Why Dell is going private

By Felix Salmon
February 5, 2013

Why are Michael Dell and Silver Lake taking Dell private at a valuation of $24.4 billion? Christopher Mims explained his theory a few weeks ago: it’s all about a company that Dell acquired last year for roughly $500 million. Wyse makes PCs-on-a-USB-stick: everything is in the cloud. According to Mims, if you combine Wyse’s technology with Dell’s ability to talk the kind of language that corporate IT buyers love, Dell is now well position to disrupt itself:

A privately held Dell, shielded from the pressure to post continual growth on a quarterly basis, could refocus itself on thin clients and cloud computing, which could set itself up for a breathtaking turnaround.

This raises an interesting question. Right now, Dell has about $9 billion of debt; that number is going to rise substantially post-buyout, with a $2 billion loan from Microsoft and a $15 billion financing package from Wall Street. The cost of servicing all that debt is going to weigh heavily on any company trying to grow fast in the highly competitive and extremely capital-intensive world of cloud computing. Wouldn’t it be easier to just stay public, announce a new cloud-based strategy, let the stock find its level, and then execute with an eye to the long term?

After all, private equity shops like Silver Lake have a clear time horizon and exit strategy: they want to come in, turn the company around, and then sell out at a substantial profit within 5-10 years. Public equity, by contrast, is permanent capital, and has an infinite time horizon — in theory, it should be better suited for people with a long-term vision.

But two things are going on here. Firstly, Dell is incredibly cheap. It has revenue of roughly $60 billion per year, gross profit of almost $14 billion, and net income of more than $2.5 billion. That means Silver Lake is paying less than 10 times earnings for the second-biggest PC manufacturer in the US, and the third-biggest in the world. And secondly, debt is incredibly cheap as well. Financing terms haven’t been disclosed, but I doubt Dell is paying more than 6% for its money. 6% of $15 billion is less than $1 billion a year, which still leaves a lot of money left over for investing in the cloud.

Winning a significant share of the cloud-computing pie is not going to be easy: both Google and Amazon are formidable competitors. But I can absolutely see what Silver Lake is thinking here. For many years, the big money in technology has been in fast-growing early-stage companies — but those companies are being increasingly boxed in by a few large firms who each hold key patents in just about every area. Dell has patents — it acquired more than 180 of them with the Wyse acquisition alone; it has the ability to invest and to reach enormous numbers of customers; and it also has a large number of boring-but-viable business units which can be sold off to generate even more capital if needed.

The valuation curve in the technology space has never been as steeply inverted as it is right now: while there are dozens of billion-dollar startups with negligible profits or revenues, the giants in the sector are trading at a significant discount to the stock market as a whole. For a company like Silver Lake, which is based in Silicon Valley and exists to turn around mature technology companies, this can be seen as a once-in-a-generation opportunity combining cheap debt with low valuations and enormous upside potential if they get it right. Frankly, if Silver Lake didn’t buy Dell at this point it should probably just pack up and liquidate.

This buyout might well fail — private equity is an inherently risky business. But it’s pretty obvious that Silver Lake has a much greater risk tolerance, right now, than the public equity markets have. If public shareholders don’t want to touch Dell, and Silver Lake sees an opportunity, then it makes perfect sense for Silver Lake to buy the company — especially since they get to keep Michael Dell himself as a key partner in the deal. If you’re a big company wanting to take big risks in technology, it seems, these days you have only three choices. You can be Amazon, you can be Google, or you can go private. Dell’s choice was clear.

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Comments
13 comments so far

Your premise makes sense, but only if you assume that Michael Dell and Silver Lake know how to successfully invest in the cloud, i.e., know what products to make. There is no evidence that either has any clue what to make. Also, there is nothing stopping Dell from doing that now, if they knew what to do next.

It’s just shuffling pieces of paper around to make money the old fashioned way – extracting wealth from the economy, only it may not work if they don’t figure out how to stay relevant.

Posted by KenG_CA | Report as abusive

Just as a sanity check, Felix, if you are asserting that “Dell is incredibly cheap” as a commodity business in a contracting segment layered on with debt, then was does that say about Apple at a P/E of 10 in a growing segment, with six multi billion dollar lines of business, gangbuster margins, mountains of cash and virtually no debt?

Scary cheap?

