Dell Technologies: Disappointing Quarter Doesn’t Impact SOTP Case

Dell Technologies (DELL) did not have a good first quarter. In its key Infrastructure Solutions Group – the servers, networking, and storage business – revenue declined 5%, and operating income dropped 10%. Shares of VMWare (VMW), of which Dell now owns 80.6%, dropped after earnings and have drifted lower in a market where most every high-growth software stock seems to be racing higher.

Pivotal Software (PVTL), in which Dell has a 61.4% stake, fell 41% after earnings, and now is down exactly half from where it closed on May 30. Dell also owns 86.6% of SecureWorks (SCWX); that stock declined 9%+ after its fiscal Q1 report and has slid 48% from February highs.

The only positive for the quarter, seemingly, came from the company’s Client Solutions Group, which saw strong PC demand. But CSG likely is the lowest-valued (in terms of multiples) and probably least important of Dell’s myriad wholly-owned and majority-owned businesses. And first-half strength for PC sales may well reverse in the second half given that tariffs likely pulled forward demand.

And so the 24% decline in DELL stock from May highs isn’t a surprise, particularly given how important VMW stock is to the equity value. Dell’s stake in VMWare is worth $57.2 billion at the moment, more than DELL’s $40 billion market capitalization. But in terms of ‘core Dell’ – owning DELL while hedging out most or all of the exposure to VMW – the news hasn’t been quite as bad.

I argued back in April that ‘core Dell’ was dramatically undervalued – and I still believe that’s the case. The declining value of the stakes in PVTL and SCWX has a modestly negative effect, admittedly. But using a 3:4 ratio of long Dell/short VMWare (owing to the balance between the respective market capitalizations at the time) would have led to a loss of just 1% in the past three-plus months. My more aggressive option trade – selling calls in VMW to fund DELL calls – is down about 8%, in part because its hedge isn’t quite as clean.

I’m happy to keep that position – and at these levels, I may look to add on. Even after a close-to-disastrous quarter, the floor for ‘core Dell’ has mostly held – which suggests a solid risk/reward if investors start assigning real value to the legacy business.

4.1x EBITDA is a cheap multiple even by the standards of low-growth IT names. But it’s not that cheap. A blended multiple of HP Enterprise (HPE) and HP Inc. (HPQ) along the lines of Dell’s ISG/CSG profit split suggests a comparable multiple in the range of 6x. Given the “Michael Dell discount”, an exaggerated combination of the more traditional discounts applied to stocks with controlled ownership and a conglomerate-like nature, that gap isn’t all that surprising.

But using the company’s ‘core debt’ figure from its 10-Q (p. 83), the valuation becomes more compelling. Core debt excludes Dell Financial Services liabilities (which are backed by receivables), $4 billion in VMWare notes and another $4 billion margin loan backed by VMWare shares. (Note that the figures in the table above exclude $3.3 billion in cash held by that company as well, which is consolidated onto Dell’s balance sheet).

Using simply ‘core debt’ on a net basis (Dell breaks out that figure in its earnings slides as well), Dell trades at less than 2x EBITDA (1.92x, to be precise). Add back the margin loan and the multiple is 2.5x. It’s a multiple that suggests either that Michael Dell is going to take advantage of common shareholders – as many believe he did in taking Dell private in 2013 in the “nastiest tech buyout ever”, and again in converting the Dell tracking stock last year – or that Dell’s business is going to collapse.

As I wrote in April, I simply don’t believe that’s going to happen. VMWare is the prize here – and it’s simply too big for Michael Dell to somehow wrest from DELL shareholders. Nor is this a case like Altaba (AABA), whose long-running discount to the value of its Alibaba (BABA) holdings was largely explained by tax factors. Dell can make a tax-efficient move with VMWare starting in September 2021, and possibly sooner.

Meanwhile, the multiple for DELL ex-VMWare has widened at points this year, including in the run-up to fiscal Q1 earnings. To be sure, it hasn’t ever reached the ~6x range implied by the valuations assigned the former Hewlett-Packard companies, but it’s actually expanded modestly since early April (when it was at 1.3x using the ‘core debt’ figure against the current 1.9x). Another turn of expansion pushes DELL up about 17% – and the pair trade up 8%+ at the current ratio required for a clean hedge. (That would be about 14 shares short for every 10 shares long.) And at least one analyst, Amit Daryanani from Evercore (EVR), has made a similar SOTP argument in assigning a price target of $90.

