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Big Dell shareholder says LBO is 'woefully inadequate'

Southeastern Asset Management fumes as Dell the man has little skin in game

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The price that something is worth is not what you can come up with in some spreadsheet, but rather the price that someone will pay for it.

That was a hard lesson for Southeastern Asset Management (SAM) to learn when it heavily invested in Sun Microsystems before it was ultimately sold to Oracle, and this could turn out to be yet another hard knocks schooling for SAM as it has amassed an 8.4 per cent stake in Dell, which is in the middle of the largest leveraged buyout since the Great Recession started five years ago.

Rumors of SAM's displeasure with the Dell LBO plan were circulating early last Friday, and later that day SAM kick out its official ownership stake filing with the US Securities and Exchange Commission, showing that it hold 8.5 per cent of Dell's outstanding shares, making it the largest holder in shares of Dell, the company, aside from Dell, the man, himself. SAM also put out a separate statement to the Dell board of directors, expressing its "extreme disappointment" the go-private deal that Dell, the man, has put together with his own stock and cash, Dell's own share buybacks, a loan from Microsoft, equity from Silver Lake Partners, and financing from Bank of America Merrill Lynch, Barclays, Credit Suisse and Royal Bank of Canada Capital Markets. The deal calls for shares to be bought back for $13.65 a pop, which is a 25 per cent premium over the price they were at on January 11, which was the Friday before the rumors of the deal broke, and that works out to $24.4bn.

Before we get into SAM's displeasure for the proposed LBO of Dell, the company, let's take a quick spin through the 8K filing that was filed with the SEC providing some of the details that were not given out in the statement announcing the LBO deal on February 5. Because Michael Dell does not has much skin in this game as many of us were led to expect when the rumors were crystalizing in the days before the deal was announced. And that is not a good thing, even if Dell does stick around to run the company in the wake of the LBO, should it actually be approved by shareholders.

The banks are providing: a $4bn senior secured term loan B facility; a $1.5bn senior secured term loan C facility; a $2 billion ABL facility; senior secured interim loan facilities consisting of a $2bn first lien bridge loan facility; a $1.25bn second lien bridge loan facility; a $1.9bn term commercial receivables financing facility; and a $1.1bn revolving consumer receivables financing facility. (Did you get all that?) Add it all up, and it is $13.75bn. Microsoft is ponying up $2bn of subordinated notes, which is a complicated way of saying it is a loan. Silver Lake will capitalize the LBO up to $1.4bn, which is a mere 5.7 per cent stake. So this is not huge skin in the game, either.

The real skin in the game is the overseas profits that will be capitalized to help pay down this debt as well as other debts the company has, and the siphon off the cash flow of Dell, the company, that will be used to service the debt. It is not clear how this is going to work yet. Dell doesn't hold its conference call to talk about its financial results for its fourth quarter of fiscal 2013 ended in January until February 19, so we don't know how much cash and debt Dell has at the moment. What we do know is that in Dell's third quarter ended in October, the company had $14.2bn in cash and short-term investments and just over $9bn in short and long-term debts. You can't just subtract those numbers because repatriating a big chunk of that cash means paying corporate income taxes on it to Uncle Sam.

So how much is really at stake for Michael Dell, besides his reputation as a whiz kid of IT? As it turns out, not very much.

MSD Capital, the separate investment arm of the Dell family, has around $12bn in assets under management, and if Dell, the man, was pledging his entire fortune as collateral against the loans to buy back shares plus rolling in his existing 14 per cent stake in the company, then that would be a powerfully strong statement about how the company's founder feels that Wall Street is not properly valuing the company.

But, then again, and perhaps luckily for Dell, he is not pledging his fortune, but rather only $500m for an additional equity stake from his personal fortune (presumably what is in the couch cushions) and another $250m in equity from MSD Capital. Add it all up, and at the striking price, you are talking about $4bn of skin. But those shares owned by Dell, the man, were pre-existing and he already has his jobs as CEO and chairman. So he is not really risking much. And let's face it, $750m is not a huge deal for the Dell family, either.

