The 'sum of the parts' case that I, and many others, have made for Dell Technologies' (NYSE:DELL) stock hasn't played out. Since I made the argument for 'core Dell' fourteen months ago, DELL has declined 19%.
The primary factor has been a similar decline in VMware (VMW), of which Dell owns 81%. But that hasn't been the only factor. Even had an investor hedged out of all of DELL's exposure to VMW (the value of its VMware stake was, and is, greater than its market capitalization), returns would be only about 2% over of that stretch.
'Core Dell' — the value of the business excluding the VMware stake — simply hasn't re-rated as bulls like myself believed it would. Last year, DELL ex-VMW looked almost absurdly cheap, at a range I estimated between 1.3x and 3.4x EBITDA depending on the treatment of debt. This year, core Dell looks just as attractive:
| Segment | Valuation | EBITDA | EV/EBITDA |
| DELL Market Cap | $37,150M | --- | --- |
| DELL Net Debt* | $36,600M | ||
| DELL Enterprise Value | $73,750M | $11,821M | 6.24x |
| VMware | $50,558M | $4,030M | -- |
| SecureWorks | $899M | $15M | -- |
| Total Publicly Traded Stakes | $51,457M | $4,045M | -- |
| Core Dell | $22,293M | $7,776M | 2.87x |
Source: author from Dell and VMware press releases and filings. EBITDA figures for trailing twelve months through Q1 FY21. Valuations for VMware and SecureWorks based on Dell's ownership, not total market cap. VMware EBITDA author calculation
* - figure from Dell Q1 earnings presentation. Equals Dell 'core debt' plus $4.0 billion margin loan and $9.1 billion related to Dell Financial Services. Does not include debt held on VMware's balance sheet
The non-VMware assets trade at less than 3x EBITDA. Use just the company's core debt figure, which excludes a margin loan used to purchase VMware stock (and is thus backed by that stake) and Dell Financial Services debt (backed by receivables), and EV/EBITDA gets to the 1.2x range.
But, again, DELL has traded at that multiple for quite some time. On this site in late February, Viceni Investing made an excellent case as to why the market hasn't bought the SOTP valuations made by myself, other authors here and elsewhere, and even Wall Street analysts. Viceni also detailed the potential "scenic route" toward a $100+ valuation for DELL, more than double the current price.
At this valuation, I'm still willing to stay patient and travel that scenic route. DELL trades at less than 8x the midpoint of FY21 (ending January) adjusted EPS guidance originally given with the Q4 release in late February. That guidance has since been withdrawn, but better-than-feared Q1 results last month suggest the pandemic-related pressure on the business at worst should be manageable. The five-year anniversary of the Dell/EMC deal arrives next year, which could provide some clarity to the story and a potential upside catalyst for the stock.
That said, I see some reason for caution as well. There are qualitative, secular, concerns across Dell's two business units as well as VMware. The market elsewhere is pricing in an acceleration of the cloud transition that amplifies those concerns. As a result, setting aside the SOTP case and the 'cheaper' method of gaining exposure to VMW, there's an increasingly real "value trap or value play?" argument with DELL stock. Over the last few years, those arguments usually have been won by the skeptics.
FY21 Guidance
From a broad standpoint, it's worth going back to the fourth-quarter reports from Dell and VMware, both released after the close on Feb. 27. Neither was well-received: VMW stock fell 11% the following day, and DELL more than 7%.
Obviously, the timing mattered, as the market was beginning its steep sell-off from mid-February highs. (It's worth noting that the NASDAQ Composite closed flat on Feb. 28, however.) But from a high level, guidance from both companies highlights the risk to both stocks.
For its part, Dell guided for non-GAAP EPS of $5.90-$6.60. That range represented a steep decline from FY21's $7.35. VMware projected revenue growth of 11.5%, but a 140 bps compression in adjusted operating margins after a 50 bps erosion in FY20.
The respective outlooks seemed to confirm the key qualitative concerns for the two businesses. For Dell, it was secular pressure on storage and server sales, along with the comparison to inflated FY20 results in the PC business. For VMware, it was elevated spending necessary to keep pace in an increasingly cloud-centric world.
Both stocks have recovered the post-earnings losses. Indeed, both are down only marginally YTD (DELL -1.7%, VMW -1.3%), thanks in part to gains after earnings beats last week. But the initial outlooks for this year, and the market's initial reaction, still underscore the broader risks to the DELL/VMW story going forward.
Dell CSG
The concern with Dell's Client Solutions Group, which generated ~30% of segment-level operating profit, isn't necessarily that the outlook is poor. To be sure, CSG isn't exactly set for long-term growth. The segment houses the PC and peripheral businesses, and demand is unlikely to rise much, if at all. In fact, revenue for the business has been stable for about 15 years now (whether that's good news or bad news depends on an investor's perspective).
The worry, rather, is that fiscal 2020 performance was so strong, at least in terms of margins. Operating income for the segment increased 60% year-over-year. Operating margins were 6.8%, up 230 bps versus the year before.