Posted by hypermark | Report as abusive

The whole deal is not about cloud or growing the company – it is, as so often in such situations, purely about getting Silver Lake investors, Dell and mgt even more filthy rich. All that away from the public eye and with little disclosure. Good luck to them. They are getting dirt cheap debt to lever the business up as much as they can, and then will keep churning out their crappy PCs to corporates (remember, they haven’t upgraded their PCs for 3-5yrs – probably the 1st time in the history of computing that the upgrade cycle of hardware is so slow)
and that will be enough to pay the debt down. They’ll also get rid of a few thousands employees, cut down R&D to the bone, maybe retreat from retail channels (ie back to Dell direct – hence huge cost savings) and in 5yrs time the business will have shrunk, look more profitable and be sold back to idiot institutional investors for a $10bn ish valuation. Every asset mger will think it’s a steal – until 2-3 yrs later they realize the company has not invested to keep up with peers and is a debt loaded shell on its way to a debt restructuring, which will wipe out the shareholders… Meanwhile, Silver Lake and Co will have paid themselves $bn in annual dividends…

If you think this is far fetched – look at UK dept store Debenhams…

An interesting point though, is that despite all the talks of cloud this and table that, the workhorse of the corporate world is still the PC. And due to lack of upgrades, many very large multinational are on the verge of renewing their PCs. You may say, who needs a PC when you can have a cloud PC (no more that a Chrome OS machine frankly) or a tablet or a phone, but the fact is that so much corporate mission critical tasks are done on 2005 XP running PCs. That will change – they’ll upgrade to Win 7 or 8 new PCs. (btw, I think that explains why MS is putting $2bn in the deal: they need to get Dell to stick to windows – as remember, you can boot a PC with a USB loaded with Linux that looks exactly like Win 7 and can run Windows made programs…)

Also, the big problem with “cloud” – as in SAAS – is that it is a lot less profitable than the traditional software business of selling licenses. In a way, it’s a bit like newspapers vs online newspaper sites. Same sort of revenue difference. Anyway, that’s great for consumers, not so much for IT firms.

Last thing: Apple may be cheap on a valuation basis. But it won’t be taken private as long as you’ll need $500bn to do the deal. Remember, the largest LBOs haven’t been more than $50ish Bn….

Posted by fxtrader7 | Report as abusive

Said a bit differently, my sense is that there’s a sum of the parts valuation play here by the buyers. They’re looking at a company that’s a mix of an enterprise software and services business (high multiple), servers (mid-range multiple), and PC’s (low multiple) and buying it at a PC multiple. The home run outcome is a successful shift in business mix toward the first two businesses followed by going public again at a multiple based on those businesses, not PC manufacturing. The execution may or may not work, but it seems like a reasonable idea.

Posted by realist50 | Report as abusive

Also, re valuation, Dell looks even cheaper on an enterprise value to EBITDA basis, which is typically how PE thinks about valuation. At $13.43 per share, Dell’s trading at 4.7x enterprise value to EBITDA, which is low. (By comparison, Apple has a similar P/E but is trading at 6.3x enterprise value to EBITDA).

My suspicion is that Dell has a fair amount of depreciation and amortization that doesn’t really represent necessary ongoing capital expenditures (as you’d traditionally expect with most D&A). Dell has completed around $12 billion of acquisitions in recent years, which means ending up with amortization of certain types of acquired intangibles (customer lists, intellectual property, etc.) It’s sort of screwy accounting because the ongoing costs of sales and R&D are expensed (and above the EBITDA line), so there’s an argument that post-acquisition net income takes a double hit. It’s one of the examples of how PE investors focus on cash flows and don’t worry much about non-cash items that are in accounting earnings.

Posted by realist50 | Report as abusive

“For a company like Silver Lake, which is based in Silicon Valley and exists to turn around mature technology companies…..”

Felix,

Silver Lake doesn’t know anything about the PC business. Like Isaiah Berlin’s hedgehog, it knows only one thing: the tax deductibility of debt.

And keeping Michael Dell in the deal? Does this make the price even cheaper?

Posted by crocodilechuck | Report as abusive

This all sound good and some of the point views are just about right, but will it work? I have been with Dell for seven year and hope that they can make the product a little better.

Posted by Jjesse285 | Report as abusive

As I read more about this deal, I think the idea that they are doing this so they can “disrupt itself” or take risks is nonsense. Why can’t they do that now? What are they going to do, fire Michael Dell? Drive the price of the stock down? If that’s what they’re worried about, they should go ahead with their grand strategy and let it happen, so they get Dell for a lower price. Then when they execute their big ideas, they’ll make even more money.

Yeah, they have a secret plan just like Nixon did.

Posted by KenG_CA | Report as abusive

By changing their capitalization from equity to debt, Dell Computer changes their relationship to their ever-constant (mostly silent) business partner — the U.S. Treasury — to whom in the future Dell can be expected to pay much less.

The deal is a tax-avoidance scam. But finding innovative still-legal ways to reduce taxes paid to the government is a “victimless crime” right?

Posted by dedalus | Report as abusive

If they stay public they will have to keep showing quarterly profits and live to the banksters expectations. If they take it private they can chop the company down to size, invest (a.k.a. loose money for a few years)and then could survive another two or three decades. If the Banksers have there way Dell will be a Shell within five years.

Posted by tmc | Report as abusive

I think fxtrader7 has the right take on this. Basically, it’s a liquidation play. Dell, for all its flaws, is an operating company with decent financials. Sucking the life out of it and leaving an empty husk is good business.

Posted by Kaleberg | Report as abusive
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