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.

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