Seeking Alpha

Dell Continues To Be 50% Undervalued Despite Cycle Pressures

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About: Dell Technologies Inc. (DELL), Includes: CSCO, NTAP, VMW
by: Thomas Lott
Thomas Lott
Long/short equity, Deep Value, special situations, hedge fund manager
Summary

Dell stock continues to suffer due to lowering its revenue forecast for the current fiscal year.

Despite that, earnings per share guidance is actually higher, and debt reduction impressive.

We view the selloff as misguided, as it continues to trade at a significant discount to every comp out there (NTAP, CSCO, HPE).

This discount makes little sense given the market share gains Dell is making across the board too.

I am nibbling on shares this week, but believe DELL might remain in the penalty box for a while.

The article was also shared with PRO+ Tech subscribers - find out more about PRO+ here.

There always seems to be one name in my portfolio that gets the best of me. Dell Technologies (DELL) lately has been a frustrating name for holders, and it reminds of the highly volatile trading pattern exhibited by Tech Data (TECD) over the past few years.

Tech Data’s business is lumpy, and not terribly predictable. Sometimes Apple (NASDAQ:AAPL) sold a lot of products in a quarter, and TECD results would be great. Other times, a revenue or slight EPS miss would be dealt with harshly. The price change on earnings day literally was all over the map. It frequently dropped up to 20% in a single day after an earnings report. Rough.

The past decade has not been a friendly time to own low revenue growth, but high earnings growth business models. That said, since our first buy recommendation in May 2013 (here), Tech Data has generated 18.3% annual returns for shareholders, a triple in terms of return in a bit over six years. (SPY has been up 12.7% per year since that day).

But back to Dell. Today, like TECD, there are revenue growth concerns, and it trades at an abysmal 6.7x earnings. But it generates a ton of free cash flow, and is easily 50% undervalued.

Just don’t expect this to be an easy path toward realizing value; some fortitude and patience will be required.

Per our math, DELL’s sum of the parts discount is one of the largest I have ever seen in the market, indicating that likely investors are concerned about the following:

  • Michael Dell and Silver Lake somehow “screwing” the current Class C equity holders.
  • Secular PC/storage demand decline fears, especially in light of Intel processor shortages, and likely component inflation next year having an impact on margins too.
  • VMware (NYSE:VMW) competition, cloud migration.
  • Balance sheet worries.

Let’s take these in turn.

Dell Control Risk

While the markets see Michael Dell as a vulture, and to some extent he is, most of his past actions were simply very smart acquisitions. The DVMT Class V transaction arguably was a better deal for Michael Dell than DVTM holders, and is likely on most investors’ minds today.

But in that case, Michael Dell and Silver Lake owned entirely different share classes (Class A and B, respectively), where incentives were not aligned. Those parties stood to benefit immensely from a deal to convert the tracking class stock into Dell holdco shares at a discount to VMW (the entity in which it was meant to track).

I never owned DVMT because, and this is the key point, DVMT holders had no legal right to the direct cash flows at VMware.

DVMT holders owned a stake at the parent (Dell Technologies), not VMware. That meant that DVMT as a class was at a distinct disadvantage to direct VMW shareholders. A conversion to parent company shares was a possibility, and so a huge discount to the VMW trading price was completely warranted.

Even in that "screwjob" scenario however, DVMT holders did pretty well. DVMT generated 45% annual returns for holders from its issuance in August 2016, until it swapped into DELL Class C stock last December.

Today, Michael Dell (MSD) and Silver Lake (SL) continue to own their stakes in Dell via Class A and B shares. They likely will continue to keep them, as they have 10 votes per share. The Class Cs only have one vote per share. It hardly matters anyway, when MSD owns 54% of all shares outstanding.

But essentially we all own shares in the same legal entity.

In fact, without a public market for B Class shares, Silver Lake cannot monetize their investment here. That is why both MSD and SL have conversion rights, to convert their shares into C Class shares at any time on a 1-1 basis.

