Dell buys itself out at $13.65/share

Dell is buying itself out at $13.65/share. My quick summary is that for existing shareholders this is probably as good as it is going to get. Cash flows are going to decrease as the PC business continues to be eroded by tablets and mobile devices, and the company is going to be forced to face a very Hewlett-Packard type of situation where they’re going to have to get into serious competition against the likes of IBM – not inconsiderable amounts of risk involved.

Investors that really feel like a glutton for punishment in the PC space should consider an investment in Intel which would have correlation to the same marketplace. At a market cap of $105 billion there is zero chance of it going private but they are trading at a reasonable valuation and are not having their margins pressured nearly as badly as anybody in the PC space is.

Dell going private makes sense

There are heavy rumours that Dell is seeking to go private. The mechanism will likely be through a leveraged buy-out assisted with some other capital partners.

The necessary condition for this to occur is shareholder approval, and since Michael Dell still owns a substantial portion of the company (about 14% according to the last DEF14 filing) there would likely be enough sway to ensure that it happens.

Business-wise, it is probably better for the company because it can then make strategic decisions that would otherwise not be possible if they were a reporting entity. Dell’s core business is clearly stagnating and going private will probably be the way for the financing firms to figure out how to carve out the various businesses within Dell and try to recapture some value in the marketplace.

Looking at raw cash flows in relation to a $10/share valuation, one can see where this thought process would proceed forward, especially if you can float some ultra-cheap debt financing in a yield-hungry bond market.

The end of Microsoft

Anybody using Windows 8 should realize it is a disaster for Microsoft. Possibly even worse than Windows Vista. Just ask the question of whether you will be seeing corporate clients (the major money-makers for Microsoft) upgrading to the new operating system.

The whole corporate strategy of Microsoft after they crushed IBM’s competitor, OS/2, has been to put a ringed gate around all software users and make it as difficult as possible to port outside of Microsoft DOS/Windows as possible. This worked for the most part for about 20 years before mobile and internet platforms started to become prevalent and relevant. Now, Microsoft’s strategy is simply about salvaging what is left inside the ringed gate with their Office and Exchange Server suites, where they still have a decent amount of entrenchment.

A chart is fairly instructive in terms of what the market is sensing is the reception to the Windows 8 launch:

Realize that institutional investors have much more powerful access to various data (e.g. channel sales data) than the everyday joe retail investor and you can easily see they have been betting significantly against Windows 8 being a material impact on Microsoft’s bottom line.

In terms of valuation, while Microsoft is more attractive than purchasing long term government debt, all of the growth should be discounted from the company’s valuation and instead a financial salvaging model should be applied to the company’s equity – eventually their domination of the office and exchange server market is going to erode to the point where they will completely lose pricing power.

I am not even going to get into the topic of their totally failed mobile phone market strategy, which has been even more of a disaster than Windows 8.

It is also not surprising as well to see the associated corporations, Dell and Intel being equivalent hammered by the marketplace.

All three companies will survive, but they are going to be shadows of the titans they used to be. I will give a bit of an exception for Intel, whom seem to somewhat still have their competitive act still together.

The Dell and PC hardware value trap

I noticed recently that Dell (Nasdaq: DELL) slipped below $10/share. They’re now at $9.5/share or roughly a market capitalization of 16 billion (if you net out the cash and debt, the enterprise value is about $12 billion). This is on $3 billion income for the trailing 12 months, so something is completely out of whack – the market is either nuts, or they’re betting that Dell’s net income is going to drop significantly in the future. The latter is more likely to be the case.

I still don’t see anything worth investing in unless if you have a good sense of salvage or residual cash flow analysis. Dell is facing a compounding problem of being in a low margin industry that is not only shrinking, but is facing longer lifespan cycles and technological shifting.

In other words, they don’t have a proprietary tablet to be selling for ultra-large margins like some other fruity-named company.

Intel (Nasdaq: INTC) has an escape route – their processors can be used elsewhere and can command market pricing. They’ll take collateral damage, but will do relatively better. However, since the consumer end is still a significant portion of their market, I will also continue to lump them in the value trap category. Their anti-trust shield, AMD (NYSE: AMD), should also struggle. Considering that embedded chip makers such as ARM (Nasdaq: ARMH) are stronger competition to Intel, it makes you wonder if AMD is at all relevant any more and will get taken out by Intel finally.

This is similar to the fate that graphic chip designers were all finally consolidated into Nvidia (Nasdaq: NVDA) – which in itself might get munched by Intel. Its as good a time as any for consolidation in this entire PC sector.

Finally, it is always easy to point out share buybacks are a mistake when your stock is richly priced, but in Dell’s case, they have cumulatively spent $32.1 billion of cash on repurchasing 1.2 billion shares of stock – an average price of $26.79 per share. If from day zero they banked this cash and simply traded at a market cap of their net cash value (not even the higher book value), they would be trading at $11.93/share today. If they traded at the premium above book value as they are trading today, they would be at $15.26/share. Quite a bit of value destruction went on with those share buybacks.