The performance last year benefited from two temporary tailwinds. First, the Microsoft (MSFT) Windows 10 refresh drove demand on the commercial side. Indeed, commercial sales were up 11% last year, per the 10-K; consumer revenue dropped 6%. Margins, meanwhile, benefited from component costs. As memory prices, in particular, fell sharply, Dell was able to keep some of the savings in-house
This isn't just a Dell-centric trend. HP Inc. (NYSE:HPQ) management has called out the same benefit. For their part, Dell executives (see the Q3 call, for instance) have said more than once that margins are going to return to a more normalized 4-5% range.
Indeed, that's going to start happening in the second half, particularly as comparisons get more difficult. CSG did have a solid Q1 revenue-wise (+2%), which management attributed to companies and governments scrambling to set up remote employees. But that spike started fading in April, per the call, and the Windows 10 tailwind starts to fade as well.
Even solid performance going forward still suggests a reasonably large stepdown from FY20 earnings on a consolidated basis. The EBIT increase for CSG in FY20 contributed over $1 per share after-tax to Dell's earnings in FY20. More normalized CSG margins in FY21 were a major contributor to the original guidance for declining earnings, and the impact may linger into FY22.
Again, the issue isn't so much that CSG is going to fall off a cliff relative to historic levels. Higher work-from-home demand may provide a short-term boost, and could even drive adoption of the company's "PCaaS" and Unified Workspace offerings, both of which charge customers on a monthly, per-user basis.
Still, CSG isn't going to drive much growth even relative to historical normalized levels, and it's likely there's still some profit pressure coming in the next couple of quarters as component costs normalize and the Windows 10 tailwind comes to an end.
Dell ISG
For FY21, the hope is that the Infrastructure Solutions Group — storage, servers, and networking — can offset some of the pressure on CSG. That's in part because ISG already saw its stepdown last year. After a blowout FY19 — revenue +19%, EBIT +35% — the segment saw revenue decline 7% last year, including a 14% drop in servers and networking sales.
But Q1 numbers for the segment were soft. Revenue declined 8%, with storage -5% and servers and networking off 10%. There's likely some coronavirus-driven disruption at play, but as management noted on the Q1 call industry analyst IDC is forecasting weakness into Q2 at least.
The broader concern about the current crisis is that investors elsewhere in the market are pricing in acceleration of the cloud trend. That's a reason why Amazon (AMZN) has rallied so significantly, in addition to the spike in demand for its e-commerce offering. More broadly, -aaS stocks of all kinds have rallied sharply.
The worry for 'core Dell' to begin with was that the secular shift to the cloud would pressure revenue going forward. If the acceleration being priced in elsewhere arrives, that in turn suggests more pressure on ISG revenue and margins.
Dell is trying to respond, in conjunction with VMware, by focusing on 'hybrid cloud' offerings. But we've seen those kinds of pivots play out poorly on a multi-year basis for hardware/on-premise plays like IBM (IBM) and HP Enterprise (HPE). If CSG sees profits normalize and flatten, and ISG starts to fade, 'core Dell' looks an awful lot like a value trap.
VMware
That shift to cloud is a threat to VMware as well. And given that the VMW stake represents 136% of Dell's market cap, any threat to VMware is magnified in the DELL stock price.
VMware, too, is an on-premise play. The core vSphere product is used to "virtualize" on-premise servers. But, as Barron's detailed late last year (and many others have noted), the rise of the open-source Kubernetes software is a significant threat to vSphere.
VMware of course is trying to respond. The acquisition of Pivotal Software was a key part of VMware's own Kubernetes strategy. VMware also made a smaller buy of Octarine, an early-stage Kubernetes security play that will be folded into Carbon Black (which too VMware recently acquired). And hybrid cloud represents another area of focus.
But vSphere is a headwind. VMware noted in the 10-K that its rate of growth has continued to decline; it's disclosed previously that vSphere no longer is a majority of licensing revenue.
The issue isn't just decelerating revenue growth — but pricing pressure as VMware pivots into a more competitive market where it lacks the same dominance. It's that risk that explains the reaction to initial FY21 guidance: VMware (before the pandemic) was projecting slower organic revenue growth and weaker margins. Investors, perhaps rightly, worried that VMware was at the start of negative trends on both fronts.
The Case for DELL Stock
To at least some extent, those risks are priced in. That's particularly true for VMW, which has rallied 74% from March lows — and extended those gains after the Q1 release. Leverage for DELL remains reasonable, and the company is targeting an investment-grade rating. Even if Dell has to shell out a premium to acquire all of VMware (as Viceni argues will happen), the balance sheet will be strong and pro forma valuation still prices in little (and potentially negative) growth going forward.
Meanwhile, both Dell and VMware will respond. And while the likes of IBM, HPE, and even Oracle (ORCL) haven't always done so successfully, those stocks were priced for success when the ground started to shift beneath them. That's just not the case for DELL, in particular (and VMW is trading at a discount relative to its space).
DELL still seems cheap enough. But that sentence alone highlights the risk. In the bull market that ended in March, a bull case based on "cheap enough" rarely worked out. As the market has rebounded, that trend seems to be repeating. It's too glib, perhaps, to argue that valuation doesn't matter, but investors have been much better off buying the business and not the stock.
And there are risks to the business for both Dell and VMware. Those risks give me some pause with DELL stock. Not enough pause to exit yet — but certainly enough to pay close attention.
