Monday, April 27, 2009

Investing in Michael Dell

Conservative Fair Value: $14

Strategy: Sell June 2009 puts with strike $10 for $.50

Result: Yield about 5% in 2 months, or buy DELL at an effective price of $9.50

Micheal Dell is back. His nitpicking, operations-heavy style is cleaning up the house that he built. Last time Dell tried to do a makeover they attempted a run on ancillary products like mp3 players, printers, and the like - in an semi-failed attempt to match innovators like Apple (iPod) and HP (printers). Unfortunately those are all low margin businesses and while some divisions have have developed scale today, they are still generally better suited for companies better-focused on those products. With start up costs high for these divisions, margins crumbled, and the stock got battered once demand for PCs started to show its cracks. Dell learned a valuable lesson: higher margin businesses are tough to replicate.

Today Dell is going through its 2nd and 3rd strategic directions in only a few short years. The 1st part is being undertaken right now as Michael Dell cut costs to improve profitability to more historic levels. Demand has fallen off the map, but Michael Dell has trying to keep pace by cutting SGA/COGS and plans of reductions of up to $4 billion in 2011. The profitability/cash flow picture will be more detailed below.

The 3rd strategic direction is yet to be seen - but is extremely important nonetheless. Dell has apparently reached some sort of critical mass in the computer hardware business. IBM faced it by expanding into services, HP faced it by expanding into services... and its only natural that Dell now do the same. The only questions will be is how?

With $6.8 billion in net cash, some talk has been in the market that they may make a play for a company like Accenture or even develop their own in-house services division. However, I'm going to go the off-the-wall route and bet Dell is going to take full advantage of the "open-source" trend, pushing for better equipped open source systems that meet specific needs of business users. Remember, Dell has always been a supporter of Linux-based systems - the story goes that back in the day big, bad Microsoft squashed any plans Dell had to market Linux PCs.

If I were Michael Dell, I would love the opportunity to take it to big Softy and enjoy it! Now that Linux has reached some level of acceptance as most major PC manufacturers have offered a Ubuntu Linux system pre-installed, now is the time for Linux to be picked up by a major outfit to push it to the next level. Let's not forget some benefits of Linux right off the map - lower power consumption, less security threats, open source architecture,and best of all, its cheaper since it's free!

Dell is in pristine financial shape. With $6.8 billion in net cash, Michael can decide to pursue almost any path he wishes - in house development of a services division, a buyout of a tech consulting business like Accenture, or purchase a Linux development business like Red Hat. Regardless, the $6.8 billion in net cash translates to a enterprise value of about $15 billion.

In 4th Q, Dell made $350 million in net income. I won't bother with previous quarters' income, since margins have contracted considerably since. With $4 billion in planned cuts in costs, I think the $350 million in income per quarter will be a steady one. Annualizing the $350 million and adding back depreciation/amortization of $800 million gets me to OCF of $2.2 billion.

Capex was about $450 million in 2008, and I think $500 million will be a good number for my model. PC manufacturing is extremely competitive and therefore all capex (growth and maintenance) should really be taken out of cash flows. The resulting Free Cash Flow is $2200 - $500 = $1.7 billion, or a EV to FCF ratio of less than 9x. This number should be closer to 12, giving credit to Dell's brand name and a low debt/high cash flow business model that focuses on cut-throat operations.

This business is not without some serious threats. First of all, demand can fall further. Secondly, is the push for netbooks made by Acer and Asus, which can potentially be even more lower margin products. Third, is HP's jump on the Linux OS market since they have already made their own customized consumer version of Ubuntu, called MIE - it puts them one leg up on Dell right off the bat. HP's margins come in around 7%, IBM's are at 10%, its only natural that Dell try to close the gap on their puny 2.5% margin! A margin of 5%, will make income hit $2.8 billion, and shares can be undervalued by more than 100%. Like I said earlier, higher margin businesses are tough to replicate so here's to Dell to becoming an innovator.

Disclosure: I own Dell


  1. There is no clever investment strategy than saving some bucks from your own pocket. It is very advised to gather hay when the sun is till shining.
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