As far as the long DELL/short VMW case goes, not all that much has changed. Nor there was much in Q1 reports from those two companies to suggest a notably different outlook. In fact, guidance for Dell’s consolidated results – which include VMWare, Pivotal, and SecureWorks – was reaffirmed. CFO Tom Sweet said on Dell’s Q1 conference call that the results were headed toward the midpoint in terms of revenue – and above the midpoint relative to operating income.

VMWare actually had a solid quarter, and after the sell-off looks attractive at 23x forward earnings. The long DELL/short VMW case still looks compelling from a risk/reward standpoint – but simply going long DELL looks like a pretty good idea at the moment as well.

Dell’s Q1 Earnings

Looking at the Dell-only part of Q1, it might seem like there’s reason for skepticism toward that part of the business. Again, ISG saw declines in sales and operating profit – and it accounted for more than twice as much operating profit as CSG in FY19.

But the year-prior comparison was exceedingly difficult; indeed, Dell management has repeatedly pointed to full year 2019 as somewhat anomalous from a growth standpoint. On a two-year basis, ISG – and Dell on the whole – still looks like it’s headed in the right direction:

Even with the comparison, management admitted on the Q1 conference call that server sales were lighter than expected. China was weak – unsurprisingly – and management said it had walked off from a few large deals due to pricing. But Vice Chairman of Products & Operations Jeff Clarke said the company still was confident that the company would gain market share when updated industry figures were released.

Storage, meanwhile, saw strength as the quarter went on – and management called out strong orders on the call. In the context of industry disruption from tariffs and other factors, plus the abnormally strong comparison, there’s little in Dell’s Q1 results to suggest any change in the outlook for ISG.

In CSG, the short-term news looks good, though long-term concerns about PC unit demand obviously remain. Lower component costs – notably in memory – boosted margins sharply: operating income rose 49% year-over-year on a 210 bps expansion in operating margin. Commercial demand remains strong, with a 13% year-over-year increase in sales.

Consumer revenue fell, but Dell is increasingly trying to stay on the higher end of the market in a bid to increase profitability. Figures from Gartner released last week suggest calendar Q2 demand for PCs was solid, which should help CSG results next quarter at least. Component cost benefits should last another couple of quarters, according to the call.

The qualitative case for ‘core Dell’, beyond the valuation excluding the publicly traded stakes, is that the business is better than investors might think at first glance. That’s still broadly the case. The servers and networking business still has some growth left, with a new hybrid cloud platform rolled out in conjunction with VMWare, along with a new ‘DCaaS’ (data-center-as-a-service). PC profitability has been stagnant in recent years – but with memory prices down from historic highs, that performance isn’t unsurprising. With prices down, Dell is able to ramp profits in that segment. This still is a pretty good business – one that shouldn’t be valued at ~2x EBITDA.

Risks, Valuation, and the Trade

It’s possible that DELL’s discount persists. Paper value isn’t always realized in practice. But, again, it’s tough to see why exactly the discount has to persist.

Debt is a concern as well. But Dell should be able to deleverage this year: the company still is planning to pay down gross debt by $4.4 billion over the next three quarters. Some of that paydown is coming from cash on the balance sheet, but there’s still a lot of cash flow coming in Q2-Q4. Free cash flow was close to zero in Q1, but the seasonal timing of bonus payouts was a factor, as is usually the case. Meanwhile, debt refinancings undertaken during the quarter push out maturities to the point that Dell can use some of its VMWare stake to delever if need be. (Admittedly, the declines at SCWX and PVTL hurt a bit, as Dell was reportedly considering selling SecureWorks.)

The biggest risk to DELL is VMW – but that risk can be teased out either by shorting VMW, or looking to the options market. One interesting trade: sell a bear call spread on VMW with a breakeven at or near the current price, and fund an in the money DELL call. If VMW rises, DELL should as well (again, at least on paper); if VMW declines, DELL might do the same, but the trade in that scenario breaks even at worst.

That’s the type of trade I put on earlier this year, and it is down modestly – but that’s kind of the point. Q1 results were ugly across the board for Dell, at least in terms of how investors perceived them. And yet the losses in the hedged option trade have been minimal, and a straight pairs trade would be down 2%+.

The risks here seemingly have proven to be manageable; the rewards if investors start ascribing a reasonable multiple to core Dell are substantial. Even 4x, with no movement in VMW, would get DELL to $72, ~35% upside. And the options market can provide similar upside – with a hedge. There’s still more value here than the market seems to realize – and I still believe that value can, and will, be realized at some point.―Seeking Alpha