The thrust of the investment opportunity I see is simple - Dell Technologies (NYSE:DELL) trades very cheap on a Sum-Of-The-Parts basis.
At the moment, Dell Technologies owns:
- Its legacy business - what we'll call 'core' Dell - which provides IT hardware, software, and service solutions, including its namesake PCs along with servers and storage hardware;
- As of the end of fiscal 2019 (February 1), 80.5% of VMWare (VMW) (note that all ownership percentages come from p. 143 of the Dell 10-K);
- 62.8% of Pivotal Software (PVTL);
- and 86.4% of SecureWorks (SCWX).
In the 10-K, Dell cites $39.3 billion in what it calls "core debt": borrowings directly assigned to the Dell operating business. VMWare has another $4 billion in notes outstanding; Dell Financial Services (commonly referred to as 'DFS') $7.544 billion in debt; and the company has a $3.34 billion margin loan as part of its conversion of its tracking stock last year.
Less $10.24 billion in cash at year-end, net debt is somewhere between $29.0 billion (counting just 'core' debt) and $43.3 billion, including all borrowings. On the Q4 conference call, Dell guided for 750-755 million fully diluted shares outstanding in FY20. Using these figures we can model the valuation of core Dell at the moment (in this model, we'll use the most conservative measure of net debt and the midpoint of diluted shares guidance; more on the potential choices there later):
|DELL Market Cap||$46,106M||--||--|
|DELL Net Debt||$43,281M||--||--|
|DELL Enterprise Value||$89,387M||$10,296M||8.68x|
|Total Publicly Traded Stakes||$66,586M||$3,469M||24.4x|
Source: author from DELL filings and press releases; EBITDA figures for FY19. Note that valuations for public company stakes are equivalent to Dell's share, not fully diluted market cap; EBITDA is for the consolidated company, so as to derive EBITDA for only core Dell. EV/EBITDA multiples adjusted accordingly.
Non-Dell public company EBITDA figures author's calculations, adding reported adjusted EBIT figures plus D&A less amortization deducted from EBIT (to avoid double-counting)
In other words, in what is basically the most conservative scenario possible, the market is valuing Dell's legacy business at 3.4x EBITDA. Using Dell's own 'core debt' figure, the multiple drops to a staggering 1.3x.
To be sure, there are reasons why core Dell should be trading at a depressed multiple. There's the so-called "conglomerate discount", which often means that theoretically sound sum-of-the-parts plays can languish for years in practice. Barron's, among many others, has hypothesized about a potential Michael Dell discount, owing to the bruising nature of the negotiations when he took Dell private back in 2013, and when he bought out the former DVMT tracking stock late last year.
Potential taxes on a VMW gain may play a part; Dell may be able to avoid those taxes through a spin-off, but that's not certain. Furthermore, it's not clear that the company can execute a tax-free spin any time soon, or that Michael Dell wants to give up ownership of what clearly is the company's prized asset. (Dell's stake in VMW now is worth 134% of its market cap.) Again, value on paper may simply stay on paper until such time as Dell decides to make a move; with Michael Dell's control of the company, minority investors have zero voice in the matter, and in the meantime worry that they themselves won't realize all of that value.
And the cheap nature of core Dell hasn't exactly been a secret. Indeed, in another piece, Barron's pointed to the cheap valuation assigned core Dell back in December: something around 4.4x EBITDA. But as the site pointed out, other hardware plays are cheap, too; Dell itself made roughly the same point in December:
Source: Dell December investor presentation
The concerns are real. But those concerns look potentially overblown. Meanwhile, the valuation is much cheaper for one key reason. Since January, along with much of tech, both VMW and DELL have soared:
But VMW has soared more. In fact, DELL hasn't been able to keep up with the bounce in VMWare shares so far this year, after VMW paid out a dividend on December 31st:
VMW & DELL YTD
|Ticker||Close 12/31/18||Close 4/2/2019||$ Change||Diluted Shares||Equity Value Gain|
source: author from public data
DELL's 80% stake in VMW has risen in value by some $16 billion so far this year. DELL stock has added just $9.33 billion in market capitalization. That's a gap of about $6.7 billion.
