Tuesday, February 7, 2012


Everyday is another opportunity to be clueless about something.

Today I ran across a nice little discussion at
http://www.cornerofberkshireandfairfax.ca/forum/index.php?PHPSESSID=3d3f27e68e2810e6516ed1618112b70a&topic=5958.0 regarding a little spin-off from General Growth Properties (GGP). Rouse properties is a B-mall operator with 30 locations across the United States, an 87% occupancy rate, and ~$271 sales/sq.ft average (below industry average, though I'm completely oblivious to what that could possibly be. Like how I'm oblivious to technical analysis and witchcraft)

I don't really want to talk about intrinsic valuation (i know 80% of you will now automatically alt+back and curse my blog), only because I'm not capable of throwing out a worthwhile opinion. However, based on the discussions from Corner and Stockspinoffs, along with Brook's $15 dollar/share backstop  and the fact that the market has punished RSE down to ~$10 and change, I think Rouse just might be a worthwhile mall to consider (if you don’t shop at TJMaxx, you ought to).

Note! I realize the stock has traded up substantially. I wrote this little puppy up in early January but then sat on it. I don’t think I personally would put more money into this stock at this time, but please continue reading or I will be sad…and furious.

The most interesting part of this whole exploration really is the numbers: Operating income, core operating income, and Funds from Operations. What in Odin’s beard do they represent? From the tattered pages of the S filing, we are told:

“We define NOI as operating revenues (rental income, including lease termination fees, tenant recoveries and other income) less property and related expenses (real estate taxes, operating costs, repairs and maintenance, marketing and other property expenses). We define Core NOI as NOI excluding straight-line rent, amortization of above and below-market tenant leases and amortization of above and below market ground rent expense....we believe that NOI and Core NOI provide performance measures that, when compared year over year, reflect the revenues and expenses directly associated with owning and operating regional shopping malls and the impact on operations from trends in occupancy rates, rental rates and operating costs. “

NAREIT defines FFO as net income (loss) (computed in accordance with current GAAP), excluding gains or losses from cumulative effects of accounting changes, extraordinary items and sales of depreciable properties, plus real estate related depreciation and amortization”

Here’s a nice little write up on amortization of above/below market tenant leases:


Inherently, I don’t think it’s wildly different from the amortization of premium / discounts on a bond purchase. When Rouse “acquired” the 30 properties, they essentially evaluated the leases they had according to market value, and quite a handful of leases were “above market” (and some below, look at the pretty chart!) and thus included in the “price” of the property. Thus, over the life of the term, the extra value of the lease has to be amortized (imagine buying a 10% bond at 105, the yield is really something below that, and it’s captured by the amortization of the bond from 105 to 100 on the balance sheet- the market value for those bonds in this case may be 9% or something). The same can be said here - the value of the above market leases is reflected on the balance sheet under prepaid expenses, and must be amortized over the next ~5 years or so. Likewise, below market leases must be “accreted” (not sure if this is the correct term, but let’s coin it) like a discount bond to its face value. While I do understand the concept management presented of operating income, I’m not sure I quite understand core operating income. By adding back the amortized values, aren’t we essentially giving credit back for the “upfront” payment? That’s like adding back the amortization of a bond purchased at a premium. That doesn’t seem quite honest.

Needless to say, I thought it was necessary to clean up some of the numbers in the filing, as it was quite a cluster of mismatched “pro forma” tables with non pro-forma-ed results. (for example, the run rate $50mm FFO doesn’t include the updated interest expense and additional annual property management costs). Here are the numbers for your mental lust:

As you can see, the FFO is hardly ebullient, at nearly three quarters of the annualized $50 million FFO from the report (and from a cap ratio, it suggests 6-7%, which doesn’t seem to be a bargain among the fellow bloggers I’ve the opportunity to read). However, since this seems absurd given the amount of adjustments in non-cash expenses, I felt compelled to tweak the numbers favorably, like a good analyst at a good investment bank.

First off, the debt rate adjustment is a funky number added to interest expense that doesn’t really belie the amount of interest truly due (which we calculated above!), so that should probably be excused from the “adjusted FFO,” bringing Adj. FFO to $51 million. While I am a bit conflicted over the amortization of leases (taking out the amortization would “normalize” earnings per-se), the inclusion of this cash flow would add another ~$17 million to adjusted FFO. The number now seems to be more akin to CFO with exclusion of working capital changes, which might be a better proxy for the mall’s operational purposes. I’m not trying to inflate how sexy Rouse is (she’s a feisty B-class), but unlike NOI, I do believe funds should serve to address the cash flow condition of the mall. 

