Dell Inc: A Possible Value Play?
Dell Inc. recently hit a speedbump after a conference call(http://seekingalpha.com/article/610301-dell-management-discusses-q1-2013-results-earnings-call-transcript?source=thestreet), after which it dropped almost 20%.
Dell Inc. Is in a competitive industry. It has no unique competitive advantage and ROE>30% is misleading. Add back treasury shares and ROE is roughly 8%. In fact, look at the 10 year Dupont Analysis:
While profit margins are on the rebound, asset turnover continues to decline, and most of the returns are really a result of leverage. So it’s clear Dell doesn’t have anything inherently special in the economics of its business. However, management is fantastic. They’ve recently promised to cut operating costs by 2B in the next 3 years. They’ve optimized Dell’s supply chain…look at their Cash Conversion Cycle:
The Cycle runs negative..they actually overall hold cash they owe for 36 days, rather than let consumers withhold payments for too long. Yes, DSO and DIO have been worsening mildly in the last 3 years, but DPO has improved enough to maintain a strong Cash Conversion Cycle rate, a small competitive advantage Dell has over its competition. Think about the implications of a CCC like this. It means Dell has bargaining power, which means while it has no fundamental economic advantage and no returns above the average, Dell’s management is singlehandedly making Dell needed. This is why I believe Dell is a possible value play. They have a super supply chain, their product is well used and they do have a brand image. Even with no apparent competitive advantage, they do have power. In the long term, their business has been transitioning to higher margin businesses as Dell Product has become a lower % of revenue each of the last 3 years. Enterprise Solutions and Services is now 31% of revenue. While most of this transition is due to serial acquisitions, goodwill and intangibles only make up 17% of total assets, and I believe in the management of the company. They are also introducing a new dividend, fit for a mature company like Dell, which will be about 2.6% at today’s prices while maintaining 10% to 30% of cash flows will be reinvested in share repurchases.
So here are the short term issues dragging it down:
1. Q1 Revenue(14.4B) was down 4% and below expectations.
Management Explanation: Bad Sales Execution(say changes have been made), Demand Environment is tougher(citing parts of Asia and India. Economic Recession is a big issue for lots of companies and I think this is a genuine concern).
2. Outlook-Emphasized a difficult and competitive environment but also said they were optimistic that momentum would build later in the year. Dell plans on giving additional outlook(including a full year estimate) in August.
In the Q&A, they were asked why they weren’t reducing full year estimates given that “you need to generate 80% of your EPS in the next 3 quarters, which is higher than what you’ve done in the past.” Management conceded the point but wanted to look at the “competitive environment” before giving estimates for the year. To me this means guidance will be revised lower in August, management just wanted to be sure before they gave the signal.
To me, this isn’t a death blow. With seasonal trends, management expects sales to pick up with each quarter by about 4%. If revenue increases by 4% each quarter, this year we’ll end up with 61.15B in revenue…we can expect at least around 5% net profit margins, so that implies around 3B in net income this year and EPS of roughly $1.71…that’s a rough projection, but it means that we can expect forward P/E of 7.3 still, and the problems really aren’t that bad for Dell. Nothing irreparable has happened, and I think this is a potential market overreaction.
So to do my valuation, I decided to take a worst case scenario approach.
Scenario1: Discount 10%, Growth 0%—-All Perpetually. Assuming FCF this year of $2B(see above..that’s conservative).
Intrinsic Value: $32.28B
Scenario2: Discount 10%, Growth 0%(10 years), Growth -3%(Perpetually after). Assuming FCF this year of $2.5B.
Intrinsic Value: $34.59B
Scenario3(My Realistic View): Discount 15%, Growth 3%(10 years), Growth -3%(perpetually). Assumes FCF of $3B.
Intrinsic Value: $39.59B
With an IV of $32B-$40B, you have a margin of safety of 33% on the low end. I think there’s a high probability that things will normalize for Dell, but I see no visible catalyst. Share repurchases at these prices will prove very beneficial to shareholders, and a new dividend policy will boost returns and help the wait.
Actual Investment: I think I’m going to hold off buying until the August conference call. I think management will probably revise the year outlook lower and the stock will take another hit. At that point, it will be time to buy. Be greedy when others are fearful!