Michael Dell's Folly

Score one for shareholders.

It doesn't look like Michael Dell, founder, chairman, and CEO of Dell, will be able to steal his company from public shareholders for just $13.65 a share now that superior preliminary offers for Dell have been submitted by Blackstone Group and activist investor Carl Icahn.

It's harder than it once was to buy businesses at unfairly low prices because deep-pocketed investors like Icahn are prowling the markets for opportunities. Moreover, big institutional holders are no longer pushovers. The Dell buyout, first announced in early February, probably was doomed due to widespread opposition from the company's larger shareholders, including Southeastern Asset Management, with 7% of the shares, and T. Rowe Price.

Blackstone, led by CEO Stephen Schwarzman, and Icahn admittedly aren't willing to pay much more than the buyout price offered by Michael Dell and his sidekick, Silver Lake Partners. But they will allow at least some Dell shareholders to remain as investors in a publicly traded Dell. Under the $24 billion deal initiated by Michael Dell, all investors would be forced to sell.

Yet many Dell holders believe the company, which sells personal computers, software, and technology services, is worth more than $20 a share, based on its earnings power, and want to participate in its potential revival. Southeastern pegs Dell's value at almost $24 a share, based on acquisitions that diversified the company's operations. Dell rose 19 cents, to $14.33, last week.

Blackstone has proposed paying "in excess" of $14.25 a share for Dell -- it won't specify how much more -- while Icahn is offering $15 for as much as 58% of the Round Rock, Texas–based company.

Both proposals, which came at the end of a 45-day "go shop" period for alternative offers, amount to what Wall Street calls a leveraged recapitalization, meaning a large chunk of stock would be retired. Investors who stick around will be left with shares in a more debt-laden company that offers both greater upside potential and downside risk than before. Dell's share count, now nearly 1.8 billion, could fall to one billion or less. Debt will rise with the recap, but likely not to onerous levels.

OUR BET IS THAT THE FINAL DEAL will give investors a chance to cash out at $15 a share or more. Those who remain invested ultimately could wind up with considerably more than $15, based on an analysis from Southeastern and others. The stock surely looks inexpensive at just nine times this fiscal year's projected profit of $1.57 a share, and seven times estimated earnings after excluding the company's net cash position (cash and marketable securities, less debt) of $6.3 billion, or $3.50 a share.

"Having the choice of cashing out or staying in is hugely superior to what Michael Dell had to offer," says Richard Pzena, co-chief investment officer at Pzena Investment Management, which owns about 1% of the company. "It's inconceivable that the Dell board can come to another conclusion."

Barron's has written critically -- and presciently -- about the Dell buyout bids since before Michael Dell's was announced on Feb. 5. In a Jan. 21 story, "How to Give Dell's Shareholders a Fair Deal," we wrote that a then-rumored deal price of $14 a share significantly undervalued the company and would run into shareholder opposition. We also speculated that Dell could attract an activist investor like Icahn, and argued that a better alternative to a buyout would be a tender offer for Dell shares at $15 a share.

These events have since occurred, even though most Wall Street analysts and media commentators initially treated the Michael Dell deal as a near certainty.

The coming battle may be over investor participation in a publicly traded Dell, an issue that has received little attention to date, amid coverage of the Blackstone and Icahn bids. Any deal approved by Dell's board is likely to enable at least some current shareholders to remain invested.

Barron's analysis suggests that half of Dell's holders would like to stay invested in the company, which Michael Dell, 48, founded in 1984. Icahn believes it is fair to offer them this opportunity, as his proposal gives shareholders the option of staying in or cashing out.

Blackstone's preliminary proposal is murkier on this score. Blackstone says it plans to "cap" the number of investors that would be allowed to remain as shareholders.

It isn't clear what Michael Dell might offer in a counter proposal.

Under one scenario, Blackstone potentially could form a "club" deal with Michael Dell, Icahn, and perhaps another big holder, and then try to force out most investors at about $15 a share. That likely would generate strong investor objections, however, as well as lawsuits.

Let's do the shareholder math: Michael Dell owns 16% of the company and is unlikely to sell any shares at about $15, whether he's involved in the winning group or not. Icahn, a 4% owner, won't sell at $15 and wants to buy more stock at that price. Southeastern and T. Rowe Price, a 4% holder, believe Dell is undervalued and probably won't sell at $15. These four holders together own more than 30% of Dell, and there are many smaller institutional holders, including Pzena, and retail investors, who presumably want to stay invested.

WHY WOULD SO MANY DELL HOLDERS want to stick with a company that has little support from Wall Street and is widely derided as a has-been by the media?

Dell's diversification is reflected in Southeastern's analysis. The firm assigns a value of just $2.78 a share to the PC business (see table), but assumes that the Dell acquisitions are worth the price paid by the company. One successful deal was for Quest Software, a $2.5 billion purchase last year that probably is worth more than what Dell paid. Add Dell's cash, server business, and financial arm, and the total value approaches $24 a share.

