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SA Editor Samir Patel
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I joined Seeking Alpha as a Senior Editor in September 2012. I work closely with company leaders on content and publishing initiatives, primarily the SA Pro and SA Buyside platforms. A little about me: - I'm a native Texan. - I'm a value investor; I always enjoy reading well-constructed and... More
  • Dell: Battle Royale For Control Offers Surprisingly Interesting Risk-Reward 3 comments
    May 23, 2013 6:54 PM | about stocks: DELL

    (Note: Adam Levine-Weinberg posted a very thoughtful response in the comments section extending the thoughts from his original article. I strongly recommend reading both his comment and his original article to obtain a different perspective on this situation.)

    As I mentioned in my last post (about Wells Fargo warrants), I recently read and loved Joel Greenblatt's You Can Be A Stock Market Genius. Quite coincidentally, I'd been looking at (and had invested in) the Wells Fargo warrants right before reading the book, and then when I hit the stub section, it reminded me of Icahn's proposal for Dell. The supposed question is financing for his offer, but given Icahn's net worth, his existing backers, and his reputation, I think there's a very high probability that he obtains enough financing; the real question is which proposal will win out. While Icahn's is definitely preferable, I think DELL shares today can be viewed as a cash equivalent with significant optionality value.

    Some brief and not necessarily relevant context: I've been following DELL closely for over a year now. About midway through last summer, I started liking DELL as a value investment last year, bought a small stake at around $12, and kept adding to it (quite heavily) as it descended below $10 through the fall. I sold out the vast majority of my position at the beginning of this year after the potential buyout was announced, since I thought upside was capped and I had other places that I wanted to invest the capital. I did feel pangs of regret when the mini-bidding-war started, but I wasn't interested in getting back in at that point, and couldn't have done so even if I'd wanted to. Since the bidding war fizzled and the stock's basically gone nowhere since I sold most of my position off in late January and early February, it seems it was a fortuitous decision.

    With four months in the rearview mirror and the vote coming up in July, however, I find myself with some spare capital and no other positions I'm actively wanting to build. So I looked into DELL again keeping Greenblatt's discussion about stub stocks in mind. I concluded that there are essentially three possible outcomes here:

    1) Michael Dell/Silver Lake take the company private for $13.65 a share. Assuming a purchase price of $13.40, you get a 1.86% return, which works out to ~5-6% annualized. Not a lot, but more than you'd earn on cash. Expected value: $13.65. Expected probability: ~50%.

    2) Icahn wins and you get $12 in cash plus the stub stock with the nominal value of $1.65. As I will establish below, I believe that very conservatively speaking, the stub's intrinsic value should be $2.24 at least, with significant optionality value beyond that. Expected value: $14.24. Expected probability: ~45%.

    3) For some bizarre reason, the deal falls through. As I will subsequently discuss, I don't think this is a realistic outcome, but I'll throw it in the model anyway. In this scenario, expected value would be $11-12 at worst - Dell was trading at $11 before news of the deal hit the tape, and PC-related names like HP, Intel, Microsoft, Cisco, and others have performed quite well since then, as investors have realized that the industry isn't going to dramatically collapse like everyone mistakenly thought it would. Expected value: $11.25. Expected probability: ~5%.

    Probability-weighting those three scenarios, you get an overall expected value of $13.80, which is admittedly only 3% above the current price over the last few days of roughly $13.40. That being said, if you eliminate the possibility of the deal falling through (which I do), and realize how conservative the assumptions behind this fair value are, it starts to look really interesting, mainly on account of the stub if Icahn wins. Why?

    Stub Valuation

    So let's get to it. One modeling technique I like to use for contrarian, deep value investments is assume that the bears are right and things go drastically wrong, then see if the company still represents a "decent" investment. If the company's current valuation suggests that it's a decent investment if things go horribly wrong, and things end up going okay or, better yet, well, then it's probably going to turn out to be a great investment. For example, I conducted this sort of analysis for HP in November, and concluded that at $12 a share, the company was being valued for bankruptcy, because even if earnings were cut in half before stabilizing, the P/E would end up being 6. Six. That suggested to me that if the turnaround was remotely successful, HP would be an easy double or triple. What's happened since November? Well... the market realized that the company wasn't at risk of going bankrupt, and that the valuation was kind of absurd. Let's just say my only regret is not buying more in the $12-14 range when I had the chance.

    The stub presents such a worst-case opportunity. While several bearish articles like this one by my good friend and respected analyst Adam Levine-Weinberg conclude that the stub could be worth much less than $1.65, I believe it could be worth much more. Here's why.

    Adam notes that pre-tax EPS could drop below $0.50 over the next year, despite Icahn and BCG's assertion that cost reduction could lead to pre-tax EPS of $0.89. Let's be conservative and assume pre-tax EPS is $0.40, a full 20% below $0.50. Now let's be even more conservative and assume that the tax rate is at 30%. Note that Dell's historical tax rate is in the mid-20%s, and due to the deductibility of interest payments, you'd expect tax rate would in fact decline. Nonetheless, this is my "worst case" model.