Let me illustrate. If you had $1m in assets saved up for your retirement as you were instructed to by your accountant, this would be roughly equivalent to you blowing a chunk of it to buy a pair of Toyota Prius Three hybrid cars.

You see, if Dell had pledged his fortune as well as his sacred honor, then he would perhaps make exactly the kind of strong argument that SAM itself is making that not only is Dell undervalued by Wall Street, but also by the takeover bid itself. Company founders doing a privatizing LBO always want to do them at the bottom, and large stakeholders just hate, hate, hate that because it makes them look like they are suckers.

The LBO deal glass is half empty

SAM makes a compelling argument that the LBO price is way too low, and it is an argument that Dell, both the company and the man, will have a tough time ignoring. Particularly if other shareholders start chanting the same tune.

Here's how the math goes. Since Dell, the man, took over as CEO in 2007, the company has spent $13.7bn on acquisitions and they yield an internal rate of return of around 15 percent, according to Dell CFO Brian Gladden. Dell has not written down any of these assets, and therefore SAM says that they are worth $7.58 per share. Dell Financial Services, SAM says, has a book value of $1.72 per share and yields net cash per share of $3.64 after taking out its structured debt (which is used to finance IT gear, software, and services for customers). That gets you to $12.64 per share of value right there. So the entire rest of the company is worth 71 cents per share at an LBO price of $13.65 per share.

"By any objective measure, that is woefully inadequate," SAM said.

Now, let's look at PCs and servers. SAM says that the PC business generates somewhere on the order of $27bn of revenue and around $1.3bn of operating profit at the moment. "While we could accept the most bearish case in assuming the 'death of the PC,' this business is certainly worth more than zero," SAM wrote in its analysis. "Even the PC's harshest critics would accept that the PC will be around for more than a few years. A multiple of operating income of 4 gives this business a value of approximately $5.0bn, or $2.78 per share." SAM said that Lenovo, which is predominantly a PC company with a net income of $700m, has a market capitalization of $11bn. The Dell software and peripherals business, which is closely aligned to the PC business, is worth another $1.67 per share, with a value of $3bn and a multiple of under seven times operating income.

That leaves servers and services. SAM estimates that the commercial and bespoke PowerEdge server businesses are together worth an easy $8bn, which works out to $4.44 per share, and that excluded SonicWall, Wyse, and Quest Software, which are in the acquisitions mentioned above. Dell's services business has revenue of $4.8bn, SAM approximates, and could produce at least $1bn in operating income. And thus with a multiple of seven, that makes it worth $7bn, or 3.89 per share.

Cut out the Dell Financial Services value embedded in the various Dell units, which is around $1 per share, and cut out another $1 per share for unallocated expenses, and SAM says the number is more like $23.72 per share. And that, when you do the math, is more like $42.4bn to do the buyout.

SAM says it makes more sense to repatriate the cash, which would raise about $9.25bn, plus the $2.2bn in free cash flow that the company is capable of generating. The asset manager and dominant stakeholder also suggests selling off Dell Financial Services for $3.1bn, borrowing another $9bn, and a few other financial tricks to generate as much as $11.86 per share in a special dividend. This would be option B.

With option A, Michael Dell and Silver Lake load up Dell with debt to buy control of the company, and with option B you sell off assets and borrow money (at 7 per cent interest mind you) as SAM wants to do to give it to shareholders. So this would presumably raise the Dell share price temporarily to the $24-ish per share, companies like SAM and others could cash out and also get the actual dividend. And then, we ask, after all this is done, what Dell shares be worth? What force of economics or nature would keep Dell, the company, from crashing after that?

Perhaps it is best to never go public at all and keep a majority stake of the company you founded. But, Dell, the man, has his billions safely tucked away in MSD Capital, so he will be alright, no matter what. It is the other Dell – the company – that you need to worry about. ®

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