Valuing Dell

With rumors of a private equity buyout, the price of DELL surged to hit a high of $13.24. Then, amidst skeptical reports from pundits that still view DELL as a PC company, the stock has sold-off today to trade in the mid-$12s. Personally, I believe the pundits are wrong.

My view has been that the most significant problem for DELL and its stockholders is the fact DELL executives have done a poor job articulating the message that DELL is no longer a PC company.

DELL has successfully restructured its business model and should now be viewed as an Enterprise Ecosystem company. Selling PCs is a part of this model, but most certainly not the core of the model.

However, unfortunately for DELL and its stockholders, that clear fact has not been embraced by the analysts covering DELL.

I've previously presented two pieces of evidence supporting my contention that DELL has changed its business model and should be viewed differently.

If we go back a dozen years to when DELL was the undisputed worldwide king of the PC sector, DELL recognized revenue when it shipped a product and deferred only a very modest reserve for warranty issues. As DELL moved to a more enterprise centric business model the amount of deferred revenue increased substantially and it is now clearly broken out in current and non-current liabilities.

The two primary contributors to this deferred revenue are long term service contracts and software. At the close of the November 2, 2012 ending quarter deferred revenue totaled just shy of $8B, or nearly 60% of DELL's reported revenue for the quarter.

Only four years ago total deferred revenue was less than 37% of reported revenue. This is a clear indication there has been a change in DELL's business model.

The fact that deferred revenue has consistently grown quarter to quarter is a clear indication that whatever has changed is probably positive.

The second piece of evidence supporting my contention that DELL operates today with a substantially different business model than it has in the past can be seen in its gross profit margin profile.

During the 10 years prior to the quarter that ended in October 2010, DELL only once reported a gross profit margin above 20%. However, beginning with the October 2010 ending quarter DELL has consistently reported a gross profit margin in the low to even mid-20% area.

If DELL is in fact a PC company, like it is presented to be by the pundits, and the PC market has been lackluster as we all know it has been, then why has DELL's gross profit margin gone up so much? As I see it, the answer to this question is self-evident - the pundits are wrong or at least missing something important.

Following its report for the November 2, 2012 ending quarter, Wall Street sold off DELL with a vengeance. When we published our last for the quarter DELL was trading at only $8.86, which represented a valuation multiple of only 4.6 times DELL's forward earnings plus my estimated balance sheet value of $0.75 (considerably less than DELL's net cash value).

Based on my view of DELL, I wrote in that report DELL's full value price was $14.75 - a 66.5% premium to DELL's then current price. Personally, I continue to view DELL as being worth $14.75.

While I could rationalize a higher price based on DELL's positioning and strong cash flow that aligns well with DELL's reported earnings, I think given the 66.5% premium from the price last November when I assigned the full value target, that is about what it would take to get a deal done.