Saturday, February 9, 2013

Dell's Buyout: Ill Conceived and Poorly Priced

Reading this quote from a Dell spokesperson made me think some more about the Dell transaction,
“Based on that work, the board concluded that the proposed all-cash transaction is in the best interests of stockholders,” said the spokesman, David Frink. “The transaction offers an attractive and immediate premium for stockholders and shifts the risks facing the business to the buyer group.”
Going back in the recent press, Dell and its journalistic allies have been peddling a story.  Wall Street, with its fixations on quarterly results, has made it impossible to transform Dell into the innovative, disruptive competitor it was when Michael Dell sold computers out of his dorm room and car's trunk. The only answer is for Silver Lake Partners, a collection of banks, Microsoft, and Michael Dell to put shareholders out of their misery and buy the company.

Wall Street investment banks J.P. Morgan and Evercore partners advised the board about strategic alternatives, but it isn't clear what other alternatives were seriously vetted and why they were ruled out. An unnamed, "leading consulting company" was also involved.  It all sounds as if the concerns were to give the patina of independence to the board from Michael Dell's self-interest in the privatization transaction.

Bank financing will be provided by Bank of America Merrill Lynch, Barclay's, Credit Suisse and RBC.  Of course, all of these banks have investment research arms with equity analysts who cover Dell.  But wait, aren't these banks precisely "Wall Street" which is putting on the debilitating psychological pressure for short-term results?  Never mind, but their Wall Street investment banking colleagues are much more understanding and will generate superior returns between fees and extending credit.

Dell's shares were as high as $41.75 some years back, and were hovering around $16 before taking the recent down trend in 2012.  It really seems incredibly opportunistic to cite an "attractive premium" over a share price which itself has been talked down by the "frustration with short-term pressures" narrative.

Southeastern Asset Management's 8.5% stake was not accumulated for a short term trade.  Since they run relatively concentrated portfolios, they also carry out their due diligence within Dell's industry over a long period of time.  Dell was a significant holding in the Partners Fund at the end of 2011 and again at the end of 2012.  Their risk-adjusted, required return on such an investment is built on a relatively long holding period. They would be concerned about understanding quarters that seemed disappointing, but if the stock traded down short-term, this kind of investor often adds to a position.

If one such long-term, fundamental investor has come on board, then it is up to Dell's Investor Relations effort to go out and recruit more owners like this.  These fundamental investors are out there looking for good ideas.

So, the whole notion of Wall Street pressure requiring an privatization is ridiculous.  Dell hasn't been a momentum stock for over a decade.  It hasn't been a growth stock either.  If it is being priced as a value stock, when in fact it has the potential for re-accelerating growth, then that is a very attractive situation for a number of fundamental investment styles.

At the current price levels, other things equal, the expected return on Dell is higher than it was when it was in the mid-twenties, for example.  So the whole notion of some arbitrary premium to an arbitrary baseline price is as meaningful as a trading pattern on a technical stock chart.

The whole notion of "shifting risks to the buying group" should raise a red flag.  There is less risk at $13, and a higher expected return than in recent memory.  As SAM points out, since Michael Dell returned as CEO in 2007, the company has spent $7.58 per share for acquisitions, which have not been written down.  Dell's CFO claims that these acquisitions to-date June 2012 have generated a 15% IRR.  SAM credits the value at the historical cost, which is understated according to management's own claims.

Strategically, these acquisitions have, among other things, doubled services as a percent of revenues to 12% from FY05 to FY11, and this percentage is said to increase to 18-22% of revenues by FY15.  Services carry an operating margin of more than 20%, based on 1Q FY12 actuals.

The transformation of the revenue mix is well underway.  Dell's established niche in SMB (small to medium sized businesses) is strong across all the business lines.  The retail consumer business, according to SAM's presentation, is 30% of a $33.7 billion business, which is balanced between SMB, public sector, and large enterprises.  The overall operating margin is in excess of 5%, diluted by what's been happening in personal computing. This trend should reverse, as products converge between tablets and laptops.

Kroger is one of the largest global food retailers, with sales in excess of $90 billion.  When I covered their stock as a retail analyst, the Street was sure that entire world was going to buy its food from Wal-Mart supercenters and that Kroger would be hemmed in by Albertson's.  After rebuffing an effort by KKR to take it private, the company did a leveraged recapitalization, which included a large special dividend, funded by debt, and a public stub for shareholders who wanted to retain an equity interest.  After valuing all the pieces, I recommended the stub, and my institutional investors did exceptionally well when the company turned itself around.

Such a transaction could have worked for Dell, as SAM points out in its letter.  It would have been a fair deal for existing shareholders.  Based on the board procedures adopted, this would appear to be off the table now.  The question is "Why?"

Unfortunately, Wall Street sell side research is totally off the reservation now. Credit Suisse analysts, for example, are restricted because the investment bank will arrange some of the debt financing for the current management's proposed deal.  Their writing does nothing more than rubber stamp the proposed premia implied by the $13.65 price.

Dell's own executive presentations at investment conferences as recent as 2012 tell very optimistic stories about what has been accomplished and about what's to come.  To force shareholders to cash out now has no basis in any economic reality.  It is, however, a terrific power play by management and Silver Lake Partners.

No comments: