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Dell (Paul Sakuma)
Dell (Paul Sakuma)

VOX

In Dell's turnaround, more questions than answers Add to ...

Dell Inc.’s deal last week to buy network-security provider SonicWALL is a reminder that the company that made its name in commodity personal computers recognizes that the key to long-term profits comes from higher-margin corporate computing services. Dell’s focus on the future, combined with a pristine balance sheet and gusher of cash flow, has made its shares catnip to value investors, and they’ve been rewarded so far in 2012 with a gain of nearly 20 per cent.

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And yet the shares are still cheap, with some analysts suggesting they reflect a worst-case scenario. Any continuation of Dell’s good news could drive further gains, they say.

The problem, however, is that much of the worst-case scenario seems as likely as not, suggesting Dell shares may remain cheap for quite some time.

First, the SonicWALL acquisition: Dell didn’t disclose the purchase price, but press reports put it at $1.2-billion (U.S.) for a company that produced $260-million in revenue in the last 12 months. (Ontario Teachers’ Pension Plan, which partnered with lead investor Thoma Bravo LLC to take SonicWALL private two years ago for $717-million, says thanks. Since the partners used just $280-million of their own cash in the leveraged transaction, they might have quadrupled their investment.)

The purchase price, if it is as reported, works out to about 68 cents for each of Dell’s 1.7 billion shares outstanding; Raymond James analyst Brian Alexander says the deal will add about 1 cent per share to Dell’s earnings in fiscal 2013, which started in February, and 2 cents to 4 cents in the year after.

The large price for small results illustrates the challenges in moving the needle at Dell. While the company is half the size of Hewlett-Packard Co., another company trying to make the same transition, it still has more than $60-billion (U.S.) in annual sales, with PCs and their related services making up roughly 70 per cent of that revenue, estimates Bernstein Research analyst A.M. Sacconaghi, Jr.

Dell’s enterprise storage business, one of the higher-margin, faster-growing businesses it’s targeting, has provided just $500-million in revenues to the company in each of the last 12 quarters, notes analyst Brian Marshall of International Strategy and Investment Group Inc. “We believe changing the composition of a $60-billion revenue base is non-trivial and takes years (not quarters) to successfully navigate,” he says.

Dell’s willingness to back off in bidding wars – it let HP pay dearly for data-storage company 3Par in 2010 – gives analysts some, but not total, comfort. “The shift to more sophisticated offerings will ultimately shape Dell's ability to create shareholder value,” says Morningstar Equity Research’s Michael Holt, “but we question if the firm will destroy more value than it creates during the transition.”

In the meantime, there’s a bull case for Dell, in addition to the premise that its new focus on enterprise business can deliver more upside.

Mr. Sacconaghi of Bernstein, who has an “outperform” rating and $21.50 target price (versus recent trades above $17), notes the company’s all-time-high gross margins – roughly 22 per cent, versus 18 per cent to 19 per cent in past years – owing to the shrinking cost of PC components.

Fears of the demise of the PC business may be premature, he argues, as computer makers might cannibalize tablets (rather than the other way around) by incorporating touch screen features into their full-keyboard devices.

And, with $4.25 in cash per share and strong cash flow each year, Dell’s valuation on an enterprise value-to-free cash flow basis puts it at a roughly 25-per-cent discount to Microsoft Corp. and HP, he says.

However, Mr. Sacconaghi acknowledges he’s “more sanguine about the PC industry” than many who question how many desktops and laptops will be sold in an iPad era. And Dell’s margin successes depend, in part, on a “pricing détente” in the PC industry.

He also helpfully notes that Dell has said that just 10 per cent to 20 per cent of its cash is in its U.S. operations, and that only 16 per cent of its pre-tax income over the last three years came from its home country. Since U.S. corporate taxation laws encourage companies to keep cash parked overseas, never to be repatriated, Dell faces “liquidity restraints” in paying a dividend or boosting buybacks, he says. (What good is cash flow if it can never flow into investors’ pockets?)

All in all, this suggests the story of Dell’s transformation is in its very early chapters. And the ending may not be as happy as many value investors expect.

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