Dell, Value or Value Trap?
Recently read an interesting article on Dell posted by Peridot Capitalist and thought I’d post my two cents on the topic. You may remember my recent post admonishing Dell’s product strategy, but sometimes bad companies can still have good stocks. Could this be the case at Dell?
Dell’s Share Performance
Dell shares are down over 60% over the past year and have been hit harder by the recession than U.S. competitors like Apple (AAPL) and Hewlett Packard (HPQ). At first glance, this may lead you to believe that an opportunity may exist here to buy a company that has been unfairly punished. But, what you might miss is that Dell’s stock has been in a 5-year funk outclassed significantly by its domestic competitors.
Not only has Dell failed to match its competitors (Apple’s ridiculous performance aside), it has actually consistently provided negative shareholder return over the last five years. Why has the market been so “unfair” to Dell? Dell is seemingly synonymous with the PC market and no one can deny that this market continues to be a stronghold for global growth despite a slowdown in Q1 2009. Dell, in fact, maintains a strong #2 marketshare position. To find the answer, let’s take a look at Dell’s performance.
Dell’s Operations
Taking a quick look at historical financial provided by Gridstone Research. We find two interesting trends here. Despite the fact that worldwide PC shipments have never grown less than 9.5% year over year (2008, 2007, 2006, 2005) since 2005, Dell’s revenues have grown at just a 4% CAGR over the same time period. Furthermore, operating margins collapsed and stayed depressed after 2007 signalling an inability to effectively capture increasing volumes in the industry without giving up pricing. Clearly, something is awry over at Dell.
My guess without having spent a lot of time analyzing Dell’s product offerings is that, having entered the PC market as a low cost competitor, the Company never invested in the R&D capacity to drive differentiation and new product innovation in the way that HP and Apple have over the last few years. Unfortunately, with the emergence of Taiwanese and Chinese computer manufacturers like Acer and Lenovo, Dell, being a U.S. based manufacturer, lost its cost advantage and has lost its pricing strength and has been forced to take lower margins in hopes of protecting market share, the last competitive advantage it has.
Dell’s Valuation
Despite poor performance justifying a handicap on its valuation, Dell is actually trading a seemingly outrageous valuations relative to peers. At $10.31 per share, the stock trades at 8.5x forward earnings and at a 3.0x EV/EBITDA multiple, unheard of for even the most mature of businesses let alone one in a growth industry (General Mills (GIS) for reference trades at 12x forward earnings and 9.9x EV/EBITDA).
More fundamentally, Dell’s cash and short term investments stands out on its balance sheet. It has $10.8 billion in cash and short term equivalents which equates to about $5.54 in cash value on its balance sheet. 53% of its share price supported by cash on the books? That’s even more ridiculous than the 25% cash support in Apple’s share price.
The difference, however, lies in the working capital needs of the two businesses as well as the operational performance of the two businesses. As I’ve discussed before, cash on the balance sheet can be used for many reasons. To support the business, investments in growth, or dividends to shareholders. In the case of Apple, management has proven that it can manage the business as a going concern while generating the free cash flow necessary to not only maintain but grow the company’s cash balance. This has lead to many investors believing that nearly all of Apple’s cash balance could be freely distributed as additional return.
For Dell, however, it seems that declining revenues between 2008 and 2009 created a $2.5 billion working capital drain that halved operating cash flow. This makes Dell’s $3 billion in net working capital (current assets ex cash – current liabilities) a more significant worry. Conservatively, the Company should reserve at least a portion of cash to cover this need. Next, due to the Company’s lagging performance versus competitors, it would seem that some investment in R&D or restructuring will be necessary to either better differentiate its products or rationalize its cost structure. How management allocates this capital will ultimately sacrifice immediate cash value in the Company’s valuation for potential ROI on management’s strategic initiatives. This uncertainty, especially given management’s lackluster recent history, is enough that we must handicap the rest of Dell’s cash value to some degree.
Investment Conclusion
To me, Dell warrants a wait and see approach. While the stock has $5.50 in cash support, many questions remain about the long term viability of the Company’s business model. I’m not calling the Company’s going concern into question but, if recent performance is any indication, competition could ultimately force the business to fundamentally reset as a significantly less profitable, commoditized manufacturer as opposed to the tech industry giant it seemed poised to be become earlier this decade. In that case, $10/share would seem an appropriate valuation provided management protect current asset value, but knowing the mentality of most publicly traded companies, much effort and cash will be expended before a Company like Dell accepts such a place in the PC supply chain and, as a result, I am uncomfortable with the margin of safety on Dell even at $10/share at least until the Company defines its long term strategy or global PC shipments rebound so strongly that the rising tide can’t help but carry Dell out of its gloom (in the latter case, better opportunities will still probably exist through the purchase of competitors’ stocks).
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