Friday, May 10, 2013

Southeastern Asset and Icahn Continue Activism With Dell

Coincidentally with the issue of a letter today from Icahn Enterprises and Southeastern Asset Management to Dell's board of directors, this post ties back well to the previous post about corporate governance.

Southeastern Asset became actively engaged with Dell's board and management on June 15, 2012, when co-founder Mason Hawkins, CFA discreetly proposed a leveraged recapitalization to unlock shareholder value.  Southeastern's idea morphed into the Dell/Silver Lake Partners all cash offer of $13.65!  To make matters worse, Southeastern and other existing shareholders were not given a way to participate in Michael Dell's deal.

Southeastern's first quarter letter to its shareholders has a very cogent description of their investment process and the transition from engagement to activism. They write,
" 'Activism' is not part of our normal process, nor is it our preferred avenue. ...Becoming active generally indicates that we made a mistake in assessing our (management) partners. ...When the company's underlying assets remain strong, the stock's undervaluation is compelling, and the primary 'fix' is to people, we will generally become active if we believe we have good odds of successfully improving our clients' outcome." 
All of this is entirely consistent with their first letter to Dell's board, which used material from Dell's own presentation to suggest a compelling valuation for the company's underutilized assets.

A chart shows that for 255 positions Southeastern has held since 1993, 90% of these positions required no 13D filings.  Of the 26 positions which required a filing, Southeastern became engaged and active. Without suggesting that their ownership was a sole causal factor, 20 of these positions resulted in higher stock prices for their clients, 2 were break-even, and 4 resulted in lower prices.  Clearly, Southeastern's principals are not corporate raiders, greenmailers, or investors who want to run their portfolio companies.  They want to close the gap between market value and intrinsic value, especially when management are felt to be not doing their jobs.

Southeastern Asset owns about 8.5% of Dell's shares, while Icahn Enterprises owns about 4.5%.  The opening salvo of the letter notes that the stock price is below Michael Dell's cash offer of $13.65.  It notes that the board has allowed management and private equity to buy Dell with the shareholders own money, using relatively little of their own equity.

Furthermore, the board poisoned the market for alternative bids by agreeing to an egregious $450 million break-up fee for Dell/Silver Lake; in the event that an alternative bid emerged and were deemed superior, the break-up fee would still be a ridiculous $180 million.

The letter says that the board accepted an analysis of Dell's value that focused solely on its mature business lines, like personal computers.  The $14 billion of recent acquisitions, including innovators like Compellent, was not factored into long-term revenue opportunities, according to Southeastern/Icahn.  The letter suggests significant value creation opportunities by selling into China, Brazil and India.  Unfortunately, this battle has already been lost.  Lenovo has China wrapped up, and it has significant inroads in Brazil also; India may not prove to be a very profitable market for a large U.S. based, public company.

No significant operating improvements were built into the Dell/Silver Lake model.  One of Carl Icahn's favorite tactics, changing the capital structure, was not factored into the $13.65 value.

The Southeastern/Icahn letter makes some interesting points about Dell's global supply chain, one of its foundational strengths.  The letter says that it can be substantially improved by removing bloated overhead, redundant costs, and by improving facilities utilization by consolidating call centers, assembly operations, and by bringing some of these closer to the U.S. Another very interesting point, which I think plagues the entire PC industry, is what the letter characterizes as "infinite customization."  It suggests an "80/20" model for revenue and profits from the mind-bending number of customized layouts offered to consumers; a stocking model could reduce the size and improve the utilization of Dell facilities as well as generating potential efficiencies in buying key components like CPUs, motherboards, drives, displays and graphic cards.

The argument boils down to $12 cash plus an equity stub with a potential value of $2-$5 per share in the near-term being better than $13.65 cash with no participation in future growth.  A $5.2 billion term loan facility would be in place to make the cash payout in the event the business ran into short-term cash generating problems.

If the Dell board were not to consider the alternative offer and deem it "superior," then the Southeastern/Icahn team would also put forward an alternative slate of directors.

Again, the Dell board's passivity and acquiescence to founder Michael Dell's talking down the company and buying a low valuation may still carry the day. Southeastern/Icahn has fired their last bullet, and credit to them for all their work which could benefit all shareholders.

An interesting academic paper germane to management machinations ahead of a management-led buyout shows how manipulative this whole process can be, especially when shareholders are passive. Southeastern Asset has done a great job in calling attention to Michael Dell grabbing the company he mismanaged in his second stint as CEO, with shareholders' money.  Aren't public markets wonderful?

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