Original URL: https://www.theregister.co.uk/2013/02/07/dell_lbo_what_next/

Friends with money: Dell's big bet on private finance

Memo to Michael: Don't be like HP

By Gavin Clarke

Posted in Business, 7th February 2013 11:19 GMT

Analysis If not a gambler, Michael Dell seems certainly a born showman. With his 50th birthday on the horizon, when most people his age and with his billions might be thinking of slowing down or going philanthropic, he and his PC company have begun a brand new phase.

Dell, a native of the brassy US state that lends its name to a brand of poker, has gone all in on his company's future, hitting up private investors for $24.4bn to take back control of his company - the world's third largest maker of PCs - by buying out investors.

It's another bold move for Michael Dell, who started the PC company in his University of Texas dorm room; became the youngest CEO on the Fortune 500 in 1992; stepped down in 2004; and then took back back the CEO's post in 2007 to save Dell from drowning in its own direct PC business.

Today, however, Dell's doing more than simply launching or expanding his company: he's re-inventing it using a plan that should - at the least - overhaul the signature Dell PC business that helped him make his billions or - at the most - see a complete sell-off of that PC business.

After years of expansion into servers, networks, software and services, it's PCs that remain Dell's single biggest concern and that's a problem because PC sales and profits are falling - right in line with falling results across the entire PC sector. And that's all thanks to tablets and smartphones.

Job number-one for Dell is to stop the company that bears his name from being dragged to the same graveyard - whether by an unwanted product line or by a structure and culture incapable of change, as was eventual cause of death of the legendary Sun Microsystems.

Will Dell succeed? That's the gamble. The competition has already - publicly - cast its judgment.

Hewlett-Packard, which knocked Dell out of its top slot as world's largest PC maker some years back, is already crowing over what it sees as the lead-up to the demise of its arch competitor. HP reckons Dell's made a big mistake in bringing in billions of dollars of loans from private equity, because that money has to get paid back from somewhere - and HP reckons it knows from where: product development.

"Leveraged buyouts tend to leave existing customers and innovation at the curb. We believe Dell's customers will now be eager to explore alternatives, and HP plans to take full advantage of that opportunity," HP said.

Risk and reward

Yes, the decision to bring in private capital and load the company up on debt is a risk, and it's all so very 2007. We all know the stories of the equity boys who load companies up to the gills with debt before trying to flip them to cheap buyers to make a return. Going private is a calculated gamble for Dell, but it does have a payoff.

By coming off the stock market, management is freed up to make changes removed from the advice, influence and opinions of investors and the markets - places concerned by quarterly profits.

Dell will also be free to enact changes that won't yield short-term returns and that could also be regarded as wrong by a Wall St that has its own set of priorities. Dell can do almost anything from developing new products to swinging the layoffs axe. And while the latter is guaranteed to hurt a company's stock, the former is is not actually guaranteed to help, as Microsoft's found on Windows 8.

For an object lesson in how staying public hurts, look at HP.

HP, like Dell, is also going through major challenges and changes as sales of PCs fall to some kind of new normal - a normal where PCs must co-exist with tablets and smartphones as form-factors for mass computing. But HP is playing out its changes in public - at great cost to its stock price and to its everlasting embarrassment.

Back in 2011, when HP's former CEO, Leo Apotheker, revealed his business transformation plan involved selling the PC business and buying UK search company Autonomy, HP's stock tanked from $32.32 to $23.60. A U-turn followed, and the board recanted on the PC sale, but buying Autonomy a decision that's turned into an open wound, while Apotheker was dumped for Meg Whitman.

What should we expect to happen to Dell behind the private veil?

Sale of the PC business, or a massive restructuring, is certain. Interestingly, Dell decided to go private in August 2012 on the heels of a second-quarter bashing that saw falling revenue and profits - down 8 and 18 per cent respectively.

When private equity steps aboard, it wants a return and a return is best achieved through growth, sale or an IPO - and it's the last option that often represents the best return.

Dell's investors will want to ensure the highest value for a Dell IPO - the kind of value attached to the stock, capitalisation and "enterprise value" of the likes of Apple and Google, not the value associated with being a lowly PC maker, which is vulnerable to the recent incursion of tablets. Dell's stock price has dropped 40 per cent in five years, from around $40 per share in 2008 to about $15 today.

Dell has plenty in reserve for investors should they want a better valued company. The company has expanded into services, software, cloud, networking and printers - but with varying degrees of success. Look at that portfolio today and what you witness is uninspiring and unexciting.

Take software. Dell's looking more like an IBM, Computer Associates or Hewlett-Packard - with end-point, applications and systems management - rather than a Salesforce or an Amazon. Tellingly, the head of Dell's software business is an ex-CA man. On the hardware side, meanwhile, Dell has a successful server business running the data centres of web-scale operators like Microsoft's Bing.

Going private would give Dell the opportunity to offload and reboot, to reorganise and present a new operation free from the negative connotations of the PC present.

Another DoubleClick?

If you doubt the power of private equity to reinvent a company that's looking for somewhere to go next, then look at DoubleClick - a once relatively unknown internet advertiser and data management business.

DoubleClick was a private operation bought by Hellman & Friedman for $1.1bn in April 2005. Hellman & Friedman sold DoubleClick's Abacus data management business to Alliance Data Systems for $435m a year later before unloading DoubleClick's ads biz on Google for $3.1bn. The Abacus sale was vital because, with Abacus, DoubleClick was thought confusing to customers - something that helped DoubleClick's competitors.