I know I stated earlier I didn’t really want to talk about valuation, but that’s just silly. Here are some comps I grabbed from Wells Fargo’s report on malls from a week ago– do be warned that these comps are wildly different, with exception of Penn REIT and CBL Associates

Tussling my hair, I happened to notice that the AFFO multiples might be mislabeled. The main problem is our inherent lack of intelligence regarding what these FFO/AFFO numbers consist of, and whether they are quite uniform across the board. Grabbing some numbers from the latest 10Q’s (and these are sloppy! Imagine a 2 year-old’s handwriting on a toilet stool) and making some half-hearted adjustments (FFO taken and annualized, CFO takes out NWC changes to match our RSE CFO and then annualized), it’s actually hard to conclude that Rouse (especially after the run-up from $11) is cheap from a comparative perspective. In fact, it’s more expensive when looking at cash flow yield, and not so much better when including capex.

So now you’re twiddling your thumbs and a bit disconcerted over this write up. I know I know – I feel a bit awful for posting this after the fact, but it’s also a nice exercise to refresh the thesis after such a rapid run. Granted I’m not releasing my bowels in excitement about RSE any longer, I think the stock is still a bit below fair value, and would be mindful of a pullback opportunity. Penn REIT might look omg so much cheaper on a cash flow basis, but with a net debt/EBITDA ratio (from capIQ) that is 3.5 turns higher, and with only $50 million of cash on hand, the leeway for error is a bit cramped. I think CBL is definitely worth a look if mall REITS look inexpensive to you (http://www.google.com/url?sa=t&rct=j&q=&esrc=s&frm=1&source=web&cd=6&ved=0CGEQtwIwBQ&url=http%3A%2F%2Fwww.reit.com%2FVideos%2FClass-B-Mall-Operators-Make-Good-Real-Estate-Investments.aspx&ei=IssxT-m2NYqRiQLq3_SKCg&usg=AFQjCNG42YUj8HqGQPXsSzSUaUmCEccAdw&sig2=g0MmhUmfle9oxuzjW9ExgA), but Rouse offers a nice ~10% cash flow yield, and will have substantially far less net debt then either of the two due to its secondary rights offering (which will provide enough cash to fund the totality of its capital expenditures in the next few years), and currently doesn’t have to pay a dividend due to high operating losses.

To further our valuation, we also use a cap rate eval.  From the NOI, we get a RSE current implied cap rate of 9.66%, and a potential IRR of 15-25% over the next 4 years if management is indeed able to raise NOI back to $200 million  by the end of 2015 (9.27% is Penn’s current cap rate):

I think it will be quite difficult to try to value the company from a comparables perspective, simply because the assets of all these REITs are so diverse that an apples to apples is quite improbable. Most mall REITS trade at cap rates around ~5.0-6.0%, but they also include estates that are brightly lit and incredibly beautiful and where you can probably never find a good sale, versus the more mundane properties that Rouse operates (though you never know what you might find at TJ Maxx…). Offsetting this is the fact that tenant occupancy rates at Rouse are significantly lower and hence have further room for improvement (like idle capacity at a DRAM producing fab), and quite a few of these properties are actually the only shopping center within a large traveling radius (refer to the Rouse presentation for some individual facts/pictures). So what rate should Rouse be trading at? The current implied rate of ~9-10% is a huge premium to GGP and its comparables. And if management does indeed achieve a $200 million CNOI in the next 4 years, the cap rate will be ~12-13% at the current stock price and capital structure. Current FFO (excluding amortization) of ~$68 million implies cash flow of ~$1.39 per share on a share price of $13.80. For comparative purposes, here are Penn and CBL:

Granted our Rouse numbers are conjectures – the matter of significant above market lease amortization points to a number of leases at the date of spinoff which may fall upon renewal or request – we should pull ourselves out of the current poopoo state and venture to wonder: will lease rates begin to strengthen this year? And the next? and the year after? Are squirrels indigenous to North America? Did you know water only makes up .07% of earth’s mass?
If you conjecture that lease rates may strengthen this year or perhaps stay flat and then increase in 2013, you are cute. I personally don’t want to venture a guess about Europe’s ECB, about Greek’s little debt shuffle, about Japan’s growing social security sending (at 52%!!), about housing prices and the ~10 million shadow inventory, about what flavors DQ might introduce into their blizzard lineup (hopefully something with yogurt pretzels), or about whether I can run a 6 minute mile. These are secrets for retrospection, and the time you spend speculating is probably more useful spent elsewhere.