    You're now left with $0.28 in after-tax EPS. We'll assign a 8 P/E multiple to this, for a "fair value" of $2.28 for the stub. The 8 multiple reflects a 20%-30% decline from the roughly 10 P/E that Dell would be trading at in the $11-12 range currently; a decline in valuation is warranted given the leveraged capital structure post-deal. (I'm not using the 12.5 currently quoted P/E since shares are trading on the deal price rather than earnings.)

    I've made very conservative assumptions here, and yet the stub's fair value still appears to be significantly (38%) above the $1.65 nominal price. To get down to $1.65, you either have to lower the P/E to under 6, or assume that EPS drops all the way to $0.20 after taxes.

    In a more middle-of-the-road but still fairly conservative scenario, pre-tax EPS is $0.55 and the tax rate is 25%. At an after-tax P/E multiple of 8, the stub should be worth $3.30, or nearly double the $1.65 nominal price.

    So what's your downside here? As Adam notes, HP has been trading at a 3-5 pre-tax EPS multiple over the past year, and has recently been in a strong uptrend along with other "old tech" companies, suggesting investors are gaining more confidence in the sector and are willing to assign a less drastic valuation. Even if Dell came in at the low end of that range (3x), and the pre-tax EPS dropped to $0.40, you're looking at $1.20 for the stub. So if you buy Dell today for $13.40 and elect to take the $12 cash payment, putting your cost basis on the stub at $1.40, your maximum downside is 1.5% on your overall investment, versus upside to over $15 if Dell simply doesn't collapse.

    And how likely is the "good" scenario of $0.50+ pre-tax EPS and $3+ for the stub? Well, Icahn's putting a lot of his money into this, and he's planning to put it all into the stubs. While there's no guarantee he'll be successful, it's hard to imagine he won't at least try. He's a smart guy, and BCG has a solid reputation, and between them, I think that at least moderate success is the most likely outcome. As HP's last two earnings reports have demonstrated, moderate success is all a stock priced for failure needs; investors quickly become willing to assign a less drastic multiple.


    Summing it all up, the stub stock looks like a really attractive risk-reward for investors willing to stomach volatility and an investment in a highly leveraged company. However, even if you wouldn't want to purchase a significant stake in the stub stock outright, I think that Icahn's all-in offer (including the cash) offers solid upside with minimal risk, and the best part is it's backstopped by Michael Dell's all-cash $13.65. It's essentially a merger arb with very low probability of any significant downside, and a lot of optionality value.

    The downside scenario, of course, is that the deal falls through and DELL shares drop a couple bucks, but I don't think that's very likely at all. If you've been following the situation since the beginning (see Market Currents' coverage of it here), it's pretty clear that Michael Dell badly wants this deal to go through. He's sunk a lot of time, money, and effort into this, and I just don't see a scenario where he decides to back away.

    One final word about the stub stock: I can definitely envision a scenario where selling pressure after the deal goes through leads to the stub dropping rapidly; many investors, especially those in favor of the Silver Lake proposal, will likely want to disassociate themselves from the stub as quickly as possible. Investors specifically interested in the stub may have the chance to swoop in and pick it up at an even more attractive valuation than the $1.40 that it's available for now. I'd certainly consider doing just that if the opportunity presented itself, but when all's said and done, I think DELL shares look interesting here since I see them as worst case a cash equivalent paying more than money market, and best case as an investment with significant upside potential.

    For what it's worth, in the event that Icahn's proposal is selected as superior (and he has my vote for sure), I am planning to elect to receive additional shares of stub stock instead of cash. That's how much I like the risk-reward here. There's always risk, of course, but if my assumptions are correct, the downside on the stub is very limited, offering an asymmetric risk-reward opportunity.

    Postscript on Dell's business - very very short version of why I'm bullish

    As a postscript on Q1, I'm by no means a conspiracy theorist, but I do think this analysis from Southeastern Asset Management re:Q1 is worth considering:

    The increase in EUC revenue and decrease in both margin and net income clearly reflect Dell's aggressive pricing strategy in its commercial accounts during the quarter - an attempt to buy meaningful market share in the shrinking PC business. Dell's broad distribution channel has always been a significant strength, and the Company will sell other products and services across this increased share. We are not aware of any point in the history of Dell, or competitors like HP, when PC margins were this low - either naturally or artificially. Sacrificing margin to gain share is a win-win for an insider making a bid for the Company. Buying share will generate higher cash flows later that will benefit only future owners, while scaring current investors and predictably generating the desired negative headlines in the near term. From a completely short term perspective, the lower margins and net income engineer the results to make Michael Dell and Silver Lake's undervalued bid look attractive.

