Dell - Icahn: March Madness!

I have expressed fairness concerns about the proposed Dell insider LBO. See the February 8, 2013 post “The dell LBO: Existing Shareholders Lookout Below”. Until recently, it appeared that despite the resistance of minority shareholders like Southeastern, the deal would proceed at the original $13.65 per share offer price. Quite simply, no other bidder could or would challenge the Michael Dell-Silver Lake sponsored deal, which Dell’s board had blessed as the best alternative. Luckily for the minority shareholders, not so lucky for Mr. Dell, et al, Carl Ichan has entered the fray. He is proposing a special $9 per share shareholder distribution funded via use of excess cash and debt. He believes the this combined with the remaining “stub” value of $13.80 per shares offers a better value for all shareholders-not just Michael Dell-Silver Lake.

The nub of the issue is related party LBOs is always prone to abuse. The proposed Dell deal is especially suspect given its large cash position. Undoubtedly, as 4Q12 results indicate, Dell’s legacy PC business continues to decline. Nonetheless, it remains cash positive and has large liquid resources. The offer price, although representing a substantial premium over the pre-offer trading price, is at a large discount to Dell’s 52 week high price-a usual selling shareholder reference point. Furthermore, based publicly available information, a higher fundamentals based price could be reasonably crafted. Dell’s share price has increased following the mounting pressure by about $1 per share as investors sense that the offer price needs to raise to avoid Ichan’s ‘years of litigation’ threat.

Some lessons I see from this unfolding sequence of events are as follows:

1)     Honesty is still the best policy: The Dell “short sighted market doesn’t understand” the reason for going private which was never very convincing. Trying to complete a turnaround in a highly leveraged LBO structure would complicate not simplify the prospects. The real reason was to capture the upside benefits for the buyout group-in particular the large net $7.4B available cash position. Interestingly, the Dell group plans to bring the foreign cash home and pay the tax penalties after years of saying it could or would not return the cash due to tax considerations.

2)     Sharing is nice: Consider sharing the upside with Dell’s long suffering shareholders rather than trying to keep it all. A special shareholder distribution involving utilization of available net cash and a debt financed share repurchase would have allowed shareholders to participate in the transaction. Also, it could have avoided the auction requirements in a going private transaction. I would love to see the Board’s analysis in rejecting this alternative.

3)     Don’t be a pig: Absent sharing, at least offer a price that does not embarrass existing shareholders like Southeastern who has a $15-16 investment basis. Let them walk away- if not happy –at least not mad.

4)     Over disclose to increase the trust level: Provide valuation information to an independent third party like The Shareholder Forum, Inc with appropriate confidentially safeguards. This would supplement the less independent traditional fairness opinion provided by the company hired investment bank.

5)     The Michael Dell Rule: When he is buying you should not be selling. He does not appear to be minority shareholder friendly.

Ultimately, the next steps in the drama include Dell dropping the deal, increasing the price, providing more information, or letting the shareholders share in the deal. God bless Carl Ichan-he is doing God’s work here-of course for a fee, but that is ok.

J

Tech Wreck - Dell, Apple and HP: A Developing Story

Technology based firms like HP (transformational M&A), Dell (Management led LBO) and Apple (huge cash reserves) have generated plenty of recent headlines. What they have in common is a maturing industry, slower growth and increasing over capacity that is common to the creative destructive process is dynamic economies. The consequences of these developments are pressured margins and falling stock prices. This has created a strategy-value gap. Essentially, the current strategy no longer creates the highest and best results because it no longer fits evolving market opportunities. This presents a huge governance challenge for boards facing management teams unable or unwilling to change.

The competitive advantage period these firms previously enjoyed has shrunk to zero as their markets and products became commoditized. Thus, the source of value has shifted from growth opportunities to assets in place. The emphasis is no longer growth but returns and profitability. This shift gives rise to the following fundamental changes:

1) Increased emphasis on capital allocation as free cash flows rise due to falling investment requirements. This produces significant agency issues as management may be tempted to waste resources in over-priced acquisitions as occurred at HP.

2) Ownership and management changes in the areas of consolidation based M&A, LBOs by frustrated management and spin-offs and divestment of SBUs that no longer fit.

3) Increased shareholder distribution thru dividends and stock repurchases of excess free cash flow.

4) Higher leverage to maximize tax benefits and increase managerial discipline over cash flows and balances.

5) Improved focus reflected in the reduced number of SBUs. This reduces cross subsidies and improves capital allocation.

