Tuesday, February 12, 2013

Michael Dell's Conflicted Buyout

Let’s say that you are interested in selling your house and hire a realtor, and that the realtor comes back with what she says is the “best” offer for the house, forgetting to mention that she is the buyer. I would assume that you would be screaming about conflict of interests from the rooftops, right? Now, let’s change the story a little bit. Assume that you are the CEO of a publicly traded company that has been targeted by a group, interested in buying the company. Your fiduciary responsibility to your stockholders, if you decide to sell, is to try to deliver the “highest price” that you can get from the potential buyers. But what if you are also heading the buyout group that is trying to buy the company? The conflict of interest you face would be untenable, since you would, as the lead buyer, want to pay the lowest price. That is, of course, the problem in any management buyout and the issue has risen to the surface with the announcement by Michael Dell, CEO of Dell, that he would like to take the company back private for $13.65/share; that would translate into a $24 billion bid for the company, with about $15 billion coming from debt. Dell will be augmenting his 14% stake in the company by investing more of his wealth but he will joined as an equity investor by Silver Lake, a private equity firm. 

The standard "management" defenses
So, how do managers in a management buyout defend what seems to be a flagrant conflict of interest? They offer one of three arguments:
  1. The “fair value” fig leaf: The managers will hire appraisers/investment bankers to value the firm and ensure that investors get a “fair” value. In fact, the board of directors at Dell will (and Silver Lake) have a bunch of investment banks (JP Morgan Chase is the lead bank but it looks like a whole nest of investment banks is involved in this deal and it is unclear who is doing what, though they are all getting paid) that they can draw on  to make this judgment on whether the offering price is a fair one. Without casting any aspersions on the valuation capabilities of these investment banks, there is no chance that any of them can deliver unbiased opinions, when so many fees ride on this deal getting done. Will they deliver a value called a fair value to justify the deal? Of course, but that value will be a “legally defensible” value, not a fair one; the gap between the two is a wide one. 
  2. The “market is right" and "we are paying a premium" kabuki: It is amazing how quickly managers in management buyouts discover the wisdom of markets. As Dell will undoubtedly point out, “if markets thought we were worth only $11/share a few weeks ago, you should consider yourself to be lucky to get a premium on that price”. Interesting argument, but the market price, even in an efficient market, is based on the information that is available about a company, often with the company as the source for the information. The problem in Dell or any other management buyout is that the same management that is buying the company from stockholders has controlled the information spigot for the months leading up to the dal. How do we know that they have not suppressed good news and been liberal about revealing bad news leading into this transaction? I may be overly suspicious of management intentions, but that is the problem when you play both sides of the field.
  3. The “open to other offers” defense:  Managers are also quick to point out that there is time for other bidders to make higher offers for the company and that they remain open to other offers. Talk is cheap, though, and all this openness requires a board of directors that will seriously consider alternate offers and an acquirer who is willing to surmount the obstacles of a shortened calendar and antipathy from managers. To give Dell credit, it has hired another investment bank, Evercore, to find potential buyers for the company, with their fees tied to their ability to find a higher bid. I applaud Dell for at least trying to create a modicum of fairness in the process, even if the intent is to fend off future lawsuits, but Dell's board has already shown their hand in this deal, as this news story indicates.
What's so special about Dell
Now, why pick on Dell, if these are problems in every management buyout? The Dell deal magnifies all of the tensions for three reasons:
  1. It is a “big” deal, not the biggest ever but at approximately $24 billion, it does rank among the biggest.
  2. Dell is a high profile stock, widely held and extensively followed. Investors believe that they understand the company and its operations.
  3. Not every buyout has a marquee name atop the buyer board that has been so closely attached to the company. Michael Dell, who started Dell when he was a student at the University of Texas, became incredibly wealthy from Dell’s success in public markets. While he did take a hiatus from the day-to-day management of the company, he has been the CEO of the company since January 2007. During those last 6 years, Michael Dell has pushed been open about his vision for the company, and with a compliant board has spent billions in acquisitions and investments to expand the company's footprint in the enterprise solutions business. In the fiscal year ended February 2012 alone, Dell spent almost $2.7 billion in acquisitions in pursuit of his dream.
Dell's possible pitches, pitfalls and fixes
I do not envy Michael Dell or his bankers, though they will be richly compensated for their stress, because there are four potential sales pitches that they can make to investors and none of them casts the company or its management (especially Michael Dell) in a favorable light.