Here are the facts (and quite a few are subjective from Rouse’s management, so take it with a salt block)
·         60% of RSE’s properties are located in one-mall markets
·         Occupancy has historically been 93%, and is currently at 87.6%
·         Leasing activity for 2011 roughly in line with expirations in terms of GLA (flat)
·         11.5% of leases expire in 2012 at relatively strong rates, followed by 14.9% in 2013 at relatively weak rates. Potentially CNOI may decline this year before strengthening
·         Core NOI was over $200 million in 2007, and has fallen 25% to $150 million
·         CBL, often known as the largest B-mall operator, trades at a cap rate of 8.0%. Penn trades slightly better than RSE, and still has a significantly worse balance sheet
Looking at some other REITS, it seems that the quick deceleration of leases isn’t completely idiosyncratic to Rouse (and this would make sense, as we probably assume that larger tenants and anchors sign contracts that are far longer in duration, and hence they become more predominant in lease makeup as we extend outwards in time). If one were to observe Equity One’s tenant expiration schedule (page 45 of the 10K), one would see an absolute trend of average minimum rent per square foot for small tenants rise linearly from 2011-2019 and even thereafter, while all tenants actually declines after 2012/2013 (with exception of a weird 2016), impacted by timing differences / cost of anchor tenants. The same goes for a majority of the REITS that you’re quite welcome to look into.
Last, to conclude the piece, I was curious about the districts where these malls are located and so pulled up some facts from the U.S. census (all 2010 data, except sales/capita, which is from 2007), along with the trade area population if Rouse mentioned it in the IR.

Sadly, I can’t seem to extrapolate anything of much consistency regarding occupancy rate on the independent variables (for example, Lansing and St. Vicent have above national average lease rates, but flunk in terms of population growth, bachelors, and median income), but suffice to say that half of these malls are in general districts where the median income is below average, half where population growth is below average, and roughly 2/3 where education is below average. The argument here, of course, is that class B malls exaggerate the business cycle – any downturn will hurt occupancy and sales far more severely than the more inelastic demand at class A malls (I read recently that non-college educated unemployment rate is ~3x that of college educated), as the unemployment rate around these areas are probably much higher than the national rate. Thus, during the recession, it wasn’t too much a question of “spending less” rather than “having nothing to spend.” If you do believe that we’re finally coming out of a recession, and nice old Mr. Bernanke can shield us from the dangers of Europe like he promises to, then it’s also quite likely that class B malls will rebound much faster in terms of sales per square feet and close the capitalization gap to its class A peers (Well’s Fargo’s primer states that historical capitalization ratios for class B malls has been ~8%, exactly what we target in our bullish recovery scenario).

Thursday, January 12, 2012

Ideas Ideas Ideas!

As most investors will probably tell you, one of the best ways to generate ideas is to troll other people's portfolios / newsletters. Here's one from T2 I just trolled:

It's a good read, though a bit simplistic at times given the number of ideas being presented (for example, i own Sandisk and am perplexed at the curt thoughts presented on valuation). Anyways, the polio marked year that was 2011 is over and T2 seems to be off to a strong start for 2012. 

Of particular interest to me is their position on Dell (which largely mirrors my own conclusion below, though now I'm more inclined to think about what potholes i might've missed. I'm a bit less optimistic and don't think Dell should be trading at 10x core. It's just a regular cone from DQ, not a blizzard for peet's sake), Iridium (their conviction in this stock is worthy of exploration, though I wish the presentation would address Iridum's shortfall in FCF to fund the NEXT generation of satellites. It's not like their satellites will poop the extra cash. I'm just not sure whether this capex will lead to increased income for the company, or will simply be passed on to consumers (ie, is there a need for this new generation of satellites that will draw customers away from competitors? Will premium pricing be warranted, or will old technology be 'good nuff'?) Also, future debt/equity needs might be an axe to the face), and GS (like all financials, so many things seem so cheap but speculative. I think GS historically traded at 2-2.5x P/B)

Anyways, maybe maybe maybe

Tuesday, January 10, 2012


There’s a lot of static in the global ecosphere (economic, not ecological) these days with the whole ECB dysfunctionality, the unfathomably large $2.6 trillion euro debt amount rolling over next year, an extremely bearish view on Japanese sovereign debt by select fundies, and a potential soft (or hard?) landing of the Chinese economy among some tidbits of news you might hear from Kiss 106.1, Bloomberg radio, or that anchor that said something last night before you turned off the TV.

