Why David Einhorn Owns Dell (DELL): Stock of the Week ~ market folly

Monday, April 2, 2012

Why David Einhorn Owns Dell (DELL): Stock of the Week

Continuing the stock of the week feature here at MarketFolly, this week's focus is on why David Einhorn of hedge fund Greenlight Capital owns Dell (DELL). If you've missed them, be sure to scroll through all the previous stocks of the week.

The following is written by Tsachy Mishal, Portfolio Manager of TAM Capital Management:

If I could only view a single 13-F, it would be David Einhorn's. His long ideas are value oriented, common sense, and simple to understand. In Greenlight Capital's latest investor letter he makes the case for Dell. I excerpted a portion of his argument for Dell below:

"DELL is a large seller of computer and technology products ... While the computer business is mature, DELL has broadened its offerings over the last few years, so that about half its sales and more than half of its gross profits come from other products. DELL has roughly $7 per share in net cash and investments and currently earns about $2 per share (up from $1.50 in 2010). Accordingly, DELL’s P/E multiple is about 7x, and net of the cash and investments, it is less than 4x *(my note: now 5 times due to price appreciation). This reflects a valuation usually associated with collapsing businesses. We expect DELL to continue to grow its earnings per share, albeit at a modest rate."

Greenlight's average purchase price on DELL was $15.53 and shares currently trade around $16.70.

It is difficult to argue with the attractive valuation of Dell at 5 times earnings, net of cash. Although I would make one adjustment to David Einhorn's analysis. The vast majority of the $7 in cash (+investments+short term finance receivables) is either tied up in their financing operation or stuck overseas. Therefore, for valuation purposes I would credit them for a maximum of $6 in cash (and possibly $5 on the more conservative side). Even after this adjustment the company trades for an attractive 5.5 to 6 times earnings and they generate more free cash than earnings.

I view Dell's business as less attractive than David Einhorn does. Even though Dell may no longer be a PC company, it is still largely a boxmaker. A server or storage solution is still a box with other people's hardware components and other people's software.

While Dell has some intellectual property (IP) due to recent acquisitions, they are still largely assembling boxes and loading software onto them. They sell additional services, expertise, and related peripherals with these boxes. I view Dell's assets as: their scale, their relationships with clients, and their trusted brand name. They are trying to transform themselves into more of an IP company but the transformation has risks.

Even though I don't view the business as attractively as does David Einhorn, that does not mean that the business does not have value. Dell probably should trade at a below market multiple but it likely should trade somewhere north of the current 5.5 to 6 times earnings. Customers want to deal with somebody they can trust and Dell has earned that trust; there is value to that.

What I Like:

- Dell is one of the cheapest stocks in the S&P 500, if not the cheapest.

- Dell's business generates more cash than earnings.

- Dell's management is the best operationally of its competitors.

- Dell has strong relationships with its enterprise customers and a trusted brand name.

What I Don't Like:

- Dell is benefiting from a corporate PC upgrade cycle. The server business is likely benefiting somewhat from this as well. Normalized earnings are likely lower than current results.

- I would not be surprised if in ten years enterprise hardware becomes commoditized just as consumer hardware has been.

- Most of Dell's cash is stuck overseas and the valuation is highly dependent on that cash being used wisely.

- Dell only plans to return 10%-30% of free cash to shareholders unless there is a repatriation tax holiday. The amount is even less after one considers employee stock option dilution.

- Dell is planning a transformation via acquisitions. While it could solidify their earnings power, there are risks.

I had a very difficult time deciding whether to purchase Dell or not. It is not the type of business I prefer to own, but the valuation is ridiculously cheap. The fact that they are barely returning cash to shareholders was the deciding factor in not purchasing the shares. At lower prices or if a repatriation holiday became more likely, I would reconsider.

Last month, David Einhorn also provided some comments on Dell in an extensive Q&A session at the CIMA Conference.

For more stock of the week features, head to:

- Why Phil Falcone likes Spectrum Brands

- Why Maverick Capital owns Amdocs

- Why George Soros owns Comverse Technology

- What Carl Icahn sees in WebMD

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