1. Company has made expensive mistakes over the last few years, it has not been well managed and the market is right in its recognition of those mistakes.
The pitfall: The same management that made those mistakes now wants to buy the company at a lower price that they, in a sense, caused. That looks to me like rewarding management for a job badly done. Furthermore, for the last few years, Michael Dell has been telling stockholders that these were not mistakes (and were making healthy returns). Paraphrasing a question that you hear in every political scandal, I would ask Mr. Dell: What did you know about these mistakes and when did you know them? Put more bluntly, were you misleading us about the quality of your decisions then or are you misleading us now? (Take a look at Michael Dell's annual reports to stockholders for the last few years)
A fair fix: As I see it, there are two possible fair solutions. One is that Michael Dell can take the company private, as long as he agrees to cover the cost of his mistakes. Put simply, take the money that Dell has spent over the last five years on acquisitions and investments (an amount in excess of $7 billion), charge a reasonable return (a break even where they delivered just the cost of equity) and add it to the value of the company now. In fact, Southeastern Asset Management, which holds more than 7% of Dell shares and is the second largest stockholder in the company, made exactly this pitch in a letter that they sent to Dell’s board, when they took Michael Dell at his word, capitalized his mistakes and estimated an value of $23.72 per share. The other is that since Michael Dell claims that $13.65 is a fair price for the shares, he should be willing to be bought out at that price. Perhaps, Southeastern should make an offer to buy out Michael Dell's stake at 13.65/share. If he refuses, it would indicate that this is a fair price for him to buy the company, but not to sell it.

2. Company has made the right decisions over the last few years but the market has been wrong in assessing the effect on value.
The pitfall: This creates a more defensible scenario for Michael Dell, since he does not have to admit to past mistakes or misleading investors about them, but it creates a whole new set of problems. If this pitch is true, he is arguing that the market price today is too low, relative to intrinsic value. If he is consistent with this argument, I would expect to see JP Morgan (or whoever his hired appraiser is) to come back  tell the board that the offered price is too low and that it has to be raised to a much higher number. I may be cynical, but I feel that this is not going to happen and that the investment bankers are going to come back with a valuation that justifies whatever the Michael-Dell led buyout team decides to do (even if it is sticking with the current offered price).
A fair fix: One is to have an appraiser who has no ties to the board, the managers or to Silver Lake make an assessment of value per share. To those who feel that no appraisal will ever be fair, here is an alternate one (and this is one that Southeastern Asset Management has suggested as well). Give the existing stockholders a chance to be part of the buyout deal. In other words, offer the shareholders a choice of either cashing out at the buyout price or staying on as part of the buyout team. Michael Dell could reduce the debt he needs for the transaction and will end up with a much larger piece of the company.

3. Company has made wrong decisions in the past, but it was forced to make these decisions by a “short sighted” market. Once it becomes a private business, it can make the right decisions for the future.
The pitfall: That is an interesting argument, but the onus for backing it up then has to be on Dell (the man and the company) both in terms of what has been done and future plans. Looking backwards, what is it that the market has forced Dell to do over the last few years? Did it force Michael Dell to spend money on these past acquisitions and investments that are not paying off? Did it force him to make the big bet on enterprise solutions?  If so, how did that happen? Looking forward, what is it that Michael Dell plans to do differently? And what is the basis for his claim that these actions will not be received well by the market. It does not seem fair to blame a market for reacting badly to changes he has not made or even made explicit.
A fair fix: Let us start with a mea culpa from Michael Dell for mistakes made in the past and an explanation of how the market forced those on him. He should then continue by putting forth the changes that he plans to make to the company, once he takes it private. Let the market react to these changes and he can then pay a price based on that reaction. 