Intel and Dell value traps

I notice Intel (Nasdaq: INTC) did a proactive release indicating that their third-quarter expectation is below their public target:

The company now expects third-quarter revenue to be $13.2 billion, plus or minus $300 million, compared to the previous expectation of $13.8 billion to $14.8 billion.

Intel is trading around a P/Es of 10, but it is a classical value trap. The company is a victim of a slower sales cycle – people no longer need to replace their PCs and notebooks every two years like they did a decade ago. Likewise, Intel is facing the declining technology refreshment cycle in addition to having traditional PCs/Laptops marginalized by tablet computers. Intel should be able to diversify enough that it can escape out of its trap over time, but I am not so sure about Dell – they are further entrenched in the traditional PC/Laptop market than Intel is. Dell has simply turned into another retailer, competing in a commoditized retail market. This is a recipe for margin shrinkage.

The market is also signalling this by virtue of Dell having a forward P/E of 6 based off of consensus analyst estimates. Anybody want to make a bet that those EPS estimates are going to go down next year? Right now they are saying $1.80/share.

I don’t have interest in either companies other than just following them for curiousity’s sake.

The decline of Dell

Dell stock is down another 6% today, reaching lows not seen since the economic crisis; before that, you have to trace back to 1997 to match their current share price ($11.57 as of this writing). A “buy and hold” investor from 1997 to today would have seen a 15 year performance of precisely zero in their Dell investment. Fortunately, not many people are 15-year investors in equities these days.

I will post a lifetime chart of Dell:

Dell did mostly nothing in its first year and a half in its public existence, but as the chart depicts, the real meaty part of the growth curve was between 1995 to 2000 when an investor would have multiplied their money by 75 times. Catching this part of a company’s trajectory is the most profitable.

Of course, this is not going to happen now with Dell – the PC cycle is long since done and the company is mature. The question for an investor is – what other types of companies out there are selling products that will become as popular as PCs, and when will they have this type of growth curve? There is one that I have in mind which I have invested in where there is a feasible Dell-like scenario.

Companies in their pre-explosive growth curve typically have smaller market caps (e.g. under a billion). Cases like Apple (where they have already been public for a considerable period of time, having gone through a few product cycles) are relatively unusual.

Kevin Graham on Microsoft

Kevin Graham writes about why he is long on Microsoft (Nasdaq: MSFT) despite quoting reviewers’ ominous warnings about the usability of the new Windows 8 interface.

Certainly from historical financial measures, Microsoft is a cash machine and he does illustrate this.

Does anybody remember the release of Office 2007, with its new ribbon interface? Here is a reminder:

Almost everybody that I talk to said that this new interface required many, many painful hours of re-learning to find out where the functional equivalents were in the older pull-down menus from Office XP and before. It is one reason why I still run Office XP today – I find that the ribbon makes it about three times as difficult to remember where the function is that you are looking for and memory retention is significantly worse.

Windows 8 is going to be a similar analogy to the difference between Office 2003 to 2007. It is throwing away a lot of the “intuition” people have built up using the Windows interface, which will result in increased training time to acclimatize to the new operating system.

While the “Windows and Windows Live” division of Microsoft is responsible for about 40% of its profits, the office (business) division is just over 50%. Businesses have very little choice but to keep with office because of the fact that most staff you can hire will already know it (including the ribbon interface). Microsoft did not lose relevant business for the interface change, albeit, I do not think they were doing themselves any favours.

Windows 8 is probably going to be another incarnation of Windows Vista. With the “appletization” of computing being the new wave of software, the operating system is continuing to be less and less relevant. It is why you still have about a quarter of the population still using Windows XP, while Windows Vista users have gone below 1%. Basically people that had Vista went and upgraded to Windows 7 as soon as it was available, while those that have Windows XP machines are keeping them until they purchase new hardware with the newer version of Windows (and I am of that type – using my old and trusty Windows XP notebook that I purchased over 3 years ago).

This is the primary reason why Microsoft-centric hardware vendors like Dell (Nasdaq: DELL) are taking it in the chin.

This upgrade cycle – upgrading your software when you purchase a new computer system – is likely extending from an upgrade every two years to an upgrade every three, four, five or even more. The new features of the upgraded systems are becoming less and less relevant to actually getting work done and as a result, Microsoft’s business metrics should also slow down, albeit still gushing cash.

At a glance, if Microsoft gave out a $6 dividend tomorrow and promised not to blow money on stupid acquisitions (including their own stock, or buying out Yahoo), you still have a company that is generating roughly 15% of its value in cash a year, which is a fairly decent return when compared against the bond market. The remaining risk is how long companies and consumers will put up purchasing licenses of Windows and Office. Even if Windows 8 is a user interface disaster, I still don’t see people migrating from Office for a long time.