Dell might be saddled with a falling PC business but it still has possibilities for its new investors. And, fortunately for Michael Dell, the business is cash-flow positive, meaning it already as the money engines in place to generate payback. They just need tuning.

The Register spoke to Alex Noton, founder and managing director of Hampton Court Capital. The MD, who has more than 15 years matching Silicon Valley companies to investment, told us Dell's investors will have seen Dell's possibilities. "They [private equity] don't buy failing companies - it doesn't make sense. They buy companies that are strong and have good growth prospects but may need restructuring so [the VCs] could help in reshaping the business," Noton said.

So what comes next?

In the short term, the deal must be closed - that's scheduled for August, at the end of Dell's Q2. We're now in a 45-day period when Dell must solicit and entertain competing offers. Theoretically, anybody can step in and must be entertained but the likelihood of this happening is small. The Lenovos and Samsungs are doing well enough without absorbing Dell. It might take somebody like an Oracle - the database giant that bought Sun in 2010 - to make another unexpected, entirely left-field opportunistic bid. In the case of Sun, Oracle's CEO Larry Ellison coveted Sun's systems business to put his database on high-performance Unix boxes.

It's almost certain that ambassadors for Dell had already reached out for such deals before the decision to go private, and came back with nothing.

Once there is an agreement, it'll be over to shareholders who must approve a deal - a deal that would, likely come with the recommendation of the board. The Silver Lake deal will give stockholders $13.65 for each share, a 25 per cent premium based on Dell's closing price of $10.88 a share on 11 January 2013.

At this stage it's unknown whether shareholders will approve or hold out. Certainly, one name stands out: Southeastern Asset Management, the largest outside holders of Dell stock. Southeastern has a history of shareholder activism - it was the company that finally gave up on years of losses at Sun and pushed the systems giant into acquisition by Oracle to "realise the true economic value of the company."

In addition to getting shareholder approval, Dell must also get the nod from regulators before it can stop being traded as a public company and return to private hands.

If approved, the day-to-day running of Dell will likely go unchanged as Michael Dell remains in position. Noton tells us equity types like to keep company founders and senior management in place rather than replace them. VCs are not, after all, experts in running the business and will want to ensure the engine they've inherited doesn't stop bringing in the cash.

There are exceptions. Kevin Ryan was DoubleClick CEO for nine years, taking it from 20 people to 1,500, but he stepped aside when Hellman & Friedman stepped in.

Noton explains the types likely to get involved with Dell. "They are finance guys but you get very sophisticated operationally focused private equity firms that deliver more than financial capital, so [they] will be involved in strategy for the business and input in helping the company build relationships and bring onboard other management teams," he told The Reg.

What will $2bn buy Microsoft?

There is a wild card: Microsoft, since the world's largest software company is taking a $2bn stake in Dell. For its loan, Microsoft will want a say in what Dell does next and this is likely to mean trying to exert its influence to ensure Dell continues stamping out PCs running Windows, particularly tablets running Windows 8. PC makers completely ignored its advice before Christmas on how they should build Windows 8 tablets, and it might want another shot with Dell.

In a statement on its investment, Microsoft told The Reg that it is committed to the long term success of the "entire PC ecosystem and invests heavily in a variety of ways to build that ecosystem for the future".

A spokesperson added: "We will continue to look for opportunities to support partners who are committed to innovating and driving business for their devices and services built on the Microsoft platform."

If Dell is serious about a reboot then it should resist listening too much to Redmond. The PC market is viable - otherwise private equity wouldn't have stepped in, as it needs the cash from the engine to help recover the debt. What's unknown is: viable at what level of sales, as we haven't hit bottom yet.

Meanwhile, Microsoft's advice on what sells has proved flawed: Microsoft encouraged PC makers to make tablets that maximised touch in Windows 8 but PC makers tell us this would have meant producing high-end Ultrabooks that would not have sold. That's because customers who aren't buying Apple are buying devices running Google's Android instead - not Windows. Android devices, unlike those running Windows 8, are selling in vast numbers. This is because Android, unlike Windows, doesn't come with a per-device or volume licence charge that eats into its margins. Android is also starting to appear on laptops from Dell's rivals.

Perhaps the best Microsoft will do is secure a stake for Windows at Dell alongside Android. Or, get the inside track on the sale of Dell's PC biz ahead of competitors to stamp out more Windows 8 PCs and tablets.

Ultimately, there's no guarantee Dell's bet will pay off. Leveraged buyouts don't always work: telecoms company Avaya was bought by Silver Lake in 2007 for $8.2bn - growth had slowed and Avaya was saddled with a legacy phone business. Under Silver Lake, Avaya bought Nortel's Enterprise Voice and Data business and filed for a $1bn IPO in 2011, but its revenue has fallen and its chief financial officer has gone, meaning the IPO hasn't materialised. A successful business, but not successful enough for its masters, it seems.

And by bringing in equity, Dell risks slowly succumbing to the agenda and goals of a different set of moneymen, this time without shareholders or the existence of a public and regulated environment to constrain them.

But Private equity does enable Michael Dell to retreat from the market and keep his cards close to his chest for a reboot that takes his company in a new direction. Dell won't disappear in private hands but it will change. The question is to what degree and if that's enough for all concerned. ®