6) New incentives added to improve accountability.

7) Enhanced governance through new more active and experienced board members.

All of the above will be driven by heightened shareholder activism by investors,such as Einhorn at Apple, seeking to improve shareholder value. Some of this will be ugly-proxy fights, litigation, transaction challenges, and ultimately possible hostile take-over attempts.

The net result will be the tech industry as the new hotbed of deal activity going forward. Firms, management and boards will struggle to adapt to an evolving industry environment. Not everyone can succeed, but for those who can the rewards will huge. In the meantime, investment bankers, lawyers and bloggers will be busy. Much more to follow.

J

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

Dell LBO: The Beat Goes On

Part 2 of our discussion of using multiples in valuation will appear Wednesday.  We wanted to get this timely post on Dell out today.

R

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The potential Dell LBO continues to develop. Microsoft is considering a $3B convertible preferred stock investment. This would greatly strengthen the outlook for the transaction. Besides improving the capital structure, it provides a deep-pocket strategic partner. This is crucial to provide comfort to debt providers as a secondary repayment source should Dell experience financial problems.

Microsoft has a strong interest in seeing Dell, a major customer, survive. An out-right Dell purchase might pose concerns with some of Microsoft's existing suppliers and Window's allies. The joint venture with Silver Lake, the lead PE firm, provides a toehold investment with the implicit option for an additional follow-on acquisition. Should Dell falter, then Microsoft could elect to support Dell by increasing its ownership under the cover of protecting its investment. If Dell prospers, then Microsoft could serve as a strategic exit partner. Bottom line, they obtain an inexpensive option for a subsequent acquisition, reduce initial supplier and allies concerns and avoid having to consolidate Dell on its balance sheet.

Next to consider is the value transfer from Dell's bondholders to the transaction.  Like most investment grade bondholders, Dell is currently rated A2/A- by Moody’s and S&P respectively.  Dell's bondholders have minimal covenant protection and cannot force Dell to repay them once Dell goes private. Thus, Dell avoids having to refund the low rate bonds with more expensive buyout debt.  The existing bondholders continue to receive an investment grade coupon on their investment, which is now non-investment grade-most likely BB post close. Worse yet, the bonds will become effectively subordinate to the buyout debt. Consequently it comes as no surprise that Dell's bonds have plunged in price since the LBO discussions began.

I still question the wisdom of a highly leveraged Dell trying to adjust to its strategic challenges in a maturing and highly competitive industry facing substantial competitors who are unburdened by high leverage. Nonetheless, the potential for financial engineering related magic may just make the transaction possible even if it remains unwise. The Dell Silver Lake guys are good.

More to follow I am sure.

J

The Dell Stock Repurchases Program - Hmmmmmmmmmmm

Ralph and I have an on-going debate on the merits (Ralph) and demerits (me) of share repurchases. My point is not all repurchases are the same. Some may be value enhancing. Others, however, are not. They can be used by executives to manipulate earnings per share (EPS) to improve their option values.

Floyd Norris' January 18,2013 New York Times article on the misuse of repurchases at Dell provides a cautionary tale for shareholders. He analyzed Dell's long running approximately $ 40 B program. He concludes over priced repurchases benefited corporate executives at the expense of long term shareholders. Michael Dell, Dell’s founder and largest shareholder, was a substantial option recipient. His gain is estimated at over $650 MM. Executives would profit if Dell stock price increased following a decline in the number of outstanding shares post repurchase compared to a dividend. This encouraged repurchases to offset potential stock price weakening by increasing EPS as operations began to mature. This occurred despite the negative impact on long-term non-tendering shareholders. This occurred because the repurchases, being over priced, transferred value from remaining shareholders to those tendering. Michael Dell's losses were offset by his option gains, which were unavailable to non-executive shareholders, plus the gain on any shares he tendered. Dell paid an average repurchase price over the years of $ 19 per share compared to the current price of $ 12. A general observation is firms facing a challenging operating environment who have stock option programs may be prone to questionable repurchases.

The current low share price due to concerns over the firm's business model has increased the interest in taking Dell private. Michael Dell is rumored to contribute his shares into the potential LBO. This raises conflict issues as to who he represents-the firm's shareholders or himself in the buyout negotiations. Given his record on the repurchase program we can only guess hmmmmmmmm.

I promise this will be the last post on repurchases for a while. There will be more posts on Dell as the story develops.

j