That figure obviously is material against DELL's current $46 billion market cap - but perhaps more importantly, it's roughly 30% of the current implied valuation of 'core' Dell. That gap can't be explained by losses in the other stocks in Dell's portfolio: in fact, PVTL is up 29% YTD, and SCWX 15%+. Nor do peer/sector movements explain it: HP (HPQ) is down 3.6% YTD, but the other IT hardware peers listed in the Dell slide above all have gained at least 18% so far in 2019. Dell's Q4 earnings were reasonably solid; FY20 analyst estimates haven't moved since the release, and there was little in the results or in guidance (which projects revenue and profit increases for core Dell) to materially change the outlook for, or the valuation of, the business.
The arguments for a discount and concerns about the outlook for the hardware business can't be dismissed out of hand. But some of those negatives look potentially overblown. Meanwhile, core Dell has gone from cheap to absurdly so. That appears to have come in part simply because VMW has risen so fast that investors in DELL haven't caught up. They will soon enough - and in the meantime, DELL offers a giant opportunity.
Why The Discount Exists
Whatever the exact valuation of DELL excluding its public stakes, it's clear that the market is assigning an enormous discount to that underlying business, and to any reasonable SOTP valuation of the stock as a whole. And, again, there are several potential reasons why that discount exists - and why it might persist:
1. Investors don't trust Michael Dell.
Dell remains controlled by founder Michael Dell, owing to a dual-class structure. Certainly, some investors don't see that as a good thing. One value investor wrote last year that he'd been "screwed" by the DVMT buyout, and he wasn't alone in seeing the deal as a transfer of billions of dollars of value from tracking stock owners to Dell and partner Silver Lake.
Shareholders sued over the 2013 go-private as well, with a group eventually winning an appraisal lawsuit. In both cases, Carl Icahn successfully stepped in with activist campaigns to draw out a higher bid before the deals closed - but many (and, at least relative to DVMT, perhaps most) shareholders of either the pre-LBO DELL and/or DVMT still saw those higher prices as undervaluing the stock.
So some investors may simply sit the 'new' Dell out. ("Fool me once...", etc. etc.) Yes, minority shareholders may have value on paper - but the man in charge of realizing that value is Michael Dell. And, at least as some shareholders and investors see it, history shows that in the process Michael Dell and his partners will capture some, or most, of that value for themselves.
That said, this is a different situation than that surrounding both prior buyouts. When Michael Dell made his buyout offer in 2012, Dell wasn't exactly a hot stock. Fortune wrote the year before that the company was "struggling to find its identity," having lost its market share lead in PCs, and questioned whether Michael Dell was capable of leading a transformation. Dell shareholders did receive a substantial premium even in the original offer: the stock traded at $9.35 before Dell offered $12 (and eventually $13.75). Some shareholders might have thought the price was too low; the market as a whole did not, and before the buyout was assigning a low multiple to the stock.
As for DVMT, it was a tracking stock - an odd setup to begin with. And Dell (both the company and the CEO) was not incentivized to pay more for it than it needed to. That's not the case now, however. Everyone knows that VMWare is the crown jewel here, representing well over half the enterprise value in any reasonable model (at least one that doesn't believe VMW is enormously overvalued). It's hard to see how Michael Dell somehow takes that asset away from DELL shareholders or captures its value for himself.
And if Dell's ownership deserves a discount, shouldn't the risk impact VMW as much as DELL, if not more? Yet VMW is up 49% YTD and trades at 23x EV/EBITDA - under the same ownership. If there is a discount, it has to be in VMW shares as well, which have the same ownership issues - but it's pretty tough to see investors backing off of that stock at the moment.
