Friday, March 29, 2013

Dell's Proxy Materials: Deal or No Deal?

For those who want to add to future global warming by killing lots of trees, Dell has issued hundreds of pages of proxy materials, including the background and timing of board discussions from the earliest days of going private to the opinions of JP Morgan, Evercore, and Goldman Sachs regarding alternative transactions.

Without doing a close reading of the materials with my  Eberhard Faber No. 2 Blackwings, here's what I put into my notebook.

The advisors agree that the issues for Dell going forward as a public company in the status quo mode include,

  1. The medium-long term growth of the PC market will be challenging, with low unit growth and lower margin sales driving gross margin downward by historical standards.  This would contrast with Dell's historical strength in sales of higher margin machines, driven by its premium name and efficient manufacturing structure. 
  2. The company has yet to demonstrate an ability to penetrate the tablet and smartphone markets.
  3. Dell has yet to leverage the more than $13 billion of recent acquisitions into a "compelling enterprise stack."  Of course, this is the peer sector where the higher valuations reside for a "new" Dell. 
  4. Can the company make the difficult, long and expensive transition from an equipment-based sales force to an Enterprise-based solutions sales force?  This is a critical question, which almost certainly accounts for the issue in point (3).  
  5. By all measures, Dell's stock performance has been abysmal, and it has almost no goodwill with equity shareholders, even with "deep value" investors. Over the past five years, Dell's stock performance was (47.6%).  HPQ was even worse at (64.1%).  Dell's PC-heavy peers were down (11.2%) as a group, excluding HPQ.  Dell's Enterprise peers were up 34.7% over the five year period.  
Put all this together, and it could make a case for taking the company private, depending on the near-term outlook for Dell as it exists today.  Well, guess what?  The near-term outlook is dismal.  Surprise, surprise!

In the earliest version of FY14, management's internal plan presented to the board,  projected revenue of $59.9 billion, with non-GAAP gross margin of $13.6 billion, and non-GAAP operating income of $4.1 billion.  The board eventually realized that this was a "pie in the sky" plan, and after a downward revision that was still not convincing, management was directed to work with board member Shantaru Narayen, the CEO of Adobe, to come up with a FY14 plan in which the board and management could be confident. 

The final FY14 plan had projected revenue of $56.5 billion, about a 6% reduction from the prior plan. Gross margin was reduced to $12.5 billion, an 8% reduction better reflecting the pressures on the PC business.  Finally, a 27% reduction in projected non-GAAP operating income to $3 billion became the latest benchmark. 

Ironically, the genesis for taking the company private was a friendly approach from Southeastern Asset Management, which was kind enough to present its spreadsheets to CEO Michael Dell. For whatever reason, SAM was never a part of the MD-SLP transaction.  Now, fast forward to evaluations of various alternatives to shareholder value creation.

JP Morgan's slides do consider a leveraged recapitalization alongside an alternative for a special dividend payment to shareholders in conjunction with going private.  The leveraged recap is said to have certain benefits for supporting the share price and perhaps being EPS accretive in the short-term; the obvious drawback, not unique to the recap, is the pressure on uncertain cash flows, given the continuous weakening in the near-term projected results.  It doesn't appear that the leveraged recap as contemplated by SAM gets the same level of consideration as does the MD-SLP plan at the given price.  

It is clear that the executive suite in a private Dell should be cleared of the executives who occupy it now, as they haven't been delivering and they are probably not suited to where the company would have to go in the future.  There are questions about Michael Dell himself: he made the $13 billion in acquisitions and allowed them to flounder.  

"Go Shop" procedures, according to Evercore's slides, produced a 6% median increase over the initial announced transaction price in larger deals.  This is a benchmark that could be met. 

It's pretty easy to see a scenario where the board could accept the MD-SLP deal at a 6% or so higher consideration.  The other players, at this point, might be out in the cold in this very cynical process.  

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