Yet, as bearish as I am (am I even bearish? i really don’t spend time dictating the economy on what i believe it should do next year - I shall say 15% GDP growth just to be a shining outlier), I do believe there are quite a number of equities out there that are “cheap” on the hypothesis of a stagnant and miserly 2012. Of course, some bear with a huge frown may come up to you and tell you that Europe is insolvent and that Japanese borrowing costs will increase by 1.5% and bankrupt the system and trundle off in a hurry to earn 2% on his 10 year treasuries (and slash your face if he were a real animal bear)- and he may ultimately be right. But assuming a tepid 2012 and a pretty agnostic eco-view, and taking into account that equity correlations are at all time highs, i reiterate the man i wish were my grandpa or best friend’s grandpa or my girlfriend’s grandpa: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

There are some wonderful companies out there that are on sale - companies that have economic moats in the form of high switching costs, extended and unassailable networks, or simply advantages in manufacturing or scale. Numbers that are reflected in persistently high returns on equity and invested capital. Numbers reflected in high operating cash flows with minimal need for capital expenditures. Numbers that take a dip now and then, but have held up in the Great Recession and throughout the better part of the last 10 years. I know you’re probably thinking of a few off the top of your head and your fingers are twitching to jot them down but the fear of the unknown acts like frostbite on your frail pathetic appendages. I too share this fear, but return can only be earned through risk - and our job is to minimize that risk, and steal as much return from other benighted investors at the opposite side of our trades.

There are quite a number of opportunities right now - I generally don’t have a strong interest in commodity related plays, and my health care enthusiasm is curbed by a vomit of undecipherable healthcare reforms taking place as we speak (including adjustments to the medicare/medicaid basket, reimbursement cuts of 75% on medicare advantage with quality promotion, an exchange to be established by 2014 with substantial leeway up to the states, 85% medical loss - the brain damage is too intense and my brain too neolithic), though if you do harbor some interest in the defensive healthcare play (i believe they’re historically 2nd in performance during recessions), I have a penchant for Wellpoint (WLP).

I believe tons of blue-chip technology stocks deserve a hard look (DELL, ORCL, WDC), as quite a few of them are at valuations that reflect not only the dying of an industry - an exaggeration of the death of the PC or the death of hard drives to the surge of NAND usage - but also a pretty rapid death at that. All of them are pretty good businesses with strong historical returns on equity, sticky services, and decent economies of scale.

Let’s pretend to have a quick discussion on Dell (since you can’t really respond, I will ignore all your pertinent counterarguments). Before we dive into the sexy financials and ultimately agree on Dell being a wonderful business at a fair price, I think it’s important to break down the company and to sweep aside some flaws in thinking about Dell.

I believe the common perception on Dell is that it makes PCs. Dell makes PCs for you and me and we are cheap, fickle consumers who have no loyalty to anyone and any brand and any nation and even worse, we hate computers and are infatuated with tablets and mobile devices. Dell’s fate is tied to the PC, and the PC is dead on a tree, hanging listlessly and moaning to be stripped from it’s perch and buried under a pile of tablets. While I don’t doubt tablets have eroded some portion of the PC space, I believe their uses remain distinct, and many people still require the use of a PC for non-Angry Birds. IDC forecasts that 376 million PCs will be shipped in 2012, down from a projection of 399 million previously due to a shortage of HDDs (a good story for STX and WDC but for another day), which is still a 6.8% increase from 2011. Gartner, on the other hand, projects 387.8 milion PCs in 2011, increasing 13.6% to 440.6 million PCs in 2012 largely on account of mobile PCs - this is a bit dated though and prior to Thailand impacts. While they express that enthusiasm for media tablets will slow home mobile PC sales, they believe growth will still “average less than 10% for the next 5 years.” While I lack the powerhouse research of good old Merrill Lynch or Gartner (quite unwilling to shell out $1,295 dollars for a report), I think you could do some quick Google on projections via IDC or Gartner and come to the same conclusion (http://www.guardian.co.uk/technology/2011/sep/22/tablet-forecast-gartner-ipad) - PC sales are not declining, they are actually still growing and in good health. It’s the absurd projected growth of tablets that are making PCs look like they’re irrelevant. But who cares if tablet sales are 60% of PCs sold in 2015? Don’t IDC, eTF, and IHS all project PCS to grow over the next few years? Where is the death of the PC coming from? Are people in developing nations going to skip PCs and just buy tablets and do everything a modernizing nation needs to do, like excel modeling and playing Starcraft2, on a tablet? Is this a series of rhetorical questions?

