus more on higher margin IT services. HP (HPQ) is also struggling like Dell to do a similar type of transformation.
The problem that I see with this from an investing perspective, is that betting on positive business prospects for Dell requires you to speculate on how successful their transformation will be.
The company is still seen as a top player for enterprise servers, and their consumer PC business is very large and will not fall off a cliff overnight. This gives them some time to execute the transition, but any missteps will mean further drops in stock price.
Putting this all together, I will therefore give a 50% score on business prospects.
Score: 50% - (0.5 out of 1pt)
With this criteria I like to check that the company I'm analyzing has a consistent record of being shareholder friendly. No matter how good the financials are or business prospects seem to be, if the company doesn't have shareholders' best interests in mind it can have a big impact on the return on investment you will receive.
In the case of Dell I think this is one of their stronger points. The company has consistently repurchased shares, and in 2012 a generous dividend was introduced. The current yield is over 3%. This criteria therefore I have scored at 100%.
Score: 100% - (1 out of 1pt)
The competitive Moat of a business is very important, as this determines how well the business (and therefore its profit margins) are insulated from the competition.
This criteria I think is really an issue for Dell. From my personal experience as an IT professional, I can say with confidence that server hardware is largely seen as a commodity for most businesses. When a hardware refresh cycle is happening, the company will look at what is cheapest more so than the brand name. Even worse for Dell is that the huge growth of Cloud computing in the coming decade will further strain their enterprise business. Although the company has made acquisitions to bolster capabilities in cloud storage, this is still a small part of their business. In IT if you ask anyone who the big names are for cloud computing and or storage solutions, Dell will not be on the top of their list. Recently I wrote an article on Microsoft (MSFT) where I made the case that MSFT has a very compelling moat around it's core business, because MS Windows and Office were so intertwined into the enterprise that they were not going away quickly. I think in general software companies can build a much stronger competitive moat around their products. This is something that I don't see happening at all with Dell's business. They are trying to build this up with specialized IT services, outsourcing, and enterprise storage/cloud solutions, but since it still makes up barely more than 25% of the business I cannot justify any strong business moat.
Score: 0% - (0 out of 1pt)
I do not like to invest in businesses with high levels of debt, because this is can be an issue especially if earnings suddenly drop off in an economic downturn or recession. Dell has a debt/equity ratio of 0.86, which is a bit higher than I prefer. Also total outstanding debt has increased every year for the past 5 years. I've scored this criteria at 50%.
Score: 50% - (0.5 out of 1pt)
I like to invest in businesses that show consistent earnings growth because this makes it much easier to have high confidence in intrinsic value calculations.
Taking a look at the 10 year historical summary of Dell, earnings have increased more or less along with sales. However due to the uncertain business prospects, this is not nearly as predictable in the coming few years. It depends how quickly they can grow higher margin services to offset declining earnings in lower margin businesses. I've scored this therefore at 50%.
Score: 50% - (0.5 out of 1pt)
Margin of Safety
To calculate whether the current price constitutes a sufficient margin of safety against what I feel is the intrinsic value of the company, I have performed a simple DCF using one my favorite DCF calculators.
- Current Earnings: $1.68/share
- 10 year average growth of Earnings: 3%
- Growth after 10 years: 0%
- Discount rate: 6%
- How confident am I in my earnings estimate? : 33% confident
These inputs give me an intrinsic value of $11.68/share. With a current price of $9.65, there is a margin of safety of about 18%. This is not compelling, and in fact I have estimated this with a very low confidence margin (33%) because of the uncertainty in the business prospects. It is therefore not a very reliable measure of intrinsic value.
It is interesting to note though that the company is currently priced as if it were already dead - the price is assuming significant negative EPS growth in the coming years. There is at least a chance this is overly pessimistic. I have scored this criteria therefore at 50%.
Score: 50% - (0.5 out of 1pt)
Total Score: 7pts.
Conclusion: Dell is not a buy. I only consider to buy a company that I score 8pts or higher.
In summary, I believe Dell is more of a speculative play than a value stock. Indeed the company is priced extremely low, so if they have any serious traction in their transformation efforts the stock could have a large jump in price. In this situation I see a lot of parallels with Nokia (NOK), which is also a technology company that is priced low because nobody knows whether the business transformation will be successful. In these kind of situations, I advise to keep an eye on the company. If the prospects improve and there are signs of the transformation working, you might still be able to buy in for a value price. However as it stands right now, I would definitely advise to stay on the sidelines with Dell.
Disclosure: I am long MSFT.