Going against Michael Dell might not seem like a good idea - and it probably isn't. But DELL shareholders are probably riding with him - not against him. I'm not sure how that's supposed to be a negative - or if it is, why no one seems to care when it comes to VMW.
2. Core Dell is a highly leveraged PC manufacturer - of course, it's cheap. It should be cheap.
The two obvious fundamental reasons to be skeptical of Dell are the company's debt load and its growth prospects. Even excluding DFS debt (which is backed by financing receivables) and the $4 billion on VMW's books, net debt is $33 billion or so. That's roughly 5x core Dell EBITDA.
Meanwhile, the PC business is in obvious decline. Worldwide unit shipments were down 1.3% last year, according to Gartner - with a 4.3% plunge in Q4. HP just tanked earnings. Maybe 2x or 3x EBITDA is a little too cheap - but it's not as if core Dell is a growing business. If profits decline, the business could shrink into something close to its current valuation in only a matter of years.
But the PC business actually is a rather small part of the company's profit stream at the moment. The CSG (Client Solutions Group) segment, which is principally driven by PCs (along with peripherals, third-party software, and other smaller offerings), drove less than one-third of core Dell EBIT last year, per figures from the K. Meanwhile, the ISG (Infrastructure Solutions Group) had a big year, with margins rising 140 bps to 11.3%, servers and networking revenue up a whopping 28%, and storage sales climbing 9%.
By my numbers (which entail backing out reported adjusted EBIT figures from the publicly traded companies from Dell's consolidated figures), core Dell adjusted operating income rose 11.8% in fiscal 2019. To be sure, that's not a sustainable growth rate: cloud demand helped ISG sales in FY19, and lower memory prices provided cost benefits across the business in the second half (though management on the Q4 call demurred on breaking out the exact tailwind). By my calculations, guidance from the four public companies suggests close to flat profits for core Dell in FY20 ($5.7-$6.3 billion against $5.89 billion in FY19).
Still, this isn't a dying PC-heavy business. And as for leverage, it's manageable - if it indeed isn't a dying business. Management said on the Q4 call that it expected to reduce debt by some $4.8 billion in FY20 alone - and is targeting an investment-grade rating. The business still generates exceptional free cash flow. Consolidated net leverage of $33 billion sits on an EBITDA base probably in the high $9 billion range in FY20, backing out non-controlling interest - a mid-3x multiple. But guidance suggests net leverage could get closer to 3x by year end, given debt repayments and potential profit growth.
Meanwhile, Dell also has ownership stakes worth $60 billion. It reportedly has considered the idea of selling SecureWorks, which could bring in $1 billion-plus. Management has made clear of late - including on the Q4 call - that deleveraging is the near-term priority. The underlying business should help - but there are options in the ownership stake to accelerate that process if Dell so chooses.
3. Tax issues and conglomerate issues prevent the paper value from being realized.
There are tax considerations here. As far as I can tell, it's not precisely clear when Dell could effect a tax-free spin-off of the remaining VMW stake were it so inclined. (I've read five years from the 2016 closing of the EMC deal - though with my limited expertise I can't confirm that.)
But even taxing the full $66 billion at 21% only takes about $14 billion of value off - and that's obviously not going to happen. In that near-impossible scenario, core Dell still is valued at ~5.5x EBITDA, more than reasonable in the context of peers and growth.
Corporate costs are another common issue in SOTP models - but Dell's segment breakdown only includes $72 million in unallocated ongoing costs. A 10x multiple on that figure, backed out of the SOTP, only affects the DELL equity value by about 1.6%. That's not material enough, or close, to affect the SOTP argument.
From a high-level perspective, there's an obvious, if unquantifiable concern. DELL has a market cap of $46 billion. For VMW, the figure is $76 billion. Why, exactly, are investors missing this opportunity? Why are investors paying huge multiples for VMW when they could - at least in theory - get similar exposure through DELL at what looks like a cheaper price? (In fact - again on paper - DELL is a leveraged play on VMW, albeit with the distraction of the legacy business.)
