Dell Inc. (DELL) shares peaked in March of 2000 after being the best performing stock in the S&P 500 throughout the 1990s, the stock had a whopping $100 billion market capitalization versus net income for fiscal year 2000 of $1.86 billion. This nearly 80% drop in market cap has been well deserved because firstly the business' intrinsic value was never close to $100 billion, and secondly Dell's core business of desktops and laptops has been commoditized to the point where Dell has had to drastically alter its business model to stay relevant in the current technology marketplace. Through the leadership of founder and CEO Michael Dell, the company has shifted its strategy from trying to dominate the PC business, to leveraging the company's prominent presence in corporate and public IT department budgets to sell higher margin enterprise solutions, services, and software (ESS&S). While the difficulties that Dell has faced and is facing are obvious to even the most casual observer, the stock price only seems to reflect the negatives without giving any credit to the steps that the company has taken to restructure the business, offering the contrarian value investor an opportunity to profit. Dell qualifies as a good business at a bargain price so we are using a more patient and conservative strategy to enhance our margin of safety.
On August 21, Dell reported fiscal year 2013 second quarter financial results that disappointed. Revenue of $14.48 billion was down 8% YoY, while earnings per share and non-GAAP earnings per share of $0.42 and $0.50 were down 13% and 7%, respectively. Large enterprise revenue was down 3% to $4.5 billion in the quarter with operating income of $433MM. Enterprise solutions and services increased 9% on 17% growth in server and networking revenue, and a 5% increase in services. Public revenue was down 6% to $4.1 billion with operating income of $379MM. Server and networking revenue increased 4%. Small and medium business revenue was down 1% to $3.3 billion, and the unit posted operating income of $382MM. ES&S grew 15% led by an increase of 27% in services revenue and 16% in servers and networking. Consumer revenue was down a staggering 22% to$2.6 billion and operating income was only $14MM. Revenues were down across the globe led by BRIC countries being down 15%. While the second quarter was expected to be weak, the company further disappointed Wall Street by reducing its earnings outlook to at least $1.70 per share on a non-GAAP basis. Dell is making radical changes to its business model and it would be foolish to expect operations to progress flawlessly, particularly when the macro-economic environment is immensely challenging.
Over the last three years, Dell has on average generated close to $4 billion of annual free cash flow. These funds combined with the company's already strong balance sheet have enabled the company to acquire 16 companies in the past two years, and eight in the last 12 months. Dell's focus has been to grow its end-to-end technology for its customers, including managed security services focused on threat intelligence and security consulting. The company is competing on the cloud, virtual infrastructure and end-user devices. Dell is also working with customers through providing services to help manage and protect these systems. While overly-acquisitive companies often generate substantial red flags, management has been clear about communicating its strategy to enter less commoditized businesses, which tend to have higher switching costs and profit margins than Dell's traditional offerings. During this process Dell has been involved in several bidding wars including the acquisitions of Perot Systems and Quest Software, which caused the company to pay higher prices than initially desired. Fortunately for Dell shareholders Michael Dell owns approximately 13% of the company and isn't as likely to annihilate shareholder value to the same extent that Hewlett-Packard's (NYSE:HPQ) former management did in its plethora of empire building transactions.
Dell's primary opportunity is to become the International Business Machines Corp. (NYSE:IBM) for small and mid-size businesses by offering comprehensive IT solutions. This strategy is perfect for the company in that most small to mid-size businesses at least consider using Dell for some aspect of their IT needs in the first place, and with the recent acquisitions and investments in improving the sales staff, Dell has increasingly been able to parlay this into lucrative and recurring business opportunities. Dell's enterprise offerings cater to the largest segment of market which is mid-tier companies, and can scale up or down depending on the needs of its clients from there. Dell's financial results reflect the fruits of this strategy, as the gross margin has grown from 17.5% to 22.3% from fiscal year 2010 to 2012. Both GAAP and non-GAAP operating margins have followed suit, growing from 4.1% and 5.6% to 7.1% and 8.3%, respectively, over the same period of time. To be clear, Dell faces considerable competition but in our estimation is well positioned to gain market share in this growing global industry.
