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David Einhorn’s Bad Stock Pick

GREENLIGHT CAPITALDell (NASDAQ: DELL) got a nice little vote of confidence late last year from David Einhorn, who disclosed a long position in the company. Einhorn, along with Mason Hawkins, Prem Watsa, Zeke Ashton, and Whitney Tilson all hold this consumer and enterprise computer systems company. Since Einhorn’s call, the PC industry has weakened more than we had expected with uninspiring consumer demand in North America and Europe. Shifts to tablets have not helped its business either and after April quarter results, the stock is down over 16%.

With macro (PC industry) and micro (company execution) headwinds, DELL reported below consensus April quarter results and issued below consensus July quarter guidance. DELL cited a moderate demand environment and aggressive hardware pricing in lower-end consumer and emerging markets. Although we did see DELL make progress toward enterprise solutions (half of quarterly gross profit), it faced execution challenges during the quarter. Given the execution challenges and push to take a bigger piece of the end-to-end enterprise IT business, DELL is not projecting FY13 revenue; additional investments will be needed as it diversifies away from PCs through acquisitions. Past acquisitions have included SonicWALL, AppAssure, Wyse Technology, Clerity Solutions and Make Technologies. We were looking forward to seeing if the company would announce any planned acquisitions but none were made. Since a rebound in PC demand is unlikely to materialize in the upcoming quarters and poor execution on DELL’s part, we are not left assured.

We suspect the weak PC demand will have ripple effects. On the chip side, Intel (NASDAQ: INTC) is most vulnerable  though it had indicated that it was seeing the same trends that we think are industry-wide given similar sentiments echoed by Cisco. Unless the trends reverse, INTC will likely have to lower guidance to be conservative, depressing shares. Nvidia (NASDAQ: NVDA) will also run into some issues given its graphics focus. NVDA’s partnership with INTC in power management will likely suffer.

DELL’s more direct competitor, Hewlett-Packard (NYSE:HPQ) is better diversified in our opinion. We are particularly interested in its cloud services that debuted last week (beta version). The much awaited HP Cloud entered public beta last week. Features include HP Cloud Compute, HP Cloud Object Storage and HP Cloud CDN with a pay-as-you-go model. We believe this to be HPQ’s most significant new revenue stream, which will compete with Amazon’s (NASDAQ: AMZN) Web Services and thus is not as dependent on PC demand.

From a financial health perspective, DELL has a good looking balance sheet even though there are some worsening in working capital stats. The cash conversion cycle was up and the company finished the quarter with a cash and equivalents balance of $17.2 billion, which translates into approximately $4.63 of cash per share. Management is still committed to share repurchases, and did so to the tune of $300 million in the quarter.

So while overall, DELL is making strides in what we view is the right direction in shifting focus to enterprises, macro headwinds and heightened competition will likely keep the stock from any big jumps. Corporations are dragging their feet on upgrades, the government is facing budget crises, and consumers are opting for tablets over standard PCs. Our concerns surround further margin pressure and higher operating expenses that will have the likely effect of dragging down earnings. This, coupled with the company’s M&A investments and near-term demand uncertainty, could continue to pressure the stock. With many headwinds ahead of the Windows 8 launch and product upgrades, we expect 2013 to be a choppy year. In light of all the uncertainty, we apply a 7.0x CY 2012 P/E for an estimated value of $13 per share, leaving little upside from current values.

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