Rumors surrounding computer maker Dell (click ticker for report: ) going private stole the show yesterday afternoon. Several reports indicate that CEO and founder Michael Dell could be leading the charge to take the company private as the market continues to saddle the firm with a low multiple. We peg Dell’s fair value at $18 per share, so we completely understand what private equity investors are looking at.
We think the deal makes a lot of sense for shareholders, but not necessarily for the company. Shares have been steadily declining as the firm’s core PC business fades, and we believe plenty of shareholders would love to be bailed out by a private equity bid that values the company at a premium to its current share price. However, we’re not sure how the deal enhances Dell’s chances for survival at all.
During the past several years, Dell, as well as HP (click ticker for report: ) has looked to transform from a hardware company to a software company in similar fashion as IBM (click ticker for report: ) has successfully done. The bulls, in our view, continually overestimate the challenges involved in such a radical change. In order to facilitate this transition, Dell will need to spend billions of dollars on M&A, R&D, or both. Therefore, loading up a company with significant debt would only add financial and leverage risk to overpayment and selection risk with respect to future acquisitive activity. If the PC industry wasn’t so challenged, then the deal would make plenty of sense. But then again, if the PC industry wasn’t so challenged, Dell wouldn’t trade at such a low multiple.
Perhaps even more pertinent is the company’s declining earnings. Our third quarter earnings note shows that free cash flow during the past few quarters has declined, though the company remains optimistic that cash flow will increase as its services revenue stream becomes a larger component of the revenue mix. However, we think the PC business could become a cash drain, and again, building an enterprise software company isn’t the easiest task.
There’s also the issue of the cost and size of this deal: a takeout of Dell would cost well in-excess of $20 billion. That’s a lot of cash even after netting out Dell’s current cash balance (which sits mostly overseas and would have to be repatriated). Though a $20 billion leveraged buyout wasn’t unheard of in 2007, such a deal is hard to fathom in the wake of the Great Recession. Frankly, given the magnitude of the deal and the current state of Dell’s core businesses, a transaction might not even make sense on a risk/reward basis. Any small private-equity firm that would be involved as part of a consortium would be betting its career on this deal.
Although we continue to believe shares of Dell look inexpensive, we’re not interested in betting on the company at this time. Private equity bids can provide an excellent catalyst for share price appreciation, but the path towards turning around Dell’s business remains unclear (and this may keep private-equity buyers on the sidelines). A deal could happen, but the Dell situation could eventually become the next Best Buy (click ticker for report: ) saga, where a transaction is kicked around for months without anything happening. At the time of this writing, the firm registers a 3 on our Valuentum Buying Index.