1176RA The Dell Deal: What’s The Deal?

What is Happening?  After weeks of marketplace speculation, Dell Inc. has formally announced its intention to buy back its outstanding shares and privatize the company for approximately $24.4B. The move will take Dell off the NASDAQ stock exchange after more than 25 years of trading. The buy-out of the remaining shares will be executed by a consortium made up of CEO Michael Dell, his own investment fund, and Silver Lake Partners. The leveraged deal will be financed by loans from four banks, and by a $2B loan from Microsoft Corp. Michael Dell owns about 14 percent of the firm’s shares; he and other senior executives will retain their existing shares.

Saugatuck believes that Dell (the company) wants to, and needs to, coalesce itself into a Cloud-oriented services provider, and that remaining publicly-traded inhibits the company’s ability to accomplish this core change in a short enough time period to survive.

Why is it Happening? Saugatuck’s position is that no company, large or small, undertakes such a significant step without a well-considered plan that has in turn been built from a significant need for core, strategic change. In short, Dell management, including founder Michael Dell and his investment partners, sees a need for, and an opportunity to, restructure the company.

Therefore, Dell management, and its investment partners, must see some strategic improvement available through privatization that they could not see happening as easily (or less expensively) by remaining publicly-traded. Regular scrutiny and input (read “meddling”) from venture firms is apparently less objectionable, and easier to endure, than the roller-coaster-style, short-term-focused analysis, demands, and regulatory scrutiny inherent in being a publicly-traded firm.  And the company needs to coalesce – nine significant acquisitions in less than two years range from IT security, software, networking hardware, and Cloud services.

A good example of where Dell would benefit from coalescing its widespread business is the consumer-oriented device business with which Dell is synonymous. Despite years and billions of dollars of investment in enterprise-grade IT hardware, software, and services, Dell today is still identified as leading provider of – and a pioneer in – the low-margin, high-churn, short-lifecycle consumer device business from PCs to TVs to printers to monitors. In 2012, Dell’s sales of consumer devices brought in $2.5B in revenue, but that was down almost 25 percent year over year.

Meanwhile, Dell has found that its acquisition of Perot Systems, Scalent, and other large-enterprise data center-oriented providers did not yield the large enterprise-related revenue growth that the company sought. In 2012, sales to large corporations declined 8 percent to $4.2 billion. The high-end, large-enterprise IT marketplace was not the growth engine that Dell thought it bought into. And in our research among large user enterprises, we find that Dell is a respected provider, especially of core server and networking hardware - but has largely been unable to reach the established status and relationships that more traditional large-enterprise IT vendors have.

Finally, when we summarize Dell’s own financial reporting by hardware, software, and services LOBs, we see steady and relatively significant declines in revenues everywhere but Servers & Networking and Services. Storage, Software & Peripherals, and Mobility all show steady double-digit declines in revenue over the past two years. The once-core PC LOB shows smaller, but still steady, single-digit declines over the same period. Figure 1 provides a snapshot of Dell’s 2011 and 2012 3^rd quarter revenue reporting.

Figure 1: Dell 3rd Quarter Revenues by LOB, 2011 - 2012

Source: Saugatuck Technology Inc., data provided by Dell Inc. 10Q via EDGAR Online

Our net from all the above: The combination of stable and profitable Servers, Networking, and Services businesses makes Dell very well-positioned to become a Cloud-focused IT provider, not just for user firms but also for other Cloud services providers.  Dell’s more modest presence and growth within large enterprises, combined with the very low margins associated with smaller firms, suggest that its core target for these Cloud-centric IT offerings will be mid-sized firms.

Market Impact  Once Dell fundamentally reshapes and repositions itself – again, outside the scrutiny and emotion of the greater Wall Street environment – we expect it to be a strong and solid Cloud IT provider.

But even as it makes important steps toward reshaping and reinventing itself to compete and thrive, Dell faces substantial challenges that will affect its ability to manage in the short term.

First of all, the company’s expected debt load after the financing and buyback is likely to hamstring its ability to restructure by reducing its ability to invest at low cost for at least a few years. Barring some unforeseen or previously-undisclosed significant cashflow influx, the company will have to be very cautious about major investments in acquisitions, partnerships, or R&D. This suggests that the company/investor strategic plan calls for organic, and relatively slow, revenue growth over the next few years, if it is to be realistic.

