Recently, I’ve added a couple of large cap tech names to my portfolio. Being large caps, these stocks are not massively undervalued, but when one considers the risk-reward involved, they are well worth the investment.
Dell’s business model is essentially the same as Walmart’s, that is, building scale and lowering unit costs. After pioneering the direct sales model and experiencing furious growth in the 1990s, Michael Dell retired as CEO and handed over the reins of the company to McKinsey consultant. The new CEO concentrated on the business/enterprise segment, and completely missed the importance of the rising laptop segment. HP began to take large market shares in laptops due to superior design and a retail presence where consumers can touch and hold the laptops before buying online. Dell stock slumped, and then completely cratered when the financial crisis hit. Michael Dell resumed his CEO duties and made many changes. He started a design unit in the company specifically dedicated to laptops, and started selling Dell laptops in retail locations, revising his long-held direct sales model. He made many small complementary acquisitions, notably Perot Systems to build up Dell Services, and Compellent Technologies for the storage capabilities. I was also impressed with the discipline Dell exhibited during the acquisition spree, especially his willingness to forgo 3Par to rival HP after the bidding pushed 3Par valuation into the realm of the ridiculous. More recently, Dell has made several sizeable buys of his own company’s stock, suggesting that he sees good things ahead for DELL. I believe that Michael Dell is an excellent businessman, and that Dell has corrected many of the past mistakes and will now take market share away from HP. I believe that HP, having experienced turmoil in its upper management, is now showing signs of lack of discipline and direction in its strategy. Also, I am less than impressed with the standard bear case against Dell, which is that the future belongs to smartphones and tablets. I do not believe that smartphones and tablets can take over the function of a laptop. Tablets and smartphones are excellent for games, movies and books, but for real work involving typing, most people would still need a laptop. I estimate that DELL has a free cash flow of $3B to $3.5B annually, and the current market cap of $28B is just below a PE of 10x. I consider this a low valuation, as I expect DELL to grow in the future at the expense of HP.
TECD is the world’s second largest distributor of IT products, next to Ingram Micro. The company sources both hardware and software from manufacturers, and distributes them to a large number of retailers and resellers. TECD operates in 3 major markets, North America, South America, and Europe. The Europe IT reseller market is more fragmented, and as a result, TECD derives 55% of its revenue from Europe. This industry is essentially a duopoly with high barriers to entry. In the 1990s, during the tech boom, a large number of small competitors entered the industry and started a price war, which ended with all of the competitors being driven out of business in the 2000 downturn, leaving only TECD and Ingram, illustrating the importance of scale and capital in this business. The capital required to build out a network of warehouses and trucks is enormous, the expertise and systems required to run an on-demand logistics operation are key competitive strengths. A distributor earns only a 0.5-1.5% profit margin, so scale is required to cover its initial overhead, and it is essentially impossible for small competitors to build up scale since both manufacturers and reseller reflexively do business with the distributor with the largest product range/reach of distribution, which means either TECD or Ingram. Even large manufacturers like Dell, which directly distributes most of its products to customers, make use of the logistical capabilities of TECD to distribute its products to resellers. The bear case for TECD is that the high growth Asian markets appear to be impenetrable. Japan is dominated by Softbank, and China seems pretty locked up by domestic distributors as well. The IT business is cyclical, so TECD’s revenues are cyclical as well. During boom times, the company spends money to build up inventory and receivables, which is then recouped in the bust phase. During the 2008-2010 bust, the company used the huge amounts of free cash flow derived from the reduction of working capital to buy back shares, shrinking share count from 55M to 46M. Recently, revenue is increasing, and free cash flow is decreasing again, which suggests that business is being built out and free cash flow will again increase in the near future. If you smooth out the cycles, I estimate that TECD has a steady state free cash flow of $200M annually, approximately 1% of revenues, which is a reasonable margin for a distributor. Furthermore, TECD has about $800M of cash on hand. If I apply a PE of 10 to the cash flow, one gets a final valuation of $2.8B, or about $59.80 per share.
Both of these positions are not dramatically undervalued, and are concentrated in the IT sector, so I have taken a half position in both. Still, I believe that they will work out fine in due time.
Disclosure : I have long positions in both DELL and TECD.
{ 4 comments… read them below or add one }
Curious why you preferred TECD over IM, which also looks like a good value play.
IM’s capital expenditure looks a little iffy to me. They seemed to have expended more capital on acquisitions to achieve roughly the same level of revenue growth as TECD achieved, plus their acquisitions is concentrated in the boom years of 2007 and 2005, whereas TECD’s acquisitions are in 2011, which just seems more rational. As a result, when you look at the cash flow (I use cash from ops minus cash from investing), IM actually seems to be giving off less cash than TECD over the last 6 fiscal years. Plus as a general rule, I tend to avoid the industry leader, which usually attracts a lot of attention and be more overvalued compared to the 2nd or 3rd placed competitor.
About Dell: I agree with you that they look cheap in terms of earnings, but are you concerned about how slim their profit margins are? They could be squeezed even further out of profitability by competitors.
The New Value Investor
Dell has a Walmart-style business model. Dell actually sent teams to Walmart to learn about logistics, and strives to have the lowest unit cost of the industry. Slim profit margins and massive scale are part of Dell’s business model. Also, it should be noted that Dell has negative working capital. Customers pay Dell before Dell ships computers, so Dell has a massive “float” of negative working capital to play with, which they use for acquisitions and to grow the company. When sales ramp up after pent-up demand during the recession is released, the negative working capital that Dell has increases. Dell can essentially run its business on other people’s money, so slim profit margin is okay because Dell deploys basically no capital, which makes return on capital huge despite slim margins. Dell has a near-lock on the enterprise market, and cannot be undercut on price, so slim profit margins is a source of stability for the company. Apple, with its huge profit margin, needs to rely on stunts like superior design, constant innovation, and locking up critical component supplies with long term contracts to fend off a large number of competitors, all of which are willing to undercut Apple on price. You need brains to run Apple. Dell runs itself, although it doesn’t hurt to have Michael Dell in charge of what is already a company with a formidable moat.