How does this effect Dell? ~50% of Dell’s revenue comes from Desktop PCs and Mobility (all in all, including software and peripherals, roughly ⅔ of revenue pertains to the PC segment). As this is conglomerated in their quarterly report into the respective Enterprise, Small & Medium business, and consumer segments, it’s hard to break out where these sells went to, and how margins performed in the computers sold to enterprise vs those sold to consumers. However, assuming that consumers only buy desktop PCs and mobility devices (no storage, services, pickles, and other stuff), the consumer portion of “Dell PCs sold” is roughly ~30-34% of the 52%, meaning in aggregate ~16-18% of Dell’s sales are to fickle consumers (in conjunction with ~15% of S&P - see page 26 of the investors presentation), while the rest are to more reliable enterprises where PCs are generally more likely to be bundled with services and thus sold at a higher margin. By comparison, HPQ, which regretably refuses to break out what PC sales are to consumers versus commercial, released some numbers in their 4Q11 slides stating $10.1 billion of PSG sales, of which 92% was notebooks and desktops. They also give us a -9% growth rate for consumer and +5% growth rate for commercial. So, as revenue was $10.6 billion in Q410, a 9% decline in consumer and 5% growth in commercial results in a $10.1 billion revenue.

Plugging this into some simple algebra: (.91)x + (10.6-x)(1.05) = 10.1, we come up to a value of ~$6.7 billion of PSG dedicated to consumers as of 4Q11, which is ~2/3 of HP’s PSG revenue. If this simplification is no mockery of reality, HP’s consumer exposure as % of PSG is significantly higher then Dell’s (piques in exclamation). Further assuming ~33 billion in quarterly revenues, ~20% of total HP revenues comes from the fickle-minded PC consumer (and doesn’t this remind you of a company we’ve been exploring...)

Dell’s consumer margins have averaged 3.3% operating this year, climbing up from break-even last year as Dell continues to simplify the product offerings, streamline operational costs, and resorting to “alternative methods” of cost reduction (sea shipping has drastically replaced air freight, etc.). There will undoubtedly be pressure costs on PCs (for those of you with short-sight and lack of glasses, I provide a bit of reprieve, though I disapprove of your whole life philosophy. Acer has stated that they will increase PC costs 2-3%, and it is likely that Asus/Dell will follow suit due to the transient rise in hard drive costs. Q4 margins will be pressured, but the industry response appears to be rational. Like how emperor penguins traverse to the same patch of land every year to lay an egg and then stay there with the egg underneath their bottoms).

What about the longer term?  PCs and mobile products have been largely commoditized. Choosing between a Dell and an Asus is like choosing whether to fill up at Shell or the Chevron across the street that’s a penny cheaper per gallon but will require to loop down to i90 and drive by that Korean restaurant before taking a left. I don’t pretend to know where operating margins for Dell will shake out - they’ve trended slightly above 0% (.2 or .3 generally) for most of 2009 and 2010 prior to breaking out to 2.1% in Q42011, 4.5% in Q12012, and roughly 2.6% for the last 2 quarters.  (Please open up Q3’s investor presentation for a pretty picture). In a cute conversation with Credit Suisse, Steve Felice reiterates Dell’s strategy of shunning crappy computers and focusing on a value proposition centered around just 3 brands (Inspiron, XPS, and Alien I believe). While you ho-hum about this rather soporific strategy, I’d venture to say that there are quite a few dimes to be saved in R&D, in marketing, in manufacturing and sourcing, and in switching to GEICO.

