Was David Einhorn Right to Dump Dell?

GREENLIGHT CAPITALIn the fourth quarter of 2011, David Einhorn and Greenlight Capital (see Greenlight Capital’s most bullish stock picks) took a position in Dell (NASDAQ:DELL) at an average price of $15.53. At the time, he wrote to investors that “the recent business performance has exceeded the recent stock performance…[Dell’s P/E] reflects a valuation usually associated with collapsing businesses.” Not only was the stock a good value in his eyes, but the company seemed committed to buying back stock. With DELL falling quite a bit since the purchase (it closed on July 25th at $11.49), Greenlight took a major loss on the stock and finally decided in the second quarter of 2012 to exit the position. Einhorn reported to investors in this letter that the company’s inability to expand its business lines “proved to be a disappointment.” It will be interesting to see if other major investors have followed, or will follow, Einhorn out of Greenlight. Southeastern Asset Management owned 132 million shares of Dell at the end of March, making it their top 13F holding (see the rest of its portfolio); this was over ten times Einhorn’s investment, and even a small percentage decrease in its holdings could signal a lack of confidence in the stock.

Dell currently has a $20 billion market cap even though its P/E ratio has fallen to 6.6. Its most recent 10-Q, for its first quarter ending in April, had revenue down 4% compared to its first quarter in 2011 and earnings per diluted share down about 25% despite a reduction in shares outstanding. Due to decreases in payables and other current liabilities, cash flow from operations was negative. Dell also discussed several acquisitions that it had completed since the beginning of the year, opting to spend its cash bolstering its commercial segments rather than buying back stock as Einhorn had hinted he would like it to continue doing.

Over the course of Einhorn’s investment, Dell has tried to reorient itself away from being a PC company and towards being an enterprise company (hence the acquisition of commercial segment-related businesses, and since the release of its 10-Q Dell has additionally announced the purchase of Quest Software (NASDAQ:QSFT)). Activist-oriented investors may wonder why Dell insists on keeping the PC unit in-house if the company is going to focus on its software operations; however, Michael Dell criticized HP (NYSE:HPQ) when HP announced plans to sell or spin off its own PC division last year, calling PCs “a growth market.” While he may have changed his mind as a parade of tablet devices rush to market, if he has not then chances are the PC division will stay where it is. Other investors may be as frustrated as Einhorn was that management insists on using cash to aggressively acquire in order to build the software business rather than buying back shares. However, Einhorn in his original letter mocked Dell for buying back shares during the dotcom bubble and invested in the stock partly on the strength of Dell’s buybacks in 2011; with such a poor record, perhaps Dell’s management has decided to stick to technology.

Assuming that Dell is able to sell its PC operations, which generated $33.2 billion in revenue through their entire last fiscal year, the company could pass on this cash however it wished. Currently Dell has a price/sales ratio of about 0.3, and HP does as well, so this is probably a good valuation multiple to use for a PC-oriented business in the current market environment. If Dell is able to sell its PC operations- presumably a less attractive business deserving of a lower multiple than the rest of the company- it might be able to get a price of $8 billion. If that cash, and half of Dell’s current $8 billion on the balance sheet, was applied to buying back stock, Dell could acquire nearly 1 billion shares, about half of the current shares outstanding. This fiscal year’s revenue, less the PC operations, could come in at $28.8 billion- no change over the last fiscal year, for conservatism. Also for conservatism, we would assume that Dell earns a 4.4% net profit margin in its new business, just as it did in its most recent quarter- the PC operations are likely lower margin, but would no longer be able to help cover corporate and administrative expenses. Dell would then be a pure software and services business similar to Oracle (NASDAQ:ORCL) or IBM (NYSE:IBM), which are much larger but trade at price/earnings ratios of nearly 15. If Dell began trading at twelve times earnings with its new quantity of shares outstanding, it would reach a value of approximately $15.21 per share- nearly gaining back every penny lost since Einhorn bought in. If company management desires, it might be possible for them to make a bold move which would deliver value to shareholders and commit Dell to a new business model.

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