Is a Dell Buyout Feasible?
Timothy is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Talk of a possible leveraged buyout of PC manufacturer Dell (NASDAQ: DELL) has been raging over the last few days. The company has a market capitalization of nearly $22 billion, making this buyout one of the largest in recent memory if it comes to fruition. With the market for PCs weakening thanks in part to the proliferation of tablets, does a Dell buyout make sense?
The PC landscape
Dell derives most of its revenue from traditional PCs and servers. Once the number one PC manufacturer Dell has fallen behind Both Hewlett-Packard and Lenovo. What's worse, the market for PCs is weakening. Global shipments in Q4 of 2012 declined 4.9% year-on-year, meaning that Dell is third string in a declining industry.
This decline is largely due to the rapid adoption of tablets by casual computer users. There will always be a market for desktop and laptop computers, especially in the enterprise, but I suspect that many people who use computers mainly to browse the internet will choose a tablet over a laptop for their next purchase.
Much like HP, Dell has been attempting to follow in the footsteps of IBM (NYSE: IBM) and become more service orientated. In 2004 IBM sold its PC division, including the popular Thinkpad line, to Lenovo. This turned out to be a prescient move as IBM was able to focus only on areas where it had a durable advantage, building itself an economic moat and spurring a large investment from Warren Buffett.
Dell has been on an acquisition spree as of late: a list of recent acquisitions can be seen here. There's a concern that Dell overpaid for some of these companies much like HP did before Meg Whitman took control as CEO. This could lead to big write-offs down the road.
A strong balance sheet
One thing Dell has going for it is a significant amount of cash on the books. Here's what the situation looked like as of October 2012:
|Item||Amount (in Billions)|
Dell has $5.15 billion in net cash, or $2.96 per share. One issue is that most of the cash is located overseas, meaning that taxes would most likely need to be paid to bring it back into the United States. If a 35% tax is levied on the cash and investments then the net cash position falls to just $1.2 billion, or about $0.69 per share. This may prove to be a significant hurdle.
The firms that may be involved in the buyout care about how much free cash flow Dell can generate. In 2011 Dell posted $4.85 billion in free cash flow, or $2.71 per share. In the TTM period the free cash flow has dropped to just $3.13 billion, or just $1.80 per share.
There isn't much doubt that the weakening PC market is the culprit here. If we could assume that Dell could reliably generate $1.80 per share every year then the stock currently trades at just 7.14 times FCF. If we take into account the full net cash position this ratio drops to 5.5.
The problem is that I don't think that's a safe assumption. I would expect the free cash flow to decline even further in the coming years as traditional PCs become less popular. So let's create a few different scenarios for Dell to see if a buyout makes sense. Because this is a highly leveraged buyout I'll assume that the internal rate of return (IRR) needs to be at least 20% for the acquirer. This means that in my discounted cash flow calculation I'll use a 20% discount rate.
In my optimistic scenario let's assume that Dell is able to grow FCF by 3% annually, starting from $1.80 per share, in perpetuity.
In my no growth scenario let's assume that Dell maintains $1.80 per share of FCF, indefinitely.
In my pessimistic scenario let's assume that FCF declines by 3% per year for the next 10 years and then begins increasing by 3% per year thereafter.
The results of these calculations are below.
|Scenario||Fair Value (all net cash)||Fair Value (35% tax on cash)|
Will it happen?
The reported price range for the potential buyout is $12 - $14 per share. My optimistic scenario, assuming that overseas cash is not taxed, provides a 20% IRR. If the buyout firms are willing to accept a lower return, say 15%, then the buyout becomes much more realistic. At a 15% IRR even the pessimistic scenario values Dell at about $13.70.
So it comes down to two questions:
- Does the cash need to be brought back into the United States?
- What rate of return is required?
If the answer to question one is yes, then this thing becomes a whole lot harder. The uncertainty in the future cash flows complicates things even further. And the sheer size of Dell is another difficulty. I think this deal is unlikely. Possible, but unlikely.
TheBargainBin has no position in any stocks mentioned. The Motley Fool owns shares of International Business Machines.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!