4. This is not about value, price or changing the way the company is run. Michael Dell is just tired of running a company in the market spotlight, with the stresses of answering to stockholders, analysts and rating agencies. He just wants to go back to running a private business.
The pitfall: Okay, fair enough, and I feel bad for Mr. Dell, but he got his riches from playing in the same market spotlight. Is he willing to return all that cash back to the market? I know that he is investing more than just his stake in the company but how much of his total wealth will be in invested in a private Dell? Also, has he made clear to Silver Lake, his private equity partner in this transaction, that this deal is not about making money but bringing him inner peace? Finally, does he really think that the lenders who lent $15 billion on this deal will be more forgiving than stockholders of mistakes?
A fair fix: Michael Dell takes the company private, and either invests back in the company all of the gains he made from the public marketplace or gives it to charity. Also, let’s get an iron card guarantee from everyone involved in the buyout that Dell will not be going back public in 5 or 10 years. 

The Investor Choices
As investors in Dell, what are your choices? I see three possible ones, depending upon how much energy and resources you are willing to pour into the battle.
  1. The “karmic” surrender: You accept that bad things happen to good investors, and that this is your fate as a Dell investor. You will take whatever the price that is offered in the deal as your best price and move on without much sound or fury. (I know that this is is the Wikipedia version of karma and that there are deeper and more profound versions of it... So, please, please don't post to tell me that...)
  2. The Primal Scream: You have your “Howard Beale” moment, where you take the best price that Michael Dell will offer, but not before you rant and rave about how unfair the world is to investors like you. 
  3. Storm the castle:  You go for the win. You will need large institutional investors to follow Southeastern Asset Management’s lead and rouse themselves from their slumber and join in the fight. To get you started, here is are some of the largest institutional stockholders as of the last filing: T. Rowe Price (4.41%), Blackrock (4.32%), Vanguard Group (3.63%), State Street (3.58%). After all, Dell owns only 14% of the shares and you could create a coalition that could this deal. I am not a stockholder in Dell, have never been excited about the company, but I will contribute a small part to your struggle. I valued Dell, using my estimates, and arrived at a value per share of $16.38/share. You will, of course, have different views about Dell's future and arrive at a different value. Go ahead and download the model, value the company, and let’s get a shared Google spreadsheet going. Revolutions start with small protests.
Here is my sense of this deal. At $13.65/share, Michael Dell is probably getting a bargain, but I don't think it is a huge one. As a consequence, it is going to be difficult to find another buyer who will offer a significant premium over the buyout price. I also think that Dell's depleted value today is a consequence of Michael Dell's management over the last few years and it bothers me that he will be benefiting as a result of his own mistakes. If nothing else, as a Dell stockholder, I would like an honest admission from Michael Dell that the wreckage at Dell is not the market's fault but his own, and a couple of dollars more per share on the buyout price will soothe my pain a little.

38 comments:

Victor said...

Hi Prof,

Nice article. Quick question based on the DCF analysis. From the numbers the imputed marginal ROIC (i.e the change in EBIT(1-t)/Invested capital over 10 years is 1.7%. Is that not too pessimistic?

Aswath Damodaran said...

Victor,
Good point but here is why I am shooting for a lower return on capital in the future. The current return on capital is very high but it is inflated because Dell's buybacks over the last few years have shrunk the denominator (since we use book value for invested capital), not because they numerator has increased. In fact, looking at Dell's investments over the last 5 years, I would be surprised if their return on capital exceeded single digits.

Anonymous said...

Aswath
Does this mean that if you include a 30% LBO premium the price you believe it should be sold at is $16.38 +30% = $21.29 which is not that far off what South Eastern say

John said...

Should Long term investments of $2,908 not be added to cash of $11,272 for input cell B12 in Input sheet ?

Narayanan said...

