Dell Technologies: Too Expensive?
Dell and the EMC M&A Deal Over a year has passed since Dell’s announcement about joining forces with EMC in a merger deal. To finance the deal, Dell issued secured bonds worth $20 billion (altogether 6 issues with a fixed rate and maturities ranging from 3 till 30 years). This is how Dell Technologies (NYSE: DVMT) was officially formed in September 2016. This deal has become the largest M&A transaction in the IT sector at a total value of $67 billion. This strategic step was taken to consolidate powers. @Dell is one of the largest PC producers in the world using a unique operating model based on the personal client-focused approach. EMC has experience in creating data storage systems. A large chunk of the former @DellEMC business is now used by @DellTechnologies in the form of @VMware (NYSE:VMW) with its software and visualization services. Dell Technologies’s main strategic focus is cloud products and services. This sector is a growth driver for many companies in the IT industry. The most notable IT vendors in this niche are @Microsoft (NASDAQ:MSFT), @IBM (NYSE:IBM), @Amazon (NASDAQ:AMZN) and @Google (NASDAQ:GOOG) (NASDAQ:GOOGL), whose revenues are not comparable with Dell’s. The cloud segment is the fastest growing operational area within the company, as you can see in the next part. Financials We are going to start by analysing the company’s revenue structure and other key metrics. The company reports its operations across three main segments: Client Solutions Group (NYSE:CSG) Infrastructure Solutions Group (ISG) VMware The first segment derives revenues from the sales of Dell’s branded hardware, software, security, and other support services. ISG’s revenues come from data center infrastructure and business services. VMware is Dell’s comparatively new business and includes virtualization software and cloud infrastructure solutions (the fastest growing market segments, as was mentioned above). In fiscal 2018, on the basis of VMware’s and Amazon Web Services’s (AWS) cooperation, Dell Technologies is going to provide its clients with private, public, and hybrid cloud environments. This segment includes vCloud Air Network, a global cloud ecosystem, with over 4,300 cloud providers like IBM. The historical financial data have been distorted by the EMC merger: the consolidated company’s revenue and gross profit demonstrated a spike in comparison to FY 2016 numbers: ￼ (Source: Dell Technologies FY 2017 annual report) Advertisement ￼ The results revealed a slump in operating income in FY 2017. This is explained by a 72.9% increase in selling expenses and a 250% increase in R&D expenses. These expenditures are connected to the new product launches and the costs related to the post-merger transition period. I expect financials to stabilize once the integration is completed – this may take two-three more quarters. However, we can definitely say that after years of stagnation in key operating segments (the PC market, for example), the current development is quite promising as long as growth in the new segment supersedes mixed results of the “cash cow” businesses. In the short term, this is most likely the case: as early as in FY 2017, VMware has become a significant source of income taking a 5% share in total revenues: ￼ (Source: Dell Technologies FY 2017 annual report) There is a declining tendency in the CSG segment’s share of total revenues. These numbers attest to the fact that Dell is fundamentally changing its operational model. In the first complete year of operations within the consolidated company, VMware has gained a share of 5.2% in the top line and fueled growth in the ISG segment due to the increase in the demand of support hardware and software for cloud infrastructure. VMware also has the highest operating margin across the reported segments: ￼ (Source: Dell Technologies FY 2017 annual report) With the successful integration of VMware and the ongoing growth in Dell’s cloud revenues, the company’s total operating margin must exceed its pre-merger level (5.3% for FY 2013). Valuation To estimate the fair value of Dell’s stock, I have constructed a DCF model based on a conservative scenario. My calculations in the base case are based on the several assumptions: Revenue CAGR is set on the level of 3% for the period of 2018-2022; EBIT’s and EBITDA’s CAGRs are 2.4% and 1.4%, respectively; WACC is calculated at 5.8% based on the cost of equity of 8.4% and the after-tax cost of debt of 2.4% (I used the information on Dell’s $49.8 billion debt balance as of January 2017). Given the current EV/EBITDA multiple of around 15x (used for calculating the terminal value of the company) and the discount rate of 6.5%, we see little upside potential for Dell’s stock: ￼ (Source: Author’s DCF model) An aside: The 15x EBITDA multiple is reasonable. I have cross-checked the figure with the implied perpetuity growth rate related to the Gordon Growth Model and found it reasonable: ￼ (Source: Author’s DCF model) The figures show that the stock is fairly valued given the current market price of the stock of around $83 per share: ￼ (Source: Author’s DCF model) Summary After the EMC merger, Dell Technologies changed its strategic focus from CSG to cloud services and infrastructure. This has proved to be extremely beneficial, at least over the one-year period. With the increasing demand for cloud environment both from private and public sectors, ISG’s top line has also exceeded the company’s average growth rate. If the process continues for at least several years, Dell Technologies will successfully transform its previously stagnating business model. In a conservative scenario, I see little growth potential for Dell’s stock as the future benefits from the new business seem to be priced in. As a result, I recommend investors holding the stock, that is, monitoring the price and waiting for a better entry point, or staying away from buying more shares, if you own it. A good idea for knowledgeable investors is to consider selling call options against their stock positions in Dell Technologies to earn extra income. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.