As an investor, Dell never really attracted my attention. Previously, it was one of Wall Street’s favorites and its start-up story a future bestseller. It thrived on a well thought-out business model based on an ancient-old trick: cut out the middleman. Dell sold its desktop PCs and laptops directly over the Internet to the end-consumer. For many years, Dell appeared to be a corporate fairy tale.
During the Internet boom its stock went up a hundredfold in just two years and an astonishing 225-fold within four years — from $0.25 to $56 USD. That’s a 22,500% return. Investing a mere $10,000 would have made you a multimillionaire.
Steadily the company fell out of favor with investors. There was nothing exciting anymore about Dell. All market fads come to an end, including the Dell hysteria. The herd formerly investing in Dell jumped on the band wagon of the next fad. Fads come and go.
Now, Dell is in dire shape. It suffers from tough competition, the PC market is languishing, and its business model is becoming rapidly outdated. The tech-industry is not an industry that really excites me. Capital investments are enormous, R&D costs are sky-high, and the competition is too fierce.
But Dell was being hammered down by every stock analyst. It was then that this former Wall Street sweetheart suddenly aroused my interest. Was its valuation near liquidation worth justified? What was going on with Dell?
Michael Dell resigned in 2004 only to rejoin three years later. He couldn’t manage watching how the ship carrying his name was sinking while standing on the dry. What was meant to be his ultimate legacy, far extending beyond his own life, was at the verge of being a mere blip in corporate history.
While Dell was being valued as if Y2K and the 2012 Mayan Apocalypse would happen simultaneously, I saw a pretty sound company. It still generated generous amounts of free cash flow, it showed a great return on equity, it had a large pile of cash and little debt, and a management with substantial stock holdings, including Michael Dell himself with, of course, the additional incentive to keep his reputation high.
To me, the widespread negativity about Dell was overblown.
I did have some concerns. The growth in hardware sales was weakening, margins were being squeezed throughout the industry, and major competitors like HP were also hopelessly trying to change their business model by spending excessive sums of money on new acquisitions. Moreover, some value investors I highly regard burned their hands on Dell. David Einhorn bought Dell at $15.53 and eventually decided to cut his losses and sell his shares, because, as he explained, he was disappointed by Dell’s (in)ability to expand its business into new lines. What were the risks that Dell would go down? After all, from $9.15 to $0 is still a 100% loss.
But, in my opinion, bankruptcy was already accounted for in Dell’s share price. While Dell was producing $1.88 per share in (annual) earnings at the moment, I subtracted Dell’s significant cash holdings ($8.01 per share) from the share price and what remained was a P/E ratio equaling a mere and astounding 0.84. I decided to delve in at around $9.60 per share.
I disagree with the market on several points. Current valuations would only make sense if the computer hardware industry would be in a free fall. It isn’t. The computer hardware industry is not a fast-growing segment anymore, but it is still growing nonetheless. And lower growth rates translate to less competition. The PC market was not the black hole that investors were making of it.
It is interesting to note that two decades ago IBM was low-rated because the mainframe business was viewed as worthless due to the rapid emergence of PCs. In 2013, however, twenty years later, IBM presented their new line of mainframe computers for 2013. While the mainframe market ceased to grow, mainframe computers still exist and competition diminished over time. IBM reaped the fruits.
Dell is aggressively cutting costs in its traditional hardware business and managed surprisingly well in keeping its margins up. Gross margins on traditional products in fact increased over the past few years.
Further, analysts were mistakenly assuming that Dell is a hardware company. It’s not. And it never has been. Dell was never really a high-tech business. They sold computers, yes, but never incurred high R&D costs. Computer chip makers such as Intel do spend a lot on R&D, around 30% of gross profit, while Dell spends on average 5% on R&D. Dell sells high tech devices, but it is not really in the business of making the technology itself. Dell is much more a service-oriented company with an extensive direct sales force.
The new Dell that our dear Michael envisions focuses primarily on data storage. And there is a huge market still untapped in China. The potential is there. And it came as a free goodie with the rest of the company when I bought it.
Given the little debt on its balance sheet, I wrote in October 2012 that “even a leveraged buy-out could be a possible scenario.” Even I at times appear to predict some things correctly. Last week, it was announced that Silver Lake, a private equity firm that specializes in buy-outs, was contemplating a take-over bid of around $13.65 per share, a $4 mark-up above the current market price. An offer, nevertheless, of $42 less than Dell’s all-time high.
It was no surprise to learn that the offer made some shareholders outrageous. As Warren Buffet once said, “Only when the tide goes out do you discover who’s been swimming naked.” Southeastern Asset Management, Pzena Investment Management en Yacktman Asset Management were buying high, selling nothing, and entirely wrong. They are now complaining and threatening to sue Dell.
I do, however, agree with those shareholders that the company is worth more than $13.65 per share. It is outrageous to first buy back stock at inflated prices and to later suddenly declare, when it suits them, that $13.65 per share “is a great price.” Why for goodness sake then have they bought the same shares for double or even triple that amount earlier?
Initially, the role of Michael Dell remained unclear. I asked on January 18: “Will Michael Dell sell its shares and leave the company or take the company private and continue as CEO?” It is now clear that he’s doing the latter. He wants to restore his flagship. He aims to turn Dell into a fairy tale again. He hopes to rebuild his reputation as a pioneer and market leader.
A new and very interesting chapter will start. I am curious to see what will become of Dell 2.0 as it is shifting the set of the sail.
I am now happy to say that I can see Michael Dell pulling it off (of course, without me having skin in the game any longer). I’m more bullish on Dell than many of its competitors, including Hewlett Packard. Meanwhile, I made a small, tidy profit for which I happily say: thank you, Michael.
As Benjamin Graham taught us: as long as you buy stocks really cheap, you’ll have a margin of safety and a low-risk investment. With a catalyst for value, in this case a buy-out, you can reasonably expect to make money of your investment within a few years. The most difficult in this task is to analyze why a company is cheap (is it justified?), what catalysts exist so that the stock price will readjust within a certain period of time, and what margin of safety is reasonable to expect.
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