During the same time, HPQ’s margins have been ~5.0 - 6.0% (though inclusive of commercial PCs, which accounts for a larger portion of Dell’s revenue), Acer’s margins (which are 87% PCs as of 2010) have trembled around 2.5% - 3.0% and have plummeted to -1.1% for the last 2 quarters on account of a 70% inventory correction, Lenovo’s margins have crooned around ~1.5% - 2.0% (mature markets are around 2-3%, brought down by negative margins in emerging markets and offset by high margins in China), Asus’ margins dance around ~5% but their revenues are slightly more diversified (with less then ⅔ from PCs) towards motherboards, graphics cards, and the eeePad (quite safe to conclude that PC margins will be lower then overall total margins though, if we take a quick peak at NVDA’s margins)

The consumer industry, however competitive, seems to have players sustaining a ~2.5%-3.0% operating margins over the long run. Without an expert network to verify operational efficiencies, it’s really quite impossible to guage the cost advantages of these monstrous OEMs (though it is absolutely every child’s dream to calculate the sourcing costs of components for their laptops). However, reading through the annual reports and conference calls of these Taiwanese companies- which are terrible by the way -  it appears to me Dell has revealed one of the most credible plans to boost operating margins, and has actually been successful in putting those blueprints to action, even as pricing comes under pressure from rapid liquidation of cheap and crappy inventories (http://allthingsd.com/20111207/acer-ceo-were-going-to-stop-selling-cheap-unprofitable-crap/)

Not dwelling too long on these competitors (as we’re only trying to figure out potential long term sustainable margins in the “end consumer market” - plus doing so would kill me), here’s a brief encapsulation of their respective business blueprints.

Acer’s “restructuring” consists of leaning out inventories, and it’s strategy is to continue designing products that “our customers want” through “collaboration with first-class suppliers and distributors.” I’m not sure what that really means, but it sounds like Acer’s pretty resolte on building products for the fickle minded. I don’t know what steps the company is implementing to drive margin expansion (besides clearing inventory? is that a strategy?), am not convinced its products are in any way differentiated, and the institution’s lack of IP makes servicing revenue pretty much impossible.

Lenovo is a realistic competitor pursuing rapid growth in emerging markets through acquisitions and aggressive volume sales. As stipulated in their annual report, Lenovo’s main target is the SMB and Home segments in both mature and emerging markets. Their cash cycle is roughly -20 days (slightly behind Dell’s -30+ CCC), overall margins are similar to Dell’s end consumer, and global market share of PC shipments recently just exceeded Dell by a bit more then 1.0% (as per IDC - Lenovo held ~14% of WW commercial PCs, and ~7% of consumer PCs as of year end 2010 vs Dell at ~12%-27% of WW commercial PCs and ~9% of consumer PCs at year end. I’m not quite sure why Lenovo is trading at such a loftier valuation, given that 1) it’s entire business is 95% dependent on PCs vs 50% for Dell 2) its total operating margin is roughly equivalent to Dell’s end-consumer operating margin (which is significantly lower then the other ~80% of revenue that comes from enterprise and public), and 3) it’s chasing growth in emerging markets where margins are currently negative. Granted Lenovo has the china halo effect, I’m concerned that the company’s high revenue growth may not translate easily down to margin expansion.

I have gotten lazy and would like to be excused from Asus and other misc. PC makers (like...Visio?) I might venture to add some news for HP in an appendix if I still have no friends by tonight.

I think it’s important for you yourself (instead of you your friend) to read up on Dell’s core structural changes in the last couple years to make up your own mind on whether these processes are repeatable, and whether Dell’s 5% operating income profitability is deliverable (in my view, it’s aggressive and probably not likely achievable in the consumer segment alone). Nevertheless, if we let the numbers speak for themselves, they would hark up to your ear and whisper “the metrics show that Dell is turning down unprofitable businesses, relying on fewer configurations, reducing manufacturing costs, and optimizing their logistics chain” and then jump back into page 42 of the investors day conference presentation as if nothing ever happened. I think ~3.0% is quite plausible (pricing pressures got a bit more aggressive last quarter as HP fooled around with shareholder wealth)

Even if Dell were to resort back to the good old days of 0.00% operating margin (and I’m not quite sure how other competitors might fare if Dell were to operate at this level), Dell’s  Q3 op.income would drop all of $76 million from $1,288 million to $1,212 million. LTM FCF would fall by ~$350 million to $4.55 billion. Considering the decompression of margin to absolute zero (yes, -273 Kelvin) only causes a 6-7% attrition on the bottom line, I’m inclined to say that the reports of Dell’s death might be merely exaggerated. (plus, Dell’s exposure to consumers is quite mild even when compared to HPQ)

Having finished the first chapter of this 87 part series, you are probably amused that we’ve only covered roughly ~20% of Dell’s total revenue (since the other 30% of PC sales are embedded into enterprise, the markets and the margins are wonderfully different, and the margins on S&P are quite different.). So What about the remainder of Dell’s businesses? Are they in as much a secular decline as the consumer PC?

