Investors have been waiting for Dell Technologies Inc (NYSE:) to sell its shares in VMware Inc (NYSE:) since personal computing giant bought EMC in 2016, and have been waiting for a fully independent VMWare EMC since it bought it in 2003 That happened last week, when Dell completed a full spin-off of VMWare. The companies have an ongoing sales agreement and Michael Dell is the independent chairman of each company, but VMWare is ultimately on its own.
Dell shares after VMW are still an attractive investment. Dell combines a legacy storage company – EMC – with a legacy PC company, which seems unexciting in a world of cloud software and super-powered phones and wearables. It has also gained 130%+ in recent years leading up to the spin-off, outperforming both the Nasdaq and the S&P 500.
Yet the current price of around $56/share is reasonable. Dell was founded to deliver solid shareholder returns.
Note: This Investing Pro chart is adjusting for the VMW spin-off, which took place on November 1. (ISG) and Client Solutions Group (CSG). ISG is closer to legacy EMC and offers storage, servers and network services. This company has historically achieved an operating margin of approximately 11% and has grown 2% since the year ended January 2018, the first full year Dell had EMC. The growth of cloud storage, such as Amazon Web Services or Microsoft's Azure, has stolen much of the old EMC business.
ISG took a bigger blow from the pandemic as infrastructure spending slowed, and so has more room to recover – up 3.5% so far this year. Dell is targeting stronger growth in this segment, at a CAGR of 3-5% from the current fiscal year (we are in FY 22, which ends in January).
I'm not going to pretend I have the nuances of the server industry's growth, but it seems likely that the need for compute will increase over time and that there will be a need for more than just public cloud solutions from the top three or four players. This seems like a reasonable goal for Dell to achieve.
The other segment is the Client Solutions Group, which you will likely encounter by purchasing a Dell PC. This saw a major Covid-related surge as people went out and bought new laptops and other home office hardware. CSG realizes an operating margin of about 7%, although it has been in the range of 4-5% for a few years. This is a fairly mature industry, with established competitors such as Lenovo (OTC:) and HP (NYSE:), and the pandemic period seems particularly abnormal – CSG grew 23.5% in the first half of this fiscal year (February-July 2021 ), vs. a CAGR of 6% since 2016. So we have to consider the risk of a hangover as we can only replenish our home office so often. Dell's target is 2-3% growth from FY 22-FY 26, which is essentially on par with their H1 run rate (as last year's growth is as a base).
(Dell has an "other companies" line that includes Secureworks Corp (NASDAQ:), Virtustream and the soon-to-be-sold company Boomi, and the results of this unit "are not material to the company's overall results." We come back to Boomi, and Boomi alone, in a second).
The bottom line is that Dell will not be a fast grower. They have spawned both their fastest growing and highest margin business in VMware. Dell is still worth considering as an investment for what it already is and how the spin-off will impact its legacy business.
The Bull Case
Cleaner Balance Sheet
One of the challenges in understanding Dell before its (expected Nov. 23), and one that will continue into the next 10-K, is sorting VMWare's financials from Dell's legacy financials . Q4 will be the first 'clean' quarter.
This shouldn't be a problem, except that Dell's financials involve a lot of adjustments. Take the balance sheet, which should be much better in the near term, as VMWare paid Dell a $9.3 billion dividend as part of the spin-off. According to pro forma figures as of July 30, Dell's net debt (current debt + long-term debt – cash and cash equivalents – long-term investments) drops from $30 billion to $21.15 billion. Then there's Dell's financing-related debt, which is debt backed by receivables and broken down as non-core debt. The company's investor day pegs that at $10.3 billion in debt. I can only repay the short and long term financial receivables to get more or less the same number. That reduces the net core debt to $10.9 billion.
And then there's Boomi, who Dell agreed to sell for $4 billion in a deal to close by the end of the year (according to the original press release) or October (per the latest 10Q). I haven't seen a press release announcing the close of sale, and Dell hasn't bothered to have anything to do with it in their pro forma accounting, but if it's not material to the bottom line and $4 billion in the balance adds sheet, the better. That would drop the net core debt to ~$7 billion, although I presume there is a risk of being taxed.
All this to say that $7 billion for a company that has earned $2.9 billion in GAAP net revenue over the past 12 months and more than $6 billion in free cash flow isn't heavily indebted. Dell is aiming for an investment grade rating, which would lower interest costs. We should already be seeing interest savings from the debt service. And lower interest charges and a strong balance sheet also lead to…
Capital return
Dell set out two principles in their Analyst Day pre-spin-off. They plan to pay a dividend of $1 billion per year in the first quarter of 2023 (real world February-April 2022) and have already embarked on a $5 billion buyback plan since the spin-off. Over the longer term, the company aims to recoup 40-60% of their Adjusted Free Cash Flow, while aiming for 1.5x leverage and that investment grade rating.
Source: Dell's Analyst Day Presentation
The dividend, at the current number of shares of 810 million, is $1.23/share per annum, or approximately 2.2% at the current range of ~$56/share. The buyback is not trivial for a company with a market cap of $45 billion, neither the first snail nor the revolving buyback, which should be $2.5 billion to $3 billion a year.
