Last week, Carl Icahn's Icahn Enterprises (NASDAQ: IEP ) teamed up with Southeastern Asset Management to propose a leveraged recapitalization for Dell (NASDAQ: DELL ) . Icahn and Southeastern, along with some other top Dell shareholders, have been upset by company founder Michael Dell's recent attempt to take the company private.
Dell, working with private equity shop Silver Lake Partners, has agreed to buy the company for $13.65 per share in cash. However, Icahn and Southeastern believe that Dell is undervaluing his company, and have gone so far as to call the go-private plan "The Great Giveaway." The Icahn-Southeastern offer is now set to be the main alternative for Dell shareholders.
However, Icahn may be overestimating Dell's earnings power, especially in the short term. New management would need to rapidly stabilize Dell's profitability through cost cuts under Icahn's plan. This plan seems excessively risky for shareholders, particularly because Icahn's financial plan for Dell assumes a "rosy" scenario that may be unrealistic.
Icahn's plan would not give shareholders as much cash up front as Michael Dell's $13.65-per-share offer. Nevertheless, Icahn has said that his offer is clearly superior because it would allow current shareholders to share in Dell's upside. Under his proposal, shareholders would receive $12 in cash but would continue to own a "stub" stock (with an estimated value of $1.65).
Alternatively, shareholders would have the option to decline the cash payment in return for 7.27 additional shares. Icahn and Southeastern (which together control nearly 13% of Dell stock) both intend to exercise this option, and they believe that some other shareholders will join them. They assume that the holders of 20% of Dell's shares will choose extra stock over cash, while the other 80% would take the $12 special dividend (for a total payout of roughly $17.3 billion).
The crux of Icahn's argument is that the stub stock, nominally valued at $1.65, would actually be worth far more than that. He argues that under new management, Dell could produce pre-tax EPS between $0.50 and $0.89 after the leveraged recapitalization. While Dell's pre-tax adjusted EPS was more than $2 last year, several factors make Icahn's estimated earnings range for Dell appear overly optimistic.
Living on the edge
The first factor to consider is the substantial dilution that would occur as Dell issues additional stock to shareholders who decline the cash payout. Even if just 20% take that option -- as Icahn and Southeastern project -- it would raise Dell's diluted share count from 1.80 billion to 4.42 billion. This would reduce pre-tax EPS by nearly 60%. Furthermore, based on the well-documented deterioration of the PC market, Dell's management expects adjusted operating income to decline from $4 billion in FY13 to just $3 billion this year. As highlighted in the company's proxy statement, earnings have repeatedly missed management's expectations over the last two years, so that $3 billion estimate may already be too high.
Lastly, Icahn's plans to raise cash to pay out $17.3 billion to shareholders would diminish earnings. Icahn plans to sell the financing receivables of Dell's captive finance arm, which would reduce interest income by $250 million. Furthermore, he would add more than $5 billion of debt while drawing down most of Dell's cash (to fund the special dividend), increasing non-operating expense by $300 million-$350 million.
Assuming 4.42 billion shares outstanding, operating income of $3 billion, and $575 million of reduced interest income and increased interest expense, Dell would produce pre-tax EPS of $0.51. Any incremental weakness in the PC market, increase in R&D spending, or execution problems caused by the transition to a new management team would push that number down further.
Don't chase the roses!
Icahn suggests that the Dell "stub" shares could be worth as much as $5.35 -- a significant premium to their nominal valuation of $1.65 -- if the company can achieve pre-tax EPS of $0.89. In order to boost earnings to this level, Icahn points to cost reduction opportunities of as much as $3.4 billion highlighted by Boston Consulting Group. However, BCG's report assumed that these cost reductions could be made with no impact to revenue, which seems very aggressive. Bankers at JPMorgan cast doubt on the feasibility of the BCG forecast. BCG's forecasts assumed that Dell could achieve margins substantially above the company's historical margins and competitors' present-day margins.
It's possible that Dell could achieve some of these cost reductions, as Icahn believes. However, as competitor Hewlett-Packard (NYSE: HPQ ) found during its recent restructuring, these cost savings may be needed just to offset headwinds to revenue and margins. Despite cutting nearly $3 billion in costs, HP is expected to post a 14% EPS decline this year, before EPS bounces back slightly next year.
If Dell follows the same trajectory, pre-tax EPS (assuming a share count of 4.42 billion) could drop below $0.50 in the next year or two. This could make the stub stock worth much less than $1.65. HP has been valued between three and five times pre-tax EPS in the past year, and Dell would have a much heavier debt load than HP after a leveraged recapitalization.
If Dell were to follow Carl Icahn's plan, it is possible that the company would achieve Icahn's lofty goals through cost reductions. However, it seems more likely that -- like HP -- Dell will need to cut costs just to offset declining profitability. Icahn's plan is thus far from a "slam dunk." In fact, Dell shareholders who want to invest in a big-tech turnaround should consider taking the $13.65 in cash offered by Michael Dell and investing it in HP. HP is already more diversified than Dell and is better positioned in areas like cloud and big data that could provide long-term growth opportunities.
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