On Tuesday, February 5, Dell Inc. (DELL) announced that it had entered into an agreement to be acquired by its founder and CEO, Michael Dell, and private equity firm Silver Lake Partners. The buyout price of $13.65 per share represents a 25% premium to the January 11 pre-rumor price of $11.83 and a 36% premium to the average trading price of the stock over the 90-days prior to the LBO announcement. Details of the specific terms of the buyout are still incomplete, but Dell filed an 8-K on February 6 that provides some additional information. From that document, we will attempt to fill in some of the gaps to provide a more complete picture of the LBO.
From an investor's perspective, there are three primary questions to be answered:
For debt investors: How will the currently outstanding bonds be treated in the buyout?
For equity investors: Is the proposed buyout price of $13.65 fair to existing shareholders?
For all investors (and other Dell stakeholders): Will the company have sufficient flexibility to follow through on its business plan and retain (or enhance) its competitive position?
Before attempting to answer these questions, let's review some of the details of the buyout:
LBO Financing. The proposed purchase price of $13.65 translates into a total equity purchase price of $24.4 billion, excluding fees paid to the LBO's financial advisors, lawyers and underwriters. There were 1.74 billion shares of common stock outstanding as of February 5. In-the-money stock options and restricted stock units and shares will also be paid in the buyout.
The LBO equity investors - Mr. Dell and Silver Lake Partners, who have organized a company called Denali Holding (Denali) as the acquisition vehicle, will contribute cash and Dell stock worth a total of $5.88 billion. Michael Dell and parties related to him (the "MD Investors") will roll their 273 million shares into the LBO. These shares are worth $3.73 billion at the buyout price. The rest of the equity, $2.15 billion, will come from Michael Dell ($500 million), Silver Lake ($1.4 billion) and MSDC Management, L.P. ($250 million), which we assume is affiliated with Mr. Dell's investment fund, MSD Capital, L.P. Mr. Dell will have a controlling equity stake in the LBO, but his actual percentage ownership has not be disclosed. Based upon the value of cash and stock committed to the deal, he and his affiliates are contributing 76.2% of the total equity.
The remaining $18.58 billion (i.e. the $24.4 billion purchase price less the $5.88 billion in equity) will come either from new debt or by using some of the cash that Dell has on its balance sheet.
While the sources of that $18.58 billion have been spelled out, the exact amounts that they will contribute to the buyout are unclear. The 8-K filing provides a detailed listing of the various financing facilities. The lead lending group includes Bank of America, Barclays, Credit Suisse and Royal Bank of Canada. Collectively, they have agreed to provide $7.5 billion in permanent facilities (term loans and an asset bank lending facility) and $3.25 billion in interim loan facilities (which presumably will be taken out with the proceeds of a high yield debt offering). They have also committed to provide $3.0 billion in commercial and consumer receivables financing facilities. We do not yet know exactly how much of this $13.75 billion in debt financing will be drawn down at closing. It is reasonable to assume that most of it will be drawn down, but Denali will probably retain some availability under some of these facilities to meet seasonal and longer-term financing needs.
The buyout agreement also anticipates that Microsoft will contribute "up to" $2 billion in the form of subordinated notes.
On November 2, 2012, the date of Dell's latest available 10-Q, the company had $14.2 billion in cash and investments on its balance sheet. This consisted of $11.0 billion in cash and cash equivalents and $3.2 billion of investments, the majority of which were in U.S. corporate bonds. The merger agreement requires that a minimum of $7.4 billion (up to a maximum of $8.1 billion) of the company's cash be available to finance the LBO or support Dell's operations and financing after the buyout is completed.
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The $15.75 billion in committed debt financing plus the $2.15 billion of cash equity plus the minimum required cash of $7.4 billion gives the LBO investors $25.3 billion of cash resources, which is enough to cover the remaining $18.58 billion of the equity purchase price and professional fees and also enough to buy back some of Dell's existing debt.
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On November 2, Dell had $9.03 billion of debt outstanding. Of this amount, $1.64 billion was in commercial paper, which will likely be repaid. Another $1.4 billion of structured financing debt will probably be refinanced by the $3.0 billion of receivables financings.
This leaves roughly $6.0 billion of existing debt in the form of senior notes and debentures. The 8-K filing says that the new owners intend to keep outstanding "certain" of the company's indebtedness. Yet, the merger agreement specifies a procedure for redeeming Dell's outstanding debt, but excludes a document that lists the specific debt issues that will be retired. All of Dell's existing unsecured debt issues have negative pledge provisions, which require that the company provide the same security interests for the benefit of existing debt holders as those provided for new secured debt. All of the $13.5 billion in new financing commitments from the banking debt will be secured. It is therefore reasonable to conclude, in the absence of any potentially clever legal workarounds, that the existing debt issues will likewise be granted security interests.
