Friday, February 8, 2013

The Dell LBO: Existing Shareholders Lookout Below ?

Details on the recently announced Dell LBO are interesting. First the deal is creditworthy. Michael Dell ($4.50B) and Silver Lake (1.4B) are investing almost $6B in equity thru rollover and new equity. This is supplemented by junior capital of $4B provided $2B each by Microsoft and de facto subordinated existing bondholders. The remaining $15, or so, of new bank provided senior debt will be supported by a strong 40% junior capital position. Add to this excess cash of over $7B being repatriated from overseas at a substantial tax penalty, and  projected annual $3B of cash flow, albeit declining, should comfortably cover annual debt service. Estimated credit ratings in the BB range reflect these facts.

Just because something can be done does not mean it should be done. Something still does not make sense. The transaction is justified as accelerating the transition from PCs to services by removing Dell from the distracting spotlight of the short term public market. The question is how? The increased debt, while supportable, reduces flexibility. Debt service requirements, unlike discretionary dividends and share repurchases, combined with new debt covenants will hamper Dell’s transition strategy implementation-especially if something goes wrong and new investments are needed. This is a key concern as Dell faces deep pocket investment grade competitors like IBM as it repositions itself. Already, HP has announced they will go after Dell’s PC customer given Dell’s increased financial vulnerability.

Next, and perhaps most importantly for Dell’s existing shareholders, the Dell investor group has yet to disclose what it will do differently, and more successfully, as a private firm than it has done as a public firm. Dell has been trying for years to reposition itself all with mixed results. This is the reason for Dell’s sagging share price. The market may not be short sighted as much as it is skeptical, given existing performance. So what is different once Dell goes private? Is there some secret sauce that has yet to be disclosed, and if so, why has it not yet been disclosed? If they have a new secret and credible, turnaround sauce, then disclose it and the market will reward the firm with a higher valuation. Of course, under that approach, Michael Dell and his investor group have to share the upside with existing shareholders instead of capturing all of it for themselves.

Could it be the investor group is planning to immediately dispose of the ailing PC business? Another possibility could be a planned special dividend to the investor group after the deal closes using some or all of the repatriated cash. This would effectively reduce the investor group’s investment basis thereby giving them a free upside option.  Perhaps, there is a good reason for the shareholder class action suits filed upon the LBO announcement.

Perhaps, I am just a confused skeptic. Alternatively, I smell a rat. Given Michael Dell past actions, when he is buying, you do not want to be selling. So for existing shareholders, the Dell LBO may indeed mean lookout below.

Your confused skeptic -Joe

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