I don’t really know - and the pessimist in me who rages out at any valuation exercise, probably thinks so. Nonetheless, let’s hold hands and briefly walk through the rest of Dell’s revenue segments:

Servers & Networking (~13-14% of revenue)

Dell’s server segment is pretty inconsequential. FALSE. Next time someone says Dell only makes PCs, slap them in the face and tell them “dude, unless something has changed since July of 2011, Dell owns 22.2% of global x86 server share and is number 2 in the United States. Disgraceful. ”

Given the numbers in the presentation, it appears that ~$7.1 billion of revenue comes from servers and ~$500 million from networking. The segment generates operating margins above 10%, so any expansion in revenue will boost company margins by way of simple algebra. To make sure these numbers aren’t heroic, we sniff out HP’s ESSN segment (enterprise storage, servers, and networking) margins of ~12-14% and conclude there is no hocus pocus accounting. As HP is the 800 million pound banana in the rain forest of servers, Dell’s margins are understandably lower at ~10% for their combined storage/server/networking segments (at half HP’s revenue and market share). Will these margins stick? I venture a sheepish yes (a bold claim from a person who had to wiki “blade server”) primarily because margins for Dell have entered the target (10-12%) presented at Dell’s 2010 analyst meeting despite a wonderfully rewarding year in the markets. In a year dominated by tepid IT spending, Dell grew server revenue 12% Y/Y in the last quarter while HPQ slipped 4% and networking 43% (excluding Force10) while HP farted out 5%. LTM revenue has grown to ~$8.1 billion versus $7.6 billion reported in July. All while the next generation of Romley servers sits on its perch, waiting to be embraced in the coming quarters.

And please note! I’m not making any assumptions on growth - I’m perfectly happy if I’ve convinced you of a 0% revenue and margin growth. My aspirations are low.

Storage (~3% of revenue, with Dell Owned IP representing ~85%)

Per RBC: “Growth: Approximately 2 billion videos are watched and 293 million emails are sent each day. This enormous amount of data leads to a projected storage compound annual growth rate of 60% over the next five years (800% growth). More important than the sheer amount of data that will be created, 80% of this data will be unstructured (emails, video, social media, and others).” You probably stopped sometime during this novel to check facebook, so you know what I’m talking about. Cisco projects data will grow at ~98% for the next 5 years, and everyone seems to be frantically buying up storage related crap at high costs (HP <3 Autonomy, Oracle <3 Pillar Data, IBM <3 god knows how many small companies). I think this segment is one of the easier ones to gloss over because 1) it’s only 3% of Dell’s revenue 2) Dell has been growing Compellent at 3 digits Y/Y, Equalogic at double digits 3) it would really take some kahunas to mess up when the revenue pie is expanding so fast so quickly 4) Storage is storage and everyone who is anyone already has the basic deduplication, snapshot, and caching technologies businesses demand 5) Dell can easily cross sell especially since they maintain tons of SMB relationships and have price points significantly less then NetApp and EMC 6) Netapp is encountering some difficulties 7) I didn’t read up on 3Par but HP’s revenue was only up 4% Y/Y vs 23% for Dell 8) margins for Dell IP are substantially higher then EMC  9) 600 Storage specialists have yet to celebrate an anniversary with the company 10) Dell has a distribution network totalling over 100,000 partners. EMC and NetApp do not 11) 10-12% of revenue is being spent on R&D here 12) Only HP can match Dell’s truly integrated system and 14) i skipped 13

Services (~14% of revenue)

Probably one of the most enticing aspects of Dell’s growth segments - services backlog increased to ~$15.5 billion in 3Q12, up 11% Y/Y. Trailing twelve months new contract signings are increasing substantially, and growth is apparent in transactional, outsourcing, and projects revenue. Analyst presentation indicate operating margins in excess of 20%, by far the most profitable segment of the company (80% from large enterprises and public). Dell targets a 2015 goal of $10-$11 billion in service revenue, up from ~$7.7 billion in FY11. This would mean an incremental ~$600 million in operating income. Before you disregard this as tomfoolery, do know that HP’s services backlog tripled in the past 5 years. Furthermore, the company has actively been staging itself as a complete solutions provider, indicated by its expanding sales force of 400 solutions engineers, 1000 security specialists, and 22 solutions centers. How could you NOT grow revenue when you’re evolving your entire company around this segment right? lol am i right?