In Dell's second quarter of fiscal year 2013, Dell's enterprise solutions and services accounted for greater than 50% of the gross margin and about 34% of revenue, highlighting the tremendous impact to profitability that this higher margin segment has on Dell's overall financial results. While Dell's operating expenses have increased from 12.6% in fiscal year 2010 to 14.5% in fiscal year 2012, the vast majority of this increase is due to the strategic initiatives of increasing enterprise solution selling capabilities and other infrastructure spending. Dell's ESS&S acquisitions generally have higher expense structures due to their different business mixes when compared with Dell's legacy business, so it is not like the company is plowing more money in an effort to become the lowest cost producer of its commoditized products. Dell has also ramped up R&D and engineering expenses to 1.5% of net revenue, compared to 1% during the prior year. Jim Chanos has made a compelling argument that Hewlett Packard and Dell have been using acquisitions to supplement R&D and I would have to agree with his assessment. Moving forward we would expect both companies to increase their R&D budgets from current levels as the reshaping of their business models continue.
While Dell's consumer business has obviously been hurt significantly by Apple's (NASDAQ:AAPL) rise to dominance, and lower cost Asian competitors such as Lenovo, it is important to note that the vast majority of Dell's revenue and profits are generated in other areas. In fiscal year 2012, Dell's three largest business segments Large Enterprise, Public, and Small and Medium Business generated $50.1 billion in revenue and $5.1 billion in operating income for an operating margin of 10.2%. This is in stark contrast to the consumer business which generated $11.9 billion in sales and $324MM in operating income for a margin of 2.7%.
Dell's acquisitions of Perot Systems, Compellent Technologies, and Quest Software have provided Dell with a much larger client base and sales staff to cross-sell within the larger Dell framework of products and services. Earlier in the year, Dell formed a software group to add to Dell's enterprise solutions capability, with an eye on accelerating growth and further differentiating Dell through proprietary intellectual property. The Quest acquisition while admittedly expensive should be critical in expanding in this area. In Dell's analyst day in July, management highlighted that when the company acquired Compellent Technologies about a year ago, the company was selling in about 30 countries and now the company is selling in 100. Many of Dell's best growth opportunities are in emerging markets and the company is one of the few vertically integrated providers that can compete at scale in these regions. The PC penetration rate in India and China is 4% and 20%, respectively, so there is a real opportunity to broaden the potential target market for Dell to sell its products to as the middle class in the emerging markets continues to grow.
Management expects that by fiscal year 2016, 60% of operating income should come from enterprise solutions and services. Windows 8 offers a huge opportunity for both Dell and HPQ to gain some momentum in the sales of desktops and notebooks, but nobody expects that aspect of the business to grow robustly over the next 3-5 years. Tablets are a huge threat but they are also an opportunity as we believe that demand for a Windows based tablet is strong, and there is no reason why Dell shouldn't be able to garner a reasonable market share over the next couple of years. We'd expect to see the company milk the cash flows from the computers business to fund its more lucrative growth ventures. Dell's recent announcement of a $0.08 a share quarterly dividend marks a huge change in the positive direction. Management has shifted its capital allocation plans for returning capital to shareholders to 20-35% of free cash flow from 10-30%. While tech stalwarts might believe these actions to be a negative as it reflects lower growth rates and opportunities, the writing has been on the wall for years and Dell is clearly not being valued as any type of growth operation whatsoever which could prove to be a mistake. The key for Dell is to grow shareholder value and the company can accomplish that by a disciplined acquisition program, improved organic R&D results, and strong capital allocation geared towards buying back stock below intrinsic value. In the 2nd quarter Dell purchased 29MM shares at an average price of $13.63. The diluted weighted average share count is down 118MM or 6% YoY.
Dell closed the second quarter with about $14.6 billion of cash and investments. The company has $5.832 billion of long term debt and other non-current liabilities of $3.914 billion which pertain primarily to warranty exposure. There are 1.764 billion shares outstanding so the net cash position of Dell is about $2.75 a share. This means that an investor is paying about $9 a share for Dell's core business which should produce adjusted earnings per share of $1.70 for fiscal year 2013. This is equivalent to about 5.3 times this years expected earnings, and it offers a free cash flow yield of around 20% for a truly global business, with reasonable growth prospects. There is no doubt that Dell is undergoing its share of problems but it is only in a market environment where the focus is always entirely on the negatives when this type of valuation could persist. Basically, Dell is offering a payback period of 4-5 years based on free cash flow, and an investment in Dell is betting the Michael Dell will get an adequate return on his investments to build out the ESS&S business. We would suggest dollar cost averaging into Dell for longer-term investors through selling puts. Currently, one can sell the January $14 13 put for $2.66. This would generate a 25.7% or 18.35% annualized return on the maximum risk assuming Dell closes above $13 at expiration, and it would reduce the cost basis to $10.34 if Dell expires below $13. This means that Dell could drop by about 11.3% before an investor holding the option till expiration would lose a penny.
Disclosure: I am long DELL, HPQ. 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.