Doesn't the US have a reverse book building process similar to the one in the link? Isn't such a process somewhat fair to everyone? Even if Dell finds no new bidder there will be something close to a price discovery in a reverse book building. It has it's imperfections, but when HP offered to delist an Indian subsidiary in 2003 (which is when this process first came into effect) for INR 566, the discovered price in the process ended up at INR 850. So it might be better than looking for offers for the entire company.

http://www.bseindia.com/Static/Markets/PublicIssues/aboutrbbs.aspx

Anonymous said...

Prof, This is regarding your response to marginal ROIC.

In your worksheet under diagnostics, marginal ROIC over the period is 10.59% when in fact it is 1.73%. I think EBIT is considered when EBIT(1-t) should have been. (Should have been 147.41instead of 902.38).

Could you confirm this please?


Anonymous said...

Interesting analysis, but I have a couple thoughts on the assumptions in the spreadsheet that arrive at the value of $16.38 per share.

- Assumed revenue growth of almost 4% per year seems too high for a base case. In the latest quarter, Dell's revenue was down 11% year-over-year. Revenue has declined y-o-y for each of the past 3 quarters, and at an accelerating rate (down 4%, then down 8%, then down 11%. Even if Dell's transformation works over time, I'd expect revenue to continue to decline since laptops ("mobility") and desktop PC's are 48% of latest quarter revenue;

- Cost of capital of 8.5% to 10% might be a bit low for a company in the midst of such a significant strategic transformation. I think that Dell will survive, but there's a legitimate risk that earnings in 5 years are 25% to 50% below what they are today;

- Due to the aforementioned shrinking of the PC business, there are one-off future restructuring costs to be considered (laying off employees, closing facilities, etc.) Not as big a variable for value as the prior two, but could be a meaningful amount of money over time.

Aswath Damodaran said...

I did report a pre-tax ROIC and I should have clarified why. The reason is because much of the drop you see is coming from the rise in tax rates from the current effective to the marginal. That is not a problem with new projects but a catching up of taxes due on your existing investments.

Anonymous said...

Prof, have you looked at the tax arbitrage if as a private company they could repatriate offshore cash and shield it against the interest deduction on the new debt.

Anonymous said...

The idea that Dell should "cover the cost of his mistakes" seems fallacious. If Michael Dell is in fact responsible for these "mistakes", then these are sunk costs. Is the business somehow worth more (via a higher premium) because Dell (as opposed to someone else) caused these mistakes? Would you expect a different group of buyers to make-whole current shareholders for previous mistakes and magically "un-do" value destroyed in the business?

Varadha said...

Dear Sir,

I find price discovery in a LBO based on just one reference point (viz., the starting bid) not adequate. Since, the price should be the price at which Mr. Dell is willing to sell (since he knows more info than me as an insider) and not the one at which he is willing to buy, should'nt the price be MAX (bid price, (price discovered through a reverse auction for the tendering shareholders)) ?

Anonymous said...

How interest expenses are NIL on 9 billion debt?

The Contrarian Individual Investor said...

Thanks for lending your thoughts on this deal.

Wilson said...

I love your idea of Michael Dell having to sell his stake at the price he is offering.

Vignesh S said...

Hi Prof,

Nice article, however i think certain things are not exactly going to happen in the real world!: esp Michael Dell accepting his mistakes as you call them.

Would it not be prudent to have a market appointed valuer to appraise the actual value of the stock and getting the Dell Group to accept it...this is based on the assumption that like the Securities Appealate authority in india there is a similar system in the US as well.

Where the appraised is of the same opinion on the offer price per share then no one is going to be pinched!

Vignesh

Anonymous said...

Dear Professor,

Could you please let us know why long-term investments of $2908 are not included in cash?

Also please tell us why interest expenses (marker value of debt) are not considered in computation of cost of capital.

Thanks for this.
regards
sp

Aswath Damodaran said...

Frank,
I did not use the interest expenses to compute a synthetic rating (that is the only place it is used) but I did use a pre-tax cost of debt of 3.65% for Dell, reflecting its current risk.
On the long term investments, I used the cash and equivalents from Bloomberg (which usually includes long term investments) but if they do not, I have to check the long term investments to make sure that they are, in fact, the equivalent of cash and not double counting.