Dell will be able to improve its financial position – though not its short-term cashflow – by jettisoning under-performing assets and lines of business. Its consumer business, for example, has seen steadily declining revenues and profits for several quarters. As noted above, that LOB does bring in $2.4B per year – but Dell’s low margins and the requirement for ongoing investment make it an easy target for removal from the company.  Selling off the consumer –oriented businesses, especially the desktop PC and Mobility LOBs along with the peripherals business, could bring in somewhere between $5B and $7B relatively quickly – in today’s challenging consumer device market, it’s difficult to see a buyer paying much more than 1x to 1.5x trailing 12 months’ revenue for such a business. If Dell can get more, fantastic. Regardless, that income would fund significant re-organization and restructuring.

Dell has to get its Cloud act together quickly. The company has made several good acquisitions (e.g., Boomi) and many announcements, and has developed substantial Cloud-related business and revenues, but its efforts have lagged well behind competitors such as HP and IBM when it comes to breadth and depth of offerings. Since 2008, Saugatuck research has continued to indicate that mid-sized enterprises are among the leading and fastest-moving group of Cloud IT adopters worldwide (534RA, SMBs Show Greatest Adoption of On-Demand Infrastructure Services, 03Dec2008; 788SSR, SaaS and SMBs Survey Data Report 2010, 29Sept2010). If our premonitions and analysis are correct, and Dell wants/plans to target this particular group of user enterprises, it has to change, coordinate, coalesce, and get to market more effectively. 

We don’t believe that Dell will forsake its SMB and LE business entirely. But we do believe that the company needs to reposition itself with a Cloud-centric portfolio, and that mid-sized firms provide the most suitable, and largest addressable, opportunity.

In order to accomplish any of the above, Dell needs to substantially increase its R&D spending. Reorganizing and restructuring goes only so far. Dell spends only between 1.5 and 2 percent of revenue on R&D; about $1B per year. Such relatively low spending is a legacy of being a PC-centric vendor, especially one focused on configuration rather than innovation. That has to change if Dell is to succeed in any Cloud-centric, services-oriented endeavor, especially if Dell expects to maintain and grow its software business. Dell needs to create and foster an innovative culture, and that requires a different attitude and more R&D in more areas, quickly.

Net guidance for Vendors/Providers: HP has already issued a statement that, basically, attempts to engender Fear, Uncertainty, and Doubt (FUD) among Dell customers and partners. We’re not sure that this is a most effective tactic, and in fact could position HP more negatively. But HP’s action really spotlights the fact that FUD does, and will, exist for Dell customers and partners. The company is going to reinvent itself (or, if it doesn’t, sink under a mountain of unnecessary debt). Re-invention is a weighty change that affects all company relationships. Microsoft is concerned enough about that to lend Dell $2B to help with the deal financing, and to help ensure a continued close working relationship. Dell partners up and down the channel need to get briefed immediately on their status and Dell’s plans; then it is time to assess the Dell+partner business relationship over the next few years. Can partners prevent the expected loss of orders, or loss of customers, or other losses of business, as Dell re-invents? It’s a big gamble for all involved.

Net guidance for Enterprise Business and IT leaders: We see no reason why enterprises of all types and sizes should stop buying Dell hardware, software or services. If Dell jettisons the low-end hardware business, that will be picked up by another provider. Despite ongoing, continuous reports of the death of the PC business, more PCs still get sold every year (1107MKT, PCs Declining Only as Sole “Go To” IT Devices, Not in Numbers, 03Aug2012). Acer, Asus, Lenovo and others are doing just fine in most markets. There will remain a market for Dell PCs and related hardware. We don’t expect to see Dell dumping its server, storage, or networking business, because those are core to either a mid-sized or large enterprise business portfolio. In fact, we expect Dell to roll out more specialized servers and appliances, such as an SAP HANA server, unified communications servers, storage management servers, and other functionally-optimized servers/appliances. Bottom line: Dell is as safe a bet as any provider right now and through the foreseeable future when it comes to products and services.