Any existing debt issues that are called will be redeemed with either the company's cash or perhaps a new (high yield) debt offering that is not contemplated in the merger agreement. According to our estimates, the company will have about $4.5 billion (and possibly more) in unallocated financing sources that can be used to buy back debt. We assume, therefore, that the new owners may therefore choose to keep up to $4.5 billion of existing debt issues outstanding. The four senior debt issues with the longest maturities, from 2021 to 2040, which have $1.48 billion in total principal amount outstanding, are all trading below par. The market seems to be betting that these debt issues will not be refinanced. On the other hand, with only $3.25 billion of "interim" loan facility commitments, there would be room to refinance all of the existing debt in a bigger high yield debt offering, provided that the interest rate and terms on the new debt are sufficiently attractive.
Of course, a majority of Dell's current shareholders (excluding the MD Investors) must vote in favor of the proposed transaction. In response to the announcement, some major holders, including Southeastern Asset Management, which holds 8.5% of Dell, have indicated that they will oppose the deal because they think the company is worth more.
LBO Valuation. In conventional terms, the price of the LBO is $33.5 billion, consisting of $24.4 billion in equity and $9.0 billion of assumed debt (but excluding professional fees). However, the effective purchase price is $26.1 billion, if Denali uses the $7.4 billion of the company's cash, to fund a portion of the equity purchase and retire roughly half of existing bonds.
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It is also possible that Denali could hold on to this cash for general corporate purposes and leave most, if not all, of the existing debt outstanding; but we would be surprised if this occurs, assuming that the new owners honor the negative pledge covenant. All of Dell's existing bondholders would then share in the security interest in Dell's assets on a pro rata basis. It is more likely, in our view, that the banks would push Denali to retire as much of the existing debt as possible to gain better collateral coverage.
Our $26.1 billion net purchase price estimate translates into a purchase price multiple of about six times trailing 12 month EBITDA of $4.3 billion. By today's standards, this is a very low purchase price. We highlight comparable valuations for big cap tech companies (AAPL, CSCO, HPQ, IBM, MSFT and ORCL) in the table below.
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Whether on a price/earnings or enterprise value/EBITDA basis, Dell's valuation is among the lowest in the technology sector. The big cap tech company with comparable valuation figures is Hewlett-Packard, the other major PC maker. The other companies focus on different businesses, especially software and services, but all, with the exception of Apple also predominately target business or enterprise customers. Profit margins in these businesses are clearly higher and the market rewards these companies with much higher valuation multiples.
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Dell is no longer just a PC and peripherals manufacturer. The company has expanded its portfolio initially through partnerships with EMC and others but also more recently through the 17 acquisitions that it has made over the past couple of years. Some of these companies were relatively young, but all were thought to have good growth potential. In building its portfolio in key areas like storage, networking, security, software and services, Dell is looking to stitch together these companies into a cohesive and coordinated product and service offering, focusing mainly on small- to medium-sized enterprises, but also serving big companies too.
At the same time, Dell will not abandon the PC business. It rightfully sees PCs as an important component of its enterprise offering. As the third-largest PC maker, Dell has the scale to both drive innovation and offer its products at competitive prices. Thus, while it will keep its ties to the PC business, but it might consider some alternative ownership arrangements, such as selling the business, but retaining a significant equity stake to ensure access and influence. Bloomberg News reported that Michael Dell has discussed strategic (post-LBO) alternatives with the Boston Consulting Group.
One of the primary drivers of Dell's low current valuation is its low operating profit margin. A key objective of the company- with or without the LBO - is to improve that margin, which has hovered around 5.5% for the past five years. Dell's operating profit margin averaged 7.8% in the 2001-2006 period, better years for the PC industry; but it should also be noted that the company paid $100 million in 2007 to settle allegations of accounting fraud during that period with the SEC. The fraud reportedly arose from payments that the PC-maker received from Intel (to keep Dell away from AMD). Those payments helped to boost Dell's earnings.
Even so, as the enterprise business gains traction and the PC business recovers from one of its most challenging years, Dell should see meaningful improvement in its operating margin. At this point, it is not clear how well these recent acquisitions have been integrated and whether the company has yet shown its best hand in the coordinated hardware, software and services solutions that Dell will eventually be able to offer its enterprise customers.
It is also too early, we believe, to write the PC business's epitaph. PC sales have suffered from the rapidly growing demand for tablets and smartphones over the past couple of years. However, new PC designs, spurred by Intel's (INTC) new Haswell chipset, will bring features like instant-on and longer battery life to laptops and usher in a new wave of detachable and convertible ultrabooks that will offer in one new sleek form factor the capabilities of both a tablet and a notebook computer. Combined with the availability of Microsoft's touch-based Windows 8 operating system, the recent refresh of Microsoft Office and the end of Microsoft's support of Windows XP in April 2014, PC demand should grow meaningfully over the next few years, especially among businesses, as long as economic conditions remain favorable.