    In other words, SAM thinks this was the kitchen sink quarter. I agree with them, and think it gets better from here with multiple drivers including a Haswell-catalyzed rebound in PCs, increased corporate IT spending, and higher margins going forward.

    Disclosure: Long CSCO, DELL, HPQ, INTC, MSFT, WFCWS. I intend to purchase more DELL shares in the next 72 hours.

    Additional Disclosure: These are my personal views and should not be taken to represent the views of Seeking Alpha.

    Stocks: DELL
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Comments (3)
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  • Adam Levine-Weinberg
    , contributor
    Comments (1432) | Send Message
    Hey Samir: Thanks for the shout out, and an interesting read. I also happened to read Greenblatt's book recently. Dell could definitely be a typical stub case for him, but I don't think so. In fact, I'm still not confident that Icahn/Southeastern will turn this proposal into a firm offer, although they do seem to be lining up lenders.


    A lot of the delta here will depend on the added interest expense and the number of shareholders who opt for additional shares rather than cash. There are two reasons why I don't like the risk-reward here:


    1) Following Icahn's numbers and plugging in the Dell management projection for $3 billion of operating income this year, the stub would have EPS of $0.51. However, Q1 non-GAAP operating income was $590 million, which makes $3 billion for the full year pretty challenging. I would say $2.5 billion is a likely figure, but not necessarily conservative. (After all it assumes sequential improvement at some point this year)


    The $500 million reduction to operating income would lead to pretax EPS of $0.40 (i.e. Samir's projection), but this is a "likely" number, not a conservative figure. I would assume tax rate of 20%-25%, which would get you to $0.30-$0.32 after tax. Dell would be more leveraged than HP in this scenario, while having higher exposure to PCs, so I think it would deserve a multiple well below HP's 7X. $1.65 might be a fair valuation here, but I don't think it's especially conservative.


    2) If every Dell shareholder opts for more stock rather than cash, this deal will function as an 8.27:1 stock split. Creating value depends on buying out a substantial proportion of Dell shareholders. I don't have a good sense of what constitutes today's shareholder base, but I wouldn't be surprised if people who love the stub stock are "selecting in", as Samir suggests here. With just 20% of shareholders opting for more stock, the share count goes to 4.4 billion. With 40%, it goes to 7 billion. This might save $200-$300 million in interest expense, but would drop EPS to the $0.20-$0.25 range. In that scenario, I think $1.65 could be a best-case valuation.


    There could be upside if the company manages to cut more expenses than are included in the current management business plan. On the other hand there could be downside if interest rates are higher than Icahn's projections or if the PC business continues to deteriorate.


    If I were a shareholder, I'd take the cash. But then again, that's why I'm not a shareholder; there are better opportunities in this market.


    23 May 2013, 09:29 PM Reply Like
  • SA Editor Samir Patel
    , contributor
    Comments (163) | Send Message
    Author’s reply » Adam, thanks so much for sharing your thoughts - you make some great points and I think anyone considering an investment in Dell (or in the stub if it goes through) should definitely fully understand the arguments for the other side.


    Regarding the HP comp: you're definitely right on the leverage aspect but I think HP deserves a much higher multiple (10ish sounds reasonable) than it's trading at today, which would explain our different conclusions from the same data. I also think that the PC fears are way overblown, and Dell is more than just PCs. Nonetheless, most people focus on the PC aspect, which is what's been depressing the valuation.


    As for taking the cash vs. the stock, I fully expect most shareholders to opt for cash rather than stock, based on both historical precedent and other factors.


    Again, thanks for the comment.
    23 May 2013, 09:44 PM Reply Like
  • Adam Levine-Weinberg
    , contributor
    Comments (1432) | Send Message
    I agree that HP is still way undervalued (HP is one of my largest holdings). But if you were going for a leveraged bet on one of these two companies, I'd probably prefer an out-of-the-money LEAPS option on HP over the Dell stub.


    The real problem with Dell from a strategic perspective is that PCs, servers, and enterprise services are basically commoditized businesses at this point. There are other areas that are potentially promising, but IBM, Oracle, HP, Cisco, etc. are already there as well, so there's no real assurance of success. The big difference between Dell and HP is that HP has the printing cash cow. I would value the printing business alone at about $25 billion.


    As for the share count: I think this could be an atypical case. If you think the stub is worth less than $1.65 (the people who would be selling right away), you would be better off taking the Dell-Silver Lake offer. On the other hand, if Icahn convinces you that the stub is worth much more than $1.65, why take just one when you're being offered the opportunity to get 7.27 more at $1.65 each?


    It would appear that Icahn needs to convince a majority of shareholders that the stub would be worth significantly more than $1.65 to win the proxy battle. Because of that setup, I could envision a lot of people taking the stock offer if Icahn's proposal is implemented.
    23 May 2013, 11:37 PM Reply Like
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