On Tuesday afternoon, Dell reported earnings roughly in line with Wall Street estimates. Revenue of $14.3 billion was 1% ahead of consensus, while non-GAAP EPS of $0.40 beat estimates by $0.01. Revenue and EPS were both down double-digits from the same quarter last year, but the numbers could have been worse given Dell's heavy exposure to the weak PC market.
In the midst of this difficult business climate, Dell recently agreed to be taken private for $13.65 per share by founder Michael Dell and investment group Silver Lake, with debt financing provided by Microsoft and others. Several major shareholders have criticized the deal, arguing that shares are worth more than the proposed price, and have accordingly pledged to vote against the buyout. The proposed buyout price is just eight times Dell's non-GAAP EPS of $1.72, providing some justification for the shareholder revolt.
If Dell had missed estimates on Tuesday, the $13.65 price tag would have been very defensible. On the other hand, an earnings blowout would have all but forced Michael Dell and Silver Lake to raise their offer. However, the in-line results Dell reported will not give either side much incentive to budge, creating substantial uncertainty for shareholders. Dell's decision not to provide guidance this quarter (due to the buyout) compounds this uncertainty.
PC market weakness continues
Since Apple launched the iPad in 2010, the cannibalization of PCs by tablets has become increasingly widespread. PC makers had hoped that the late October launch of Microsoft's new touch-friendly Windows 8 OS would boost sales. However, the launch of Windows 8 was not nearly as successful as either of Microsoft's previous two Windows launches. This had a clear impact on Dell's top line, as PC revenue dropped 20% year over year.
Dell has been trying to offset weakness in the PC market by growing in other, more profitable areas. Dell produced strong growth of 42% in its networking business, along with more modest 5% growth in servers. However, this favorable mix shift only boosted gross margin by 60 basis points (from 21.1% to 21.7%): clearly not enough to offset the PC revenue decline.
Dell's strategy of growing into higher-margin and more differentiated areas is smart, but even after the recent PC market contraction, PCs still account for nearly half of Dell's revenue. This will be an ongoing headwind for growth. A private equity buyout is probably the best option for shareholders, although a price closer to $15 would better reflect Dell's value.
Dell shares have already surged above the proposed buyout price, closing Tuesday at $13.81. This indicates that shareholders expect the offer price to be raised. This may occur, but I would not advise holding Dell shares at this point. Owning Dell above the proposed buyout price is like playing a game of chicken; you need to be prepared to vote against the buyout to encourage a higher offer, but you run the risk of the offer being withdrawn (which could cause the stock price to crash).
There are better opportunities in the market than a risky proposition of that sort. For example, I think HP is a promising turnaround candidate, and is likely to exceed analysts' pessimistic estimates this year. Furthermore, HP trades at a much lower valuation than Dell, despite having less exposure to the troubled PC market.
Can Mr. Softy survive the decline of PCs?
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