MorningWord 1/15/13: $DELL LBO, That Ol’ Chestnut

by Dan January 15, 2013 9:23 am • Commentary

MorningWord 1/15/13:  Yesterday afternoon Bloomberg news reported that Michael Dell, CEO and founder of the computer maker is exploring with private equity firms the potential for a leveraged buyout, to take the company that bears his name private, 25 years after its IPO.  Michael Dell is the largest shareholder of the company with nearly 16% of the shares outstanding, and it is easy see why he and large shareholders are dissatisfied with the valuation that the public markets have placed on the company.   As a result of DELL’s declining earnings and sales growth over the last few years, the company trades at 7.5x earnings (one of the cheapest stocks in the entire S&P 500) despite a balance sheet that has 50% of their market cap in cash (net of debt about 10%).

Make no mistake about it, regardless of business performance, CEO’s of public companies are ultimately judged in a large part by the performance of their stock, and their ability to return cash to shareholders.  DELL started paying a dividend last year that has a current yield of 2.6%, and some would argue that they have been entirely too generous with their share buybacks over the last decade.   Felix Salmon who reports for Reuters detailed last Sept (here) DELL’s near historic negative equity issuance as he calls it:  

Over the course of the intervening 15 years, Dell has been solidly profitable, and in fact reached record earnings per share of $1.87 in 2011.

How is it possible that Dell has earned more than $15 per share since 1997, has never lost any money, has never paid a dividend (until 2 qtrs ago), and is now worth less than $11? The answer, of course, is buybacks:

Based on their annual 10K filings, from Fiscal Year 2005 to 2012, Dell has purchased approximately 989 million of its own shares at a cost of over $24bn… Going back further to 1997 (through February 3, 2012), Dell has reportedly spent approximately $39 billion in share repurchases under a $45 billion repurchase program.

$39 billion is more than double Dell’s current market capitalization of $18 billion

As you would expect, DELL shares saw one of their biggest rallies on the rumor (up 13% yesterday) in more than 5 years.   My sense is that this will be a hard one to chase in the low teems.  While Michael Dell had little to lose as the largest and most frustrated shareholder to get his PE dealings “out there”, there are many large shareholders that may not let DELL steal the company away at a valuation level that they see as entirely too cheap.  DELL has nothing much to lose at the moment, the company has desperately tried to diversify their revenue base away from PCs, and has yet to show meaningful results in the form of earnings growth.  If their is no appetite for a deal either by private equity or is blocked by shareholders, the stock will likely give back some of the recent gains, but my assumption would be that there will be a new floor in the stock, somewhere above the recent lows.  The likelihood of seeing DELL as a hat size anytime soon aint great though.

Analysts are out there scrambling to do some quick math to see if an LBO is even possible based on the company’s free cash flow.  Bernstein analyst Tony Saccanoaghi did some fine work on the topic, detailed  in a note to clients this morning:

 -an LBO is financially feasible, though it would be one of the larger LBOs in history – we estimate annual interest payments might be ~$820M vs. current trailing 12- month FCF of $3.1B. Moreover, we note that Dell is currently committed to paying $560M/year in dividends, and has returned a total of $1.4B and $2.4B in cash to shareholders in each of the last two years, suggesting that interest payments for the LBO wouldn’t necessarily impact Dell’s ability to effect its desired transformation.

– Deal financing. We have assumed that (1) the LBO occurs at a 30% premium to the current stock price (~$16); (2) Dell repatriates its offshore cash at a 30% tax penalty; and (3) Dell finances the deal with debt at a 4.5% interest rate. Based on these assumptions, Dell would face an annual interest payment of ~$820 million (~$675 mil. assuming they are able to bring their cash back tax-free).

– Interest payments vs. cash return metrics. Dell’s purported reason for not doing an LBO is that it would divert cash away from required investments (i.e., largely acquisitions) in transforming the business.  However, we note that Dell’s current dividend commitment is $560M/year, and that Dell has provided guidance that 20-35% of free cash flow will be returned to shareholders.

-an LBO could limit Dell’s flexibility to do large US-based acquisitions and provides incremental financial risk to the company, particularly if it continues to descale. Given Dell’s desire to boost its enterprise business through both organic and inorganic investments, devoting a significant portion of “excess” US FCF could ultimately limit the company’s ability to acquire companies.

Given the vagueness of the rumor and the market’s strong reaction, this is likely to be the sort of story that plays out in the options market over the coming weeks/months.  Short dated Implied Volatility spiked hard in the name yesterday due to the unexpected demand for calls, and while vol is not likely to stay this well bid, it will remain elevated for some time, which could suggest that the best trading opportunities in the name could be vol over direction.  Given the uncertainty of potential outcomes, many traders would rather express their view with defined risk, we will be sure to update unusual options activity in the space and detail strategies that look attractive as the story unfolds.



MorningWord 1/14/13:  From the 2009 lows to its recent 2012 all time high above $700, AAPL’s stock price gained nearly 800%.  Since the company launched the iPhone back in mid 2007, revenues have increased more than 6 fold, which at the time were heavily skewed to iPods (~45%), compared to iOS (iPhone and iPad) now accounting for 2/3 of AAPL’s sales.  Over the last ten years, the company’s ability to anticipate consumer trends, create products that would be met with insatiable demand and innovate has been the one of the most unique consumer stories the world has ever seen.  Let me repeat, HAS.  The price action in the stock since the Sept 21st, 2012 iPhone launch is a fairly obvious statement that the investment community is hip to the HAS part.  While the story is far from over, the fever has clearly broken, and the stock will be left to trade on its own merits, rather than just floating along on the fumes of the product and stock mania of the last few years.

Take the story from the Wall Street Journal overnight suggesting that AAPL has, “cut its component orders for the iPhone 5 due to weaker-than-expected demand”, this coming just a little more than 3 months after the release of the product. I am not exactly sure why this comes as a huge surprise, as this was one of the many rumors bedeviling the stock after the Sept launch of the iPhone, and given recent OS market share data (showing continued strength by Android), AAPL clearly has their hands full with an increasingly competitive smartphone landscape.  There seemed to be a continued disconnect (until very recently)  btwn sell side expectations, as some analysts were expecting unit sales north of 50 million in the quarter, implying year over year growth of more than 40%.  Now it appears the street is getting a tad nervous and continue to slowly rachet down expectations as we get closer to the company’s fiscal Q1 report next week on Jan 23rd.  Since AAPL’s Q4 report in Oct, sell side expectations for Q1 that once sat at $15.50 have now been tempered by almost 15%, which would signal the first year over year earnings decline in the fiscal Q4 results for AAPL in the last 10 years.  I guess my point here is that sentiment has gone in lock step with the stock price, and it appears to be getting increasingly negative as the stock flirts this morning with the psychologically important $500 level.  See Enis’ technical thoughts on Friday’s CotD post.

The lower the stock goes, and the higher the implied vol  in the near term, the greater the opportunities will be into next week’s print.  The stock is clearly a hard press here on the short side, but everyone (and their mother) is looking to buy this with a 4 handle, which makes the set up kind of treacherous from a directional standpoint.  It seems like one of the few things that could turn the sentiment tide would be a deal China Mobile and their 700 million users, maybe Tim Cook gets that and why he just completed his second trip to Beijing in the last few months.

Tune in later to our Webinar for more detail.