Tuesday, September 7, 2010

Dell: Value Trap?

Dell is the definition of a fallen angel. This former tech darling has fallen to earth after years of flying high. It is also a company that bedevils me. Is it ridiculously undervalued or a value trap that will ultimately burn shareholders?

At year-end 2009, Dell had approximately $11 billion in cash and $4 billion of debt. Add in $2 billion or so in annual free cash flow and there is something to get excited about. This is especially true considering the company’s $25 billion market value. Not surprisingly some of my favorite value firms are among the largest owners of Dell shares, including Southeastern (Longleaf), Brandes, and Harris Associates (Oakmark).

Earlier this year, I too was seduced into owning Dell. It didn’t last long. A talk with investor relations woke me up. In discussing uses of cash, we covered buybacks, special/regular dividends, acquisitions and more.  It became very obvious that acquisitions were to be the focus.  In closing, the investor relations rep said my opinions were similar to those of Mason Hawkins.  I took that as a huge compliment, but it wasn't meant to be.  Dell clearly has no intention of listening to either of us.

This is a company that doesn't speak our language, to say nothing of their "new math".

I've seen companies fritter away billions and have nothing to show for it thanks to this attitude, so my Dell shares quickly found new homes.  Given the continued decline in Dell shares, I should be grateful, but I keep revisiting this company and its odd capital decisions. 

Given Dell’s track record on share repurchases, one can understand if the company swore off buybacks.  Shares have declined from nearly 3 billion shares to below 2 billion in the past 15 years and the stock has fallen nearly the entire time.  In fact, since the shares peaked in 2000, shares outstanding have dropped from 2.6 billion to 1.9 billion.  Hindsight tells us that they should have been more patient.  Ironically, the cheaper the shares have gotten the less attractive they’ve become to Dell management as a use of excess cash.  Buy low?  No thank you.

As for dividends?  Just like real men don’t ask directions, real tech companies don’t pay dividends.  This is especially so for "growth" companies.  And that is how Dell sees itself, even if the world no longer does.  And paying dividends sends the wrong message.  And here I thought dividend payments were about using capital wisely?!?

Instead Dell has decided to hold the cash and use it to “invest in the business”.  For the uninitiated, that’s code for acquisitions.  In this, Dell looks like a desperate company.  Margin compression in Dell’s core business helps explain why this may be the case.  Of more concern, everywhere Dell wants to be there seems to be a superior company occupying the space.

Whether large integrated firms like IBM and HP or specialized firms like storage giant EMC, Dell seems caught in the mushy middle strategically.  This 2009 headline speaks volumes:  Dell to Buy Perot in Catch-Up Deal.

Perhaps in response to Hewlett Packard’s purchase of EDS, Dell bought Perot Systems a year ago for $3.9 billion, a 68% premium to Perot's public market price and 30x its earnings. 

Shareholders should be relieved in a way.  The Perot deal was relatively cheap compared to the attempted purchase of 3Par.  Whether it’s the $18 a share bid in August or the final one at $32 (or $2.4 billion), it is a hefty bid for a company that is barely profitable.  The financial press must have been feeling nostalgic about the Internet Bubble because they were again able to use the price-to-sales multiple to explain the deal instead of price-to-earnings.  In fact, HP “won” the day with a bid valuing 3Par (PAR) at 8 times sales.  Congratulations!

I’ve been told many times that as a value investor, I just don’t understand growth, that I am incapable of understanding the world of possibilities that opens up because of such strategic acquisitions.  I admit that I hate the word “synergy” and have no imagination!  I will only say that growth is a variable to be valued not an end.  Growth at any price does not benefit shareholders.    

If this was a make or buy decision, both companies are admitting something by the price they were willing to pay for PAR.  By ignoring other uses for cash, Dell is admitting still more. 

A value trap is a company that may be undervalued, but where intrinsic value is falling.  Margin of safety is eroded and there is no guarantee of upside.  Some companies do this by losing money and burning up asset value.  Others do it through poor capital allocation decisions.

If the competitive environment and value were static, Dell would be a buy.  But these are dynamic forces.  Dell’s reaction to their competitive positioning is eating away at intrinsic value.  Dividends and aggressive share repurchases (at current prices) would be vastly superior to acquisitions at ridiculous prices.

Luckily for Dell, 3Par found a “greater fool” in HP, but don’t think that another deal isn’t around the corner.  Lexmark (LXK) perhaps?   Either way, this flailing around isn’t pretty to watch.

If Dell keeps throwing its cash away, their IR department can relax.  That phone won’t be ringing as often. 

Disclosure: In addition to numerous Dell computers, author owns LXK.


  1. Lexmark isn't a good place to be in the long term. As storage and the 'cloud' become more reliable and 'overreaching' ... the need to print on paper becomes unnecessary.

    The same can be said of investing in drive in theatres back in the 1980s ... not a very good idea.

  2. I've been hearing about the paperless office for 15 years. I'm not convinced. And either way, I don't have to have a macro view of printing to like LXK. Besides I bought it last summer below $15 a share.

    No doubt you would have used a similar argument to talk me out of it then? Ultimately it comes down to price.

    BTW LXK is now over $38. So I'll be content to think my own thoughts on this one.

  3. Great writing and wonderful insights that can be applied to many companies.

    I'd be interested in your view of Seagate Technology PLC (STX). I don't have a position, but wish I had time to dig deeper as it appears like it could be good value.

  4. Sorry Dean, but I don't do anything with disk drive manufacturers. They are outside my circle of competence... or at least my circle of comfort! Thanks for reading.