We won't see that $7 billion net core debt given these efforts, but it's a sign of what a stronger company can afford.
Operating leverage
Dell targets 6%+ EPS growth with 100%+ conversion to free cash flow versus 3-4% overall revenue growth. Given that the company's operations have been refocused, this seems like a reasonable target. The savings on interest costs should flow into the bottom line fairly directly, and I would expect some room to improve operations/costs, especially as supply chain problems diminish.
Management
This is perhaps the most controversial. Michael Dell, Dell's chairman and CEO, has earned credibility for his business instincts, as well as a reputation as always willing to put shareholder interests aside. His takeover of Dell in 2013 and his antics around VMW tracking stocks in 2018 each led to legendary battles with investor/shareholder activist Carl Icahn.
Since he made Dell public again, he has been in contact with shareholders and the performance has been good. Dell's outperformance can be attributed to some degree to pandemic tailwinds in technology, but the VMWare spin-off played no small part either. Dell remains a major shareholder in its eponymous company (and the chairman of VMWare, now a separate matter). Dell is 56 and together with his wife own more than 50% of the total shares in Dell. I don't see why he won't stay motivated and eager to build on this recent success.
I have already brought this up. While we can expect tech spending as a whole to grow secularly, the PC rush of the past 18 months is unlikely to continue. Dell's longer term guidelines suggest they understand the headwinds for CSG.
But the market may not have priced it in. Dell's guidance for the third quarter was for high single-digit sequential sales growth from CSG, defying typical seasonality. Supply chain issues may be helping Dell to smooth out the peak of their revenue growth, but at some point they will lead to a meaningful slowdown in CSG and the market may not be prepared for this.
The accounting is funky
Dell reports adjusted earnings, with adjustments primarily due to amortization of intangible assets (60% of last year's adjustments), share-based compensation (20%) and other issues such as purchase accounting (20%) . I'm not a big fan of adjusted earnings, but it's what both Dell and the street focus on, so that's a grain of salt to consider, and it makes a big difference: $6.05/share in non-GAAP net income vs. $3.56 /share of GAAP income.
All the math in this article is based on the pro forma figures provided by Dell around VMWare, and there are a lot of puts and takes that will manifest in the next 10Q and especially the next 10K. This adds a degree of uncertainty to the analysis as these pro forma figures translate into actual business performance.
It rolls into the free cash flow number. At Dell's Investor Day presentation, there were few adjustments to free cash flow – they started with the reported cash flow statements of their filings, pulled the numbers from VMW, made a small adjustment around operating leases and added a benefit from lower interest savings. I wouldn't have added the latter like they did, but it's fair to mention that.
Dell tends to take advantage of working capital as a source of funding, which can be erratic from year to year. Between that fluctuation and the picking up of the pandemic versus gears, it can be hard to say where to start with a valuation of Dell. The company uses an adjusted free cash flow of $7.4 billion as a basis, after the series of adjustments in the previous section. I'm starting with $6.5 billion, Dell's free cash flow minus VMW's. Whether that is further inflated by the current circumstances remains to be seen for our valuation. think it is necessary to build out a fully discounted cash flow model. Dell would like to point out its 8x TTM gain multiple, which is great, but non-GAAP, so I'd rather not use that either.
Instead I just want to capitalize the free cash flow number. If I use my $6.5 billion and assume zero growth, a 10% discount rate gives me a terminal value of $71 per share, more than 27% upward before taking into account reductions in the number of shares or dividends (while you the $7 billion in core debt). If I use $5.2 billion, the company's FY 2021 number, and zero growth, I get the current stock price. From there you can work out the scenarios.
To check my sanity, I also pulled up Dell's Fair Value in Investing Pro. Although analysts are a bit more conservative, the quantitative models in Pro also point to a positive development:
P/B multiples make sense since Dell has no positive stock value. The 5Y DCF Growth Exit is the closest thing to what I would build myself, although each modeler will use slightly different inputs.
As a final check, if you plot the midpoint of the company's revenue growth target in each segment and apply 11% operating margins to ISG and 7% to CSG, you get $8.2 billion in operating income. Using Dell's estimate of $1.2 billion of cash interest at current levels, we have a pre-tax income of $7 billion; apply a 25% tax rate to be conservative and we get an income of $5.25 billion. That's $6.47/share of GAAP revenue in 2025/FY 2026, with some conservatism built into the estimate of interest, tax rate, and number of shares.
Maybe that won't get a huge multiple, but the current GAAP multiple is 15.7; apply that to $6.47 and you get $102/share. Icahn and again thousands of shareholders, then deliver solid, albeit macro-driven, results.
After Dell released its crown jewel for market independence, it is still a reasonably priced stock with promising prospects. That outlook doesn't bring growth and excitement on Day 1, but instead a lot of free cash flow that should go into equity and be paid out to shareholders. At the current price, I think Dell has attractive risk/reward, and I look forward to getting more Dell stock when it hits the low $50.