I do not see the stock itself, however, becoming a quick “double” or anything radical like that. If anything you will see some P/EV compression as the cash continues rolling into the bank account.

The week ahead

In what promises to be a less exciting week coming up in the market as it continues its summer doldrums, market participants should be aware that most of the brains behind the heavy money funds will be on vacation in August.

It would not surprise me in the least to see some sort of bounceback in the S&P 500 to levels about 5% higher than here, but there are larger undercurrents going on that may continue having the computer traders pound anything that is offering liquidity – mainly the well-known European sovereign debt crisis.

Back in 2008 when Bear Stearns, Merrill Lynch and Lehman Brothers were collapsing, everybody knew what was causing the financial crisis, but nobody had a clue when the damage would stop – in this case, it was in March 2009 when the ultimate lows were reached. I suspect that something like this will be happening again, but it is difficult to tell whether it will be a few months after a main triggering event, or even a few years.

Either way, the root cause of most financial problems stem from debt and leverage. Right now, the problem is that certain banks assumed that their assets (debt in less than reputable soverign nations) were worth as much as they are on their balance sheets, but ultimately they are not.

Looking a little less globally, when less knowledgeable people listen to their “financial advisors” and borrow money at prime (3%) to invest in some bond or index fund which will make them a “long term stable return” of 6%, they will also discover the urge for liqudiation when their leverage factor imparts huge losses on their net worths.

I do not believe it is time to start buying things yet, but the valuations look compelling. Rather, now is the time to research things that will be worth buying when the market decides to take another deleveraging-induced dive.

Something I have consistently found puzzling is that there are a variety of companies that are selling under projected P/Es of 10, which makes them seem infinitely more attractive than the 10-year government bonds that are giving out a yield of 2.24%. Just to use an arbitrary example of Dell (Nasdaq: DELL), we have a company that has a market cap of $28 billion, about $7 billion net cash on the balance sheet, and for the past two years has generated about $3.5 billion in free cash flow (about $1.87/share) and trading at a stock price of $14.87, or roughly 8 times free cash flow generation.

What the bond market is effectively betting is that companies like Dell aren’t going to make as much money as they have been, or that the risk premium afforded to common shares of Dell is quite high. It is not like the company is in the pharmaceutical industry where you have to worry about patent expirations and other time-sensitive risk. It is quite difficult to conceive of scenarios where you would see the diminution of the business – perhaps Amazon will compete? An investor would have to answer this question in order to consider owning the stock, otherwise they are playing poker without looking at their own cards.

Quick review of some large cap technology stocks

I am continuing to look at the US large cap sector, just for personal review rather than serious consideration. I am continued to be surprised by relatively good valuations, around the 10% yield levels. Most of these are in the first-generation “old-school” technology sector. Very well-known companies include the following, with some very anecdotal remarks on my behalf:

Microsoft (MSFT) – Trading at 9.3x FY2012 projected earnings, with $30B net cash on balance sheet, Windows/Office empire continued to be chipped away at with competition;
Intel (INTC) – Trading at 9.5x FY2012 projected earnings, $20B net cash on balance sheet, likely to be around for a long time, competition in mobile processors, but nothing in really ‘large scale’ CPUs except AMD;
Dell (DELL) – Trading at 8.6x FY2012 projected earnings, $8B net cash, well-known customer support/service issues, but otherwise entrenched in computer/IT market;
Hewlett-Packard (HPQ) – Trading at 7.3x FY2012 projected earnings, $10B net debt, along with Dell, entrenched in computer/IT market;
Lexmark (LMK) – Trading at 7.7x FY2012 projected earnings, $600M net cash, major supplier in printer/imaging market;
Xerox (XRX) – Trading at 8.3x FY2012 projected earnings, $8B net debt, in a similar domain as Lexmark;
Seagate (STX) – Trading at 7.2x FY2012 projected earnings, $0 net cash/debt, hard drive/storage manufacturer;
Western Digital (WDC) – Trading at 9.3x FY2012 projected earnings, $3B net cash, in a similar domain as Seagate;
Micron Technology (MU) – Trading at 8.4x FY2012 projected earnings, $600M net cash, memory manufacturer;

One would think that diversifying a position into these nine companies and calling it the “Old-school technology fund” would probably be considered a relatively safe alternative over the next 10 years, compared to the 3.4% you would achieve with a 10-year US treasury bond.

My gut instinct would suggest that these companies would still be around in 10 years, especially Intel, which has the biggest competitive advantage out of the nine listed above.

I am also assuming that smarter eyeballs than my own have looked at these companies, which is why I suspect there isn’t much extraordinary value here other than receiving a nominal 10% return on equity, which is pretty good for zero research.