Dell’s Possible LBO: Arguments For And Against

On Monday, Dell Inc. (NASDAQ:DELL) dominated business headlines, with talks of a possible buyout by private equity firms.

Dell's Possible LBO: Arguments For And Against

At the time, BMO analysts (one of many analysts to give their two cents), calculated that should Dell Inc. (NASDAQ:DELL) go private at $17/share, and CEO Michael Dell Inc. (NASDAQ:DELL) moved his equity into the deal, the company would need $20 billion in financing.

Numerous stories are still being circulated, and in a Bloomberg story, Dell’s market value has been increasingly connected to its cash and money- market securities holdings, which may explain why the company may be considering a leveraged buyout.

In a CHART OF THE DAY, Dell’s investments have been equal to more than 50 percent of the company’s value for the last eight months, with a peak occurring in October at 74 percent. This came one month prior to Dell’s stock falling to its lowest level since March 2009, according to Bloomberg data.

The percentage rose while Dell’s cash and short-term investments (a year or less maturity) fell four of the last five fiscal quarters. As of Nov. 2, Dell held $11.3 billion as the third quarter concluded.

Last month, Bill Shope, a Goldman Sachs Group, Inc. (NYSE:GS) analyst, wrote in a research report that Dell’s net cash balance offered a buyout opportunity if it’s “under the right conditions.” For the third quarter balance, which showed longer-term investments and debt outstanding, it ended at $5.15 billion.

Over the last few days, the banks jumped on the news and delivered the following research reports for a possible Dell LBO.

Deutsche Bank – Buy Dell, Price Target of $15

In a Jan. 14 report, “Dell LBO looks good on paper” analysts reviewed a possible LBO with the following points:

Dell LBO looks good on paper – Citing Silver Lake and TPG as possible private equity firms, analysts saw a potential problem with the scale of the requisite financing (estimated between $20 to $25 billion), the willingness of key investors such as Michael Dell ( approx. a 16% holder) and the ability to execute the transaction. But it could provide very attractive returns for new investors and give an opportunity to manage the Dell Inc. (NASDAQ:DELL) turnaround strategy sans public market scrutiny.

Analysts raised their target from $13 to $15 (6x CY13 P/E ex cash) and maintained a “Buy” rating.

Is it doable? – Under the assumption that Dell repatriates foreign cash (and pays taxes), analysts put together a multi-scenario analysis with various levels of equity and debt raised in differing financial performance scenarios. They believe a transaction is do-able on paper, from a balance sheet capacity, interest coverage and leverage standpoint, but its challenge is deal size and the large capital amount required to execute this transaction.

Does the math work? – The LBO could grab $15+ per DELL share and new equity holders would see a 25-30% IRR, based on the conservative assumptions of ~0% top line growth and EBITDA margin expansion from 9.2% to 9.5% over five years. More conservatively, PE investors could see a 20-25% return annually over the next five years.

The value creation opportunity for PE investors is centered around the ability to borrow at ~6-7% to buy an asset generating ~20% FCF yields.

Raising PT to $15, maintain Buy – Dell is an undervalued asset. A $15-16 deal would generate substantial returns for any possible buy-out group, while still offering material upside to Dell’s current price. The price increased from $13 to $15 and assumes DELL trades at ~4x CY13E EV/EBITDA. This is appropriate considering Dell’s growth and profit profile and current macro uncertainty. Risks include weaker PC demand and a strategy mis-execution.

Bank of America – Arguments for and against LBO

In this report, analysts listed reasons for and against the LBO with an end view that it’s unlikely.

Arguments against the deal

1) Based on the LBO model, the IRR is likely to be 10-15% vs. the 20%+ typically required by PE firms; an estimated ~85-90% of Dell’s $14.2 billion cash is outside the U.S. (35% tax imposed to bring the international cash). An  ~25% IRR would be calculated if Dell’s $14 billion cash were domestic.

(2) Given Dell’s ~$16 billion EV, the deal’s potential size could be a challenge. While Dell’s debt capacity and overall interest rate are favorable, it would still require significant PE firm and bank commitment.

(3) To make the deal more financially attractive, Michael Dell would stay with the company and roll his equity into the new capital structure. This could be a stretch as its viewed Dell would likely prefer to run the company without having his ownership / managing power diluted.

Arguments for the deal

1) Dell Inc. (NASDAQ:DELL) has historically generated healthy FCF with double-digit FCF yields.

(2) While Dell has been making modest progress in recent years toward becoming an IT solutions company, investor sentiment is still low. (<0.5x S&P 500’s C2013 P/E of 13.6x).

(3) Enterprise revenue is expected to grow 5% Y/Y in C2013, to represent 37% of total vs. 29%/34% in C2010/2012, and the current stock price implies ~10x C2013 net income of the business alone (no value assigned to Dell’s client business) vs. EMC’s 15x and IBM’s 12x.

If PE firms could monetize the PC business, the deal would be more attractive.

Maintain estimates and $13 PO

The F2013/2014 EPS estimates of $1.68/$1.65 will remain. The $13 PO is based on ~6x C2013 NOPAT of $1.76 plus $3 net cash per share.