The possible answer is that investors still are figuring out the Dell story; the company, after all, was private for some five years. The narrative surrounding the company still seems to focus on the supposedly struggling hardware businesses - despite reported growth and despite the fact that PCs aren't that big a part of the profit story for core Dell. Meanwhile, trading after the buyout no doubt was affected by arbitrageurs and the large VMW dividend, and the market may still be catching up on that front as well.
For what it's worth, analysts do appear to see upside here: the average price target currently sits at $65, per finviz.com data. But VMW's gains in the last month alone (about $5.3 billion in market value) have added ~$5.60 per share in value to DELL shares, and it's almost certain that not all published targets have incorporated even that move.
In terms of actually realizing the paper value here, there are concerns about how long it will take - and how little input minority shareholders will have. But, again, Dell and Michael Dell are incentivized to find a way to realize that value. At this valuation, significant discounts to reasonable valuation for core Dell still suggest substantial upside. And the fact that DELL hasn't tracked VMW since the spin suggests that there's room for DELL to catch up - and gain nicely.
From here, there's a case for enormous upside in DELL shares even after the recent rally. I'd calculate 'true' net debt as $37 billion, which includes the $4 billion in VMWare notes, as the DFS borrowings are largely securitizations backed by receivables. Market cap of $46 billion leads to an enterprise value of $83 billion. Less the value of stakes in the publicly traded companies, then, core Dell is valued at a bit under $17 billion.
That's 2.5x EV/EBITDA. It's 5x FY19 free cash flow excluding VMWare and receivables, based on data from the Q4 investor presentation. Even assuming there should be some discount here, owing to the controlled company status, the conglomerate/value realization timeline, and even hardware concerns, those multiples are far too low.
Every turn in the EV/EBITDA multiple assigned core Dell suggests a nearly 15% increase in DELL shares. 5x gets the stock to $84, 37% upside. Move to the 7-8x range where HPQ, IBM (IBM), and other low-growth hardware plays trade and DELL is over $100.
Those are not particularly aggressive multiples. Even simply recapturing the $6 billion-plus YTD increase in the value of VMW stock that hasn't yet been reflected in DELL shares moves the stock nearly 15% higher, to ~$70.
And if Dell's underlying business does disappoint in FY20, how much multiple compression honestly is left? Can the stock trade at 1x core Dell EBITDA? Even assuming a y/y decline to $6B, that still suggests less than 25% downside - in a scenario that seems close to outlandish.
Obviously, the biggest risk here is that VMW stock pulls back. Again, the value of Dell's stake in VMWare is 134% of its market capitalization. And VMW does look potentially stretched from a valuation standpoint, given expectations for maybe 10% adjusted EBIT growth this year (and in fact a weaker performance in terms of EPS) against low 20s EV/EBITDA and high 20s P/E multiples. It's possible that some of the recent gains are a result of the low float as well - and as a result may reverse quickly if sentiment toward the stock, or tech more broadly, weakens at all.
That risk, however, can be hedged out by shorting VMW at a 3:4 ratio. There are also some interesting options trades to consider - for instance, selling VMW calls (or spreads) and using the proceeds to fund DELL calls. Obviously, that trade wouldn't have worked out all that well YTD - but the bet here is that DELL's valuation relative to VMW likely is near, or at, a floor. As such, any upside in VMW should - at some point - be reflected in DELL.
From here, all else equal, there's a strong case for DELL to gain 25% simply as the value of the VMW stake is priced in - even at a discount. 6x core DELL EBITDA and 10% discount to the value of the publicly held stakes get the stock to $82 - and that's not a particularly aggressive model. It's also 30% upside. As investors understand that fact, DELL should continue to gain - as long as VMW cooperates.
Disclosure: I am/we are long DELL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am short VMW as a partial hedge to my long position in DELL.