Friday, January 18, 2013

Gin Rummy LBO Screening: The Case of Dell

My previous Best Buy post highlighted why I considered it to be a poor LBO candidate. Best Buy's big box retail model was rapidly losing out to on line firms like Amazon. Firms suffering from declining operations due to industry structural changes, which put their existing business into question, involve too much business risk. They have poor prospects of turning themselves around in a highly leveraged state.

Now another structurally challenged firm, Dell, is considering an LBO. Dell's shares declined 30% last year despite an overall rise in the stock market. Its core direct order PC business has fallen prey to retail stores and new products like smart phones and tablets. The result is that sales declined 19% and profits fell 47% last year. They have been trying to offset the decline by repositioning the firm through almost $13B in new initiatives (including acquisitions) for some time.

Dell's market value exceeds $20 B. Applying a reasonable premium suggests a transaction price around $24B. A 40% equity requirement generates a $9.5B equity need.  Assuming the rollover of Michael Dell's ownership reduces the new equity need to $6B. This is a large amount and would probably be split among multiple private equity sponsors as had occurred during the 2003/2007 LBO boom. Shared deals like this can be tricky if something goes wrong as it is difficult to know who is in charge.

Debt in excess of $13B would be needed. Dell has a sizable cash position. Unfortunately, it is largely overseas, and probably subject to substantial taxes if returned to the U.S. to support the proposed LBO. The key impediment to the debt levels is Dell's declining core earnings and market share-despite years of continued turnaround efforts by Michael Dell. How can you build a realistic capital structure if you are unsure about your cash flow?

Michael Dell is likely to continue in a senior role in the LBO. Thus, it is difficult to see what new turnaround efforts he will employ in a highly leveraged firm that will be more successful than past efforts. It is difficult to reinvent and implement a new business model in a leveraged firm. There is little room for delay or error. The fact that this project can even be seriously considered is a testament the current highly receptive bank and capital markets.

I understand Dell's frustration given the market's response to their existing turnaround efforts. Nevertheless, an ill-advised LBO is not the best alternative choice of action. Absent a strategic buyer, a more realistic option is to manage the firm for cash, and return the cash to shareholders. Part of the disappointing stock market performance may be due to shareholder concerns that Dell is over investing in low return activities, or overpaying for acquisitions.

The high financial risk in LBOs requires a stable operating environment with predictable cash flows. It is difficult at best to try a high-wire business turnaround in leveraged firm. A concern is banks and other investors in search for high returns will proceed with the transaction despite its size and risk. Wilbur Ross gives the proposal a 50% chance of proceeding. Investors should beware of LBO candidates representing weak discarded cards as in gin rummy.


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