Interestingly, MSD and SL have already been converting shares into C Class shares this year. SL has a few co-investors in their original 2016 Dell investment who received 17.65mm shares this past June. They converted to C Class shares. They will receive, and hence convert another 17.65mm shares into Class C shares again on January 2, 2020.

This could continue to be a technical overhang next year, as these holders will have discretionary trading authority over their blocks.

But key point, Silver Lake cannot monetize its B Class shares without either 1) selling them to a third party (e.g. MSD, who has said publicly he’d love to buy them), or 2) converting them to Class C shares, and monetizing them in the public markets.

Obviously, with VMW locked up into Dell, there is little likelihood that SL will simply sell DELL shares publicly, particularly at these discounts to fair value.

That leaves the only option we see in the future, which is to realize (via a spin or sale) the value of the sum of the parts to capture full value in DELL. Like Vodafone (NASDAQ:VOD) from a few years ago, or FOX recently, a breakup can mean huge gains. I continue to expect that in September 2021, when VMW can be spun off tax-free, there will be a monetization event.

The problem of course is waiting for that day to come.

PC/Storage Demand Concerns, VMware Competition

I view current margin and demand fluctuations as not exactly encouraging, but part of the unavoidable PC and storage upgrade cycle. This year, the Windows 10 refresh cycle helped demand, and memory chip oversupply helped on the margin side. Next year, chip prices will go up. Intel (NASDAQ:INTC) has recently admitted to curtailing processor supplies too. Probably won’t help with prices, and Dell has indicated that 2020 CSG (PC business) margins will likely look more like last year than this year.

That takes EBIT margins from 7.27% this year at CSG, to potentially as low as 4.55% as the company did in 2018.

At 4.55% in EBIT margins, that is a $1.20 hit to EPS. It probably won't be that bad given management's ability to manage costs, but it's hard to say.

On the storage (ISG) side, revenue has been quite weak this year, as China and large enterprises continue to scale back purchases. Dell has been selective in its bidding however, and continues to maintain its margins.

Over the past few years, storage margins have ranged between 9% and 13%. Last quarter they were on the high side at 12%. Again big picture, the demand for storage remains, as files and data require more and more gigabytes every day. Revenue may remain weak next year, but overall probably won’t be affected as much as ISG.

I estimate perhaps a $0.10-0.20 hit to EPS.

VMware, whose stock rolled over immediately after the Barron’s article on container risk, continues to perform well from a fundamental perspective. Last quarter, VMW topline jumped 12%, about in line with recent history. And, impressive deferred revenue growth also indicates near term future solid growth (up 12% ex the Carbon Black acquisition), so right now I am not too worried. The large enterprise continues to utilize a hybrid cloud approach for now, seemingly keeping VMW in the driver’s seat.

By the way, Barron's also wrote up Dell, suggesting its sum of the parts was $90 per share last summer.

Here is a good quote from VMW CEO speaking at a Deutsche Bank conference discussing the issue around cloud migration (thanks to one of my subscribers for sending this):

Source

With guidance this year at $7.30 in EPS, DELL now is trading at 6.7x this year earnings, quite a terrible multiple.

For 2020, assuming:

  • VMW grows 10-12% again, or 30-40c net to Dell, and
  • Interest expense falls $200mm, a 20c improvement to EPS, and
  • Core Dell drops $1.35 in EPS give or take,

Then a conservative EPS figure for 2020 is in the $6.30 range. It could be as high as $7.00 however. Street estimates for 2020 are $6.80 per share.

Here is the problem: nobody has any idea what EPS will be in 2020, with the “experts” on the sellside forecasting a huge range of $5.79 to $8.07 in EPS.

Even at $6.30, that still implies Dell is trading at only 7.7x earnings. On the bright side, this is a FCF machine, and they will generate roughly that much in FCF per share. When a company pays down $5-6 per share in debt annually, then the value of the stock should increase by that much, perhaps more (as lower levered companies often trade at premium multiples).

Here are recent segment financials:

Source: Author spreadsheet, company financials

That brings up the balance sheet.

