Dell Explodes Up 12% -- and It's Still a Great Buy!

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Please excuse my enthusiasm. I've been screaming at the top of my lungs about Dell's (Nasdaq: DELL  ) undervaluation ever since I joined the Fool crew (and long before that on CAPS). I even wrote an open letter to Larry Ellison pointing out what a wonderful acquisition Dell would make. Unlike many un-Foolish commentators I like to put my money where my mouth is (and vice versa): I'm a Dell owner.

But enough about me (and the biases I'm very proud to have) -- let's talk Dell. The stock was up more than 12% yesterday. In the fourth quarter, the company once again shrugged off a miss by fellow enterprise-focused peer Cisco (Nasdaq: CSCO  ) to GAAP EPS growth of 182%, up to $0.48 from $0.17 a year earlier. Non-GAAP EPS was $0.53, beating analyst expectations of $0.36 for the quarter.

And for the fiscal year diluted GAAP EPS almost doubled-from $0.73 to $1.35.

Wall Street is wrong about Dell
The story the Street is telling is that superior gross margins (up 4.40% to 21% in Q4 from 16.6% a year earlier, and 18.5% for the fiscal year) are responsible for the bounce, and that competitors will eventually pick away at those margins, causing the stock to fall.

Don't believe it. The fiscal year's gross margin of 18.50% isn't that far off the long-term average, and the company's acquisitions have rapidly diversified it into higher margin areas than in the past. Enterprise solutions and services revenues now represent 29% of Dell's revenue, and those sales were up 27% for the full year. Compared to Hewlett-Packard's (NYSE: HPQ  ) gross margins of 23% and IBM's (NYSE: IBM  ) margins of 40%-plus -- two companies Dell is slowly but surely starting to resemble -- 18.5% doesn't seem so extreme.

But more importantly, what the Street is missing is that the stock was already terribly undervalued to begin with, and is still undervalued now.

A good look at Dell's real valuation
Using the "whole firm" valuation methodology I used previously and a 9.5% WACC (weighted average cost of capital), the stock is worth $23.54 versus the current price of $15.41. And that $23.54 assumes the company stops growing ... for all of eternity! So even if the economy stays in a perpetual purgatory of slow or no growth, the stock is still priced for great returns.

To look at Dell's valuation another way, the company throws off a minimum $3.5 billion in free cash flow to shareholders (not including balance sheet financings), and can still be purchased for $29.75 billion. That's a massive 11.8% free cash flow yield on your investment.

And while Hewlett-Parkard and IBM are themselves cheap, comparing Dell's 11.8% free cash flow yield to Hewlett-Packard's 7.7% and IBM's 8.5% shows what a bargain Dell really is. And since more than a quarter of Dell's market cap is in net cash (a larger percentage than the others), the 11.8% understates the real undervaluation.

The Foolish bottom line
It should be obvious that I'm not selling. And if you're as enthusiastic as I am about Dell, or at least interested in news about the company, add Dell to your watchlist.

Fool contributor Chris Baines wishes he could earn 12% every day. Chris, obviously, owns shares of Dell. He actively participates in CAPS as cbaines2. The Fool has created a bull call spread position on Cisco Systems. Motley Fool Alpha owns shares of Cisco Systems. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (2) | Recommend This Article (10)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 17, 2011, at 1:54 PM, TheZooCrew wrote:

    I agree.....My opinion is that Dell is now where Apple was in 1998.......wait and learn.....

  • Report this Comment On February 18, 2011, at 6:51 AM, evanlier wrote:

    Hi Chris,

    Great to hear that you value Dell at more than $23.

    I looked at it, also in terms of perpetual free cash flow to arrive at $12.5, using basic assumptions like equity beta 1.31, revenue growth 8% over the next 10 years and 3% perpetual, etc.

    So we’re far away with our basi assumptions and I hope you are right, but how can we tell?

    Of course nothing to do with share price but the figures should be getting closer if the market were to follow the value.

    Best regards,

    Ed Van Lier

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