S&P (~16% of revenue)

Not sure what to say here, but S&P has substantially better margins then PC sales, and are highly correlated to the total number of PCs sold. So if you’re moderately happy with the discussion we just had regarding Dell’s nefarious PC exposure, then you should be even more moderately happy here. Dell has acknowledged that margins should be 5-7% if PC margins are around 5%, so can’t see them really losing money in software. As you can tell I’m very tired from typing and would like to end this charade.

PCs (50% of revenue) – blah see above

Focusing on the bottom line?
“A good proof point for this is our displays business, where we revenue increase 5 percent, but gross margin dollars increased 46 percent.”

“Our high-end consumer notebook line, XPS, grew revenue 207 percent overall, and is now approaching 20 percent of our total consumer notebook revenue, and 30 percent of our consumer notebook margins.”


I’m not going to stifle you with pleads and tears and whimpers about how Dell has a competitive advantage. Truthfully, the moat that was its supply chain management has been emulated by competitors (Lenovo) - and while Dell still outdoes everyone in its cash conversion cycle, the infringement causes us all to fret in concern. Yet - if you simply google “dell morningstar” and click on the historical ratios, you’d see a decade’s worth of ROEs in the mid to high 30’s, unimpacted all these years by competitors that have known of Dell’s unique model. And while this moat may be drying up slowly, Dell has begun capitalizing on its many relationships to create new offerings through the bundling and offering of services, software, and storage. To escape the doldrums of the mindless PC-making drones, Dell has set out distinct plans to become a HPQ/IBM for SMB businesses - a model that is oft criticized by the street who slap a “neutral” on the stock and a mindless $15 price target while praising the likes of Lenovo, which continues to expand by purchasing PC makers around the world and becoming increasingly more reliant on the life of the PC (though I will not argue that Dell generates only 30% of revenue from EM vs >50% for Lenovo)

Dell has a market cap of ~$28 billion and an enterprise value of ~$20.5 billion ($7.8 billion of net cash including LT investments), EV/FCF yield is an incredible 4.2x, yielding ~24% fcf yield to enterprise. P/E net of cash is somewhere in ~5x. While I hesitate to tell you what the fair price should be, the company just seems far too embroiled in pessimism. Take a gander at the FCF generation:

I know no one will say Dell deserves to trade as richly as HPQ. But the companies really don’t seem to be all that different in terms of revenue composition and industry exposure (besides HP’s IPG segment). For fun, let’s do assume that Dell trades at the same EV/FCF multiple as HP:

HP currently has an EV of ~67 billion, LTM FCF of ~$8 billion (let’s say it can go up to ~$10 billion) for a EV/FCF of 6.7x - 8.4x. That means, at the lower end of 6.7 - if Dell matched this capital structure, it would raise 2.5x FCF and pay it out a dividend (so >$12 billion dollars, or ~$6.67 a share)

Now, I think lonelyvalue characterized the same selling points last year here: http://www.lonelyvalue.com/2010/09/dell-value-trap.html
(this guy is a really worthwhile read by the way) - and while his points are still valid and no one’s quite sure whether Dell will go out and make an Autonomy-like acquisition, I think they’ve realized that their shares are quite cheap (>$7 billion repurchase program): http://www.foxbusiness.com/markets/2011/09/13/dell-plans-additional-5-billion-buyback/

Here’s the output of a simple model flatlining growth and margins:

More importantly, we show free cash flow of roughly ~$4.5 billion (down ~$500 million from LTM), and using 25% of cash flow to purchase back shares throughout each year (Michael guides from 10-30%, so this is towards the higher end), and assuming a 6.5x multiple on core earnings (completely arbitrary), we project a price of >$19 dollars at the end of the year (21% growth), and then ~15% appreciation over the next few fiscal years. While this doesn’t seem great, I believe the assumptions are quite pessimistic at 0% growth across all segments and absolutely no margin improvement (7.6% is already 80 basis points below last quarter, not to mention the assumption of refinancing at past rates).
I started this blog entry excited for Dell and now I’m concluding it with a smidge of hatred at having spent so long on this ridiculous piece.