Icahn values Dell at more than $22 a share. Retiring a large chunk of Dell's shares would boost the company's earnings per share, since likely debt costs of about 6% are below the earnings yield of about 11%. (The earnings yield is the inverse of the price/earnings ratio.)

This is evidently what Michael Dell and Silver Lake see. Dell, who is worth an estimated $15 billion, was a big seller of the company's shares a decade ago when the stock traded above $30, and now senses opportunity. So does Silicon Valley–based Silver Lake, a shrewd bottom-fisher in tech. The private-equity firm led a group that bought 70% of Skype from eBay (EBAY) for $1.9 billion in 2009, and then flipped it to Microsoft (MSFT) for $8.5 billion in 2011. As Ben Stein wrote in Barron's, the Dell buyout proposal smacked of insider trading because Michael Dell, who probably knows more about the company than anyone, should be required to put shareholder interests ahead of his own ("Dell Deal: The Same as Insider Trading," Feb. 18).

That was echoed last week by investment manager Leon Cooperman of Omega Advisors, who told the New York Times, "Dell has a moral responsibility to work for his shareholders."

Referring to the buyout, Cooperman added: "He's not doing this because he thinks his company is overvalued. He wants to make money."

THE FOUR-MEMBER SPECIAL COMMITTEE of the Dell board that approved the Michael Dell buyout deal apparently wasn't troubled by Dell's role. That committee looked to be so concerned by Dell's weakening profits that it OK'd the low-ball price. The committee defends itself, stating that it "conducted a disciplined and independent process intended to ensure the best outcome for shareholders."

The committee should have done better, particularly since one of its members is Laura Conigliaro, a former Goldman Sachs technology research analyst who covered Dell as recently as 2007. As Barron's has reported, Conigliaro had a $35 price target on Dell in October 2007, according to a story posted at the time on MarketWatch.com, which also is owned by Barron's parent Dow Jones. That target was in place before she gave up her analyst responsibilities to become co-head of Goldman's Americas research group. She retired from Goldman as a partner in 2011.

Dell was much more highly regarded in 2007 than now, but Conigliaro carried that $35 price target when the stock traded at $30 and the company had about $1.30 of annual earnings power. She voted in favor of a deal at $13.65, with Dell's profits having risen to $1.72 a share in 2012.

THE BUYOUT PROXY, released late Friday, details the negotiations over many months that led to the February deal and the eroding internal financial projections that motivated the special committee to embrace the Michael Dell offer. Because those internal projections had been leaked prior to Friday in an effort to defend the buyout, the numbers come as no surprise and probably will do little to sway investors who oppose the deal.

Projections for operating income in the fiscal year ending next January have come down sharply since July, when the company was expected to report $5.6 billion for the current fiscal year. The subsequently lowered outlook is already reflected in current Wall Street estimates and was known to the Dell board in January.

A revised March management projection of $3.7 billion for the current year looks consistent with the Street estimate of $1.58 a share in earnings. An alternative and more conservative March projection, prompted by a board request, is $3 billion. Dell maintains two internal projections. The $3 billion is the leaked number that supposedly underscores Dell's grim outlook, but it seems more of a worst-case scenario than a likely outcome.

Even if Dell's operating profit is only $3 billion in fiscal 2014, the company still could earn about $1.30 a share for the year. That means the special committee approved a buyout at 10 times a pessimistic 2014 forecast, or less than eight times earnings, excluding net cash. No major company has ever gone private at such a low valuation.

THE DELL DRAMA, which began last August with a discussion between Michael Dell and Silver Lake, could go on for months because Blackstone and Icahn need to firm up their bids with committed financing. Michael Dell and Silver Lake would then get a chance to top any proposal deemed superior by the special committee; Blackstone or Icahn would get final topping rights.

Dell thus could waste a year on a buyout ordeal that has distracted management from its business challenges.

It is possible and perhaps fitting that Michael Dell could lose his job under the terms of the final deal. There have been leaked reports that he has talked to Blackstone, which supposedly is amenable to his participation in its buyout bid. But Blackstone, like most private-equity firms, wants some control over businesses it buys, and might not want a headstrong founder around to second-guess the firm.

Should Michael Dell drop his bid and align with Blackstone, that would trigger a nice payday for Silver Lake, which stands to pocket a $180 million break-up fee.

The Michael Dell camp has argued that absent a buyout, Dell stock would plunge. But that's unlikely. Shares of rival Hewlett-Packard (HPQ) are up 67%, to $24, this year, as investors smell the early signs of a recovery. Dell shares are up just 41% in the same period.

Dell's board made a mistake in approving the Michael Dell buyout. It now has a chance to redeem itself.