Aswath Damodaran said...

Frank,
I did not use the interest expenses to compute a synthetic rating (that is the only place it is used) but I did use a pre-tax cost of debt of 3.65% for Dell, reflecting its current risk.
On the long term investments, I used the cash and equivalents from Bloomberg (which usually includes long term investments) but if they do not, I have to check the long term investments to make sure that they are, in fact, the equivalent of cash and not double counting.

QUALITY STOCKS UNDER 5 DOLLARS said...

Most of the time when a family owned company wants to go from being a public company to a private company greed is the big factor in their decision. The family cannot resist the desire to buy all the shares outstanding at a great price even if they already own better than two thirds of all the stock in the company. Sometimes lots of debt must be incurred in order for the buyout to take place. The situation being created is not in the best interest of the company. The companies credit rating may be reduced to junk bond status. And yet this type of thing occurs again and again.

Anonymous said...

Dear Professor,

Thanks for the response on both interest expenses and long-term investments.

1) As per 10Q: Cash includes cash 10991 + ST investments 281 + LT investments 2908 = Total cash would be 14180.

2) Interest expenses: Under cost of capital worksheet - To compute market value of straight debt you convert both interest expenses and principal value of debt to present value at pre-tax cost of debt. Since there is no interest expense the present value is shown at 7551 which is present value of only principal. If interest expenses of 157 were included (in cell B13) the market value would have been 8257. Cost of capital would change from 10.36% to 10.31%. This is hardly any change. But I would really appreciate your response on whether what I have mentioned is correct.

Thanks once again.

regards
sp

marcos bakerm said...

Michael Saul Dell (born February 23, 1965) is an American business magnate, philanthropist, and author. He is known as the founder and CEO of Dell Inc., one of the world’s leading sellers of personal computers (PCs). outsourcing services

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marcos bakerm said...

one of the world’s leading sellers of personal computers (PCs). He was ranked the 41st richest person in the world on 2012 Forbes Billionaires list, with a net worth of US$15.9 billion as of March 2012. web development

marcos bakerm said...

In 2011, his 243.35 million shares of Dell stock were worth $3.5 billion, giving him 12% ownership of the company.[2] His remaining wealth of roughly $10 billion is invested in other companies and is managed by a firm whose name, MSD Capital, incorporates Dell's initials.latest technology

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QUALITY STOCKS UNDER 5 DOLLARS said...

A lot of buyout deals are designed in a way to prevent or keep other potential suiters from making a much better offer for a company. Private equity firms will play lots of dirty little tricks to keep from having to pay a higher premium. The valuations of a lot of companies is often very difficult to determine. Valuation can be very subjective.

Anonymous said...

Thank God for Carl Icahn!

Anonymous said...

How is value created from Icahn's proposal which he suggests is worth almost $23 / share? I am struggling with this.

I get that shareholders receive $9 from the special dividend. Of course, this will be worth something less than $9 for many investors after paying personal taxes. The dividend will be financed with new debt and existing cash (much of it offshore and subject to tax if repatriated).

Icahn says that post dividend the shares will be worth almost $14 - I don't know how he comes up with this number.

After the dividend is paid, the shares are worth price - $9. And the equity is riskier now due to the recap. So how does Icahn get a value of almost $14 post dividend?
Is it that there is a substantial discount on Dell's cash holdings that will be eliminated? Will the new debt will create tax shields worth a substantial amount? Is it that the recap will solve some agency issues that are lowering the value of the equity?

Anonymous said...

thanks for share.

Nirajan Joshi said...

Respected sir,
I am from India doing the chartered accountancy course.
I have learned a lot from you.
It's because of you, I did a lot of project on valuation.
I learned what stock market is.

You are my god.
Thanks a lot professor Damadoran.

Nirajan Joshi

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SpoiledRottenBrat said...

Dell and some Silcon Valley venture capital firm with deep pockets used a Cayman offshore company to shelter a lot of money.

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