Balance Sheet Concerns

I read sellside reports indicating that they remain cautious on DELL given the high levels of “Core Dell” debt. Core Dell of course is the PCs (CSG) and the EMC storage business (ISG).

First of all, VMW is a separate stock holding, so even if “Core” Dell is worthless, then the company could spin out VMW stock and holders would get $69 per share. Core Dell would have to be worth less than 3.9x EBITDA for that $69 to be impacted. Fat chance of that.

Dell has been a large and growing business for decades now. Gartner Group expects 4% revenue growth in IT spending over the next 5 years. Next year may look worse, but then the following year may be better.

Over the past 12 months, Dell has generated $8.1BB of FCF, and taken leverage from 4.2x debt/EBITDA, to 3.4x this year to date.

https://static.seekingalpha.com/uploads/2019/11/29/544737-15750607858935688.png

Source

If they pay down another $4BB next year (and company guidance is “at least” this amount), then they will be close to investment grade metrics by mid-2021.

In the case of AT&T (NYSE:T), I originally purchased shares when the drumbeat of “high leverage” and “avoid” were highest. But these companies, which throw off tons of cash, are often able to de-lever quite quickly. AT&T will be leveraged less than 2.5x debt/EBITDA by year-end, and I view Dell as one year behind them.

Below is my summary cap table on Dell. Given the valuation, investors create the Core Dell business at 2.26x EBITDA. That is really cheap.

Note that at the end of the day, total company leverage is 2.99x, which is pretty manageable.

https://static.seekingalpha.com/uploads/2019/11/29/544737-1575060784560662.png

Source: Author Spreadsheet, Company Financials

Valuation

Below is my sum of the parts model, using 2019, 2020 and 2021 estimates.

I conservatively used NTAP EBITDA multiples, and HPE multiples (now at all-time lows) to value Dell Core. I used VMW stock trading levels as a valuation estimate for DELL's stake there for 2019 and 2020.

In my upside case, for 2021 I assumed growth would take the value of VMW to $198.50 per share, a little higher than analysts' $183 target which only go out one year.

Source: Author Spreadsheet, Company Financials

Note the highlights in yellow. One illustrates the value of VMW, the other the Core Dell businesses (ISG and CSG).

I get a total value range here of $73 per share for DELL (using a 20% conglomerate discount), to $133 in a couple of years assuming a spin-off of VMW (and hence a zero STP discount).

That is upside of 50% to 170%.

Note that using a NTAP and HPE multiple could be deemed too conservative, as DELL is a better performer. One storage sales person indicated that NTAP is losing share, and struggling amidst heightened competition.

From Dell's last conference call:

We have gained 375 basis points of storage share over the last two years, 580 basis points of mainstream server revenue share over the last three years and approximately 600 basis points of PC share over the last six years."

There potentially is multiple upside here, especially in CSG.

Conclusion

The company trades very cheap on almost any metric. But don’t expect any near-term turnaround. There is a chance this falls to $40 per share; it continues to defy logic where it trades today.

Even in a non-spin scenario, an 11.6x multiple of cash earnings puts the stock at $73, upside of 50%. Cisco (NASDAQ:CSCO) and NetApp (NASDAQ:NTAP) trade at 14x. The VMW stake is worth far more.

Michael Dell, for all the criticism he takes, is a very smart guy. Not only financially, but operationally as well. This is a big company, taking share, that isn’t going away anytime soon. Like a few of our Compounders, revenue growth isn’t amazing, but FCF, ROEs, and EPS growth rates are.

Someday the market will realize the value here. Fox traded poorly for roughly two years, until one day it popped on a sale.

Finally, I note too that Elliott owns 13mm shares of DELL (the third-largest holder of the C Class shares). I am sure they know Silver Lake, and are not the kind of guys to sit around and do nothing when valuations can be unlocked via corporate action. They are quite good at forcing change; AT&T and Marathon (MPC) are a couple of good recent examples.

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: Long TECD