LBO Investment Potential. Besides improving operating margins, there are two primary ways that LBO investors can generate positive returns on investments:
One is to reduce the debt assumed and taken on in the buyout. The other, which is related to the improvement in operating margins, is to improve the market's perception of the future earnings potential of the business, as typically reflected in the enterprise's exit valuation multiple. (As the valuation table above shows, most large cap technology companies have both higher operating margins and higher enterprise valuation multiples than Dell.)
We illustrate the potential prospects for LBO investors in two simplified scenarios: The first assumes essentially no improvement in Dell's revenues and operating profit margins in the five years after the buyout. The second shows average annual revenue growth of 4% combined with an improvement in operating margins from its recent historical average of 5.5% to 7% over the five-year time frame.
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Under the first scenario, Dell generates $3.4 billion in free cash flow per year before debt service and cash taxes - an amount that is roughly consistent with its recent historical performance, excluding acquisitions and share buybacks. Over the five year time horizon, the company reduces debt outstanding by about $10 billion. With the enterprise value of the company nearly unchanged over this time frame, the increase in the value of the equity accounts for all of equity's return on investment. This produces an IRR of 23% on the value of the original investment, which is a solid return.
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Under the second scenario, which assumes modest revenue growth and an increase in operating profit margins, the buyout produces an IRR for equity investors of 41%, which is very attractive. Our model leaves the enterprise value/EBITDA multiple essentially where it started at 7.0 times, which is probably conservative. Others might argue that if Dell can improve its operating margins to 7.0%, its exit valuation multiple would probably be higher.
These scenarios are essentially "back-of-the-envelope" calculations meant to scope out the opportunity here in simple terms. They are based upon the company's recent (i.e. fiscal 2009 to fiscal 2013) financial performance, which we assume is accurate. As with all models, different assumptions can produce different conclusions. We assume, for example, that the average interest rate paid on debt is just under 7% and an income tax rate of 25%.
Others obviously may make different assumptions. For example, the business media has reported that Southeastern Asset Management, the investment firm headed by O. Mason Hawkins which owns 8.5% of Dell, thinks that Dell's shares are worth $24. Southeastern apparently believes that the new enterprise businesses are collectively worth about $13 per share, which leaves the PC business worth only about $1 under the buyout proposal, which it thinks is too low. Thus, Southeastern is opposing the buyout bid.
On the other hand, the Financial Times reported that Silver Lake Partners threatened to scotch the deal unless Dell's Board suspended the remaining dividend payments, worth $0.08 per payment per share or 0.6% of the proposed buyout price. Silver Lake eventually backed off of this threat.
Under our simple LBO analysis, the company would have to generate higher revenue growth (7%), improve operating margins to 10% and obtain an exit valuation multiple of 10.0, in order for equity investors to get a 30% IRR at a $24 buyout price.
We do not think that Southeastern is necessarily wrong. The intrinsic value of Dell's enterprise business will probably not become evident for a few more years and a rebound in the PC business is likely. But based upon Dell's historical performance, it seems quite a stretch to think that the company will be able to grow its revenues by 7% annually and double its operating profit margins on a sustained basis.
Our analysis suggests that Denali can probably afford to pay $1 or perhaps as much as $2 more per share. It is important for Dell to retain some financing flexibility to be able to boost its R&D spending and possibly to make one or two more acquisitions to round out its product portfolio, if necessary. A buyout price significantly in excess of $15 or $16 would probably force the new equity investors to focus almost exclusively on reducing debt, which could eventually harm the company's longer-term prospects and thus all of its stakeholders.
The merger agreement provides a process for soliciting alternative bids. It has specified a 45-day period from February 6 date of the agreement for that purpose. Given the importance of Mr. Dell to the company, the agreement allows for the possibility that he might join with another investment group to pursue the buyout. It also provides a procedure whereby Mr. Dell will stand aside, if the Board or shareholders decide to pursue other options (for example, by abandoning the LBO alternative altogether).
That said, Denali's commitment to the buyout is firm. There is no financing contingency and it will have to pay $750 million to Dell, if it fails to complete the deal. On the other side, Dell will pay $250 million to Denali, if it terminates the agreement.
Take a guess on when they might sweeten the offer by $1-2 per share? I know of the 45 day window but I'm thinking they will want to "squash" this uprising asap so I would expect the new offer by weeks end.
I seriously doubt it. He had to betg borrow and steal to get the funds for the buyout. Someone earlier mentioned this, if he were serious about paying a nice premium he would be working with 15 or higher. 13 shows just how poor he really is :P M. Dell always lowballing and cutting corners.