8 Feb 2013

Dell Goes Private: Ownership Control vs. Turnaround Strategy

Michael Dell

The long-rumored leveraged buyout (LBO) of Dell is finally a reality. Dell announced that it will go private in a $24.4 billion deal led by CEO Michael Dell and private equity firm Silver Lake Partners. Microsoft is chipping in with $2 billion in subordinated debt as well. Let's take a look at what this means for Dell.

On the face of it, this deal makes perfect sense. The PC industry is under seige because of the mobile revolution and going private would theoretically allow Dell to make the tough decisions to transition to an enterprise services company (much like IBM). Public companies need to meet Wall Street's short-term growth expectations just to keep the company's stock price flat - a factor that private companies don't need to deal with. Part of Michael Dell's long-stated strategy has been to "prune" the PC business and use operating cash flows to acquire companies in "computer networking, storage, and enterprise software". A reasonable strategy.

So what's the problem? The LBO.

A leveraged buyout is one in which a large portion of the deal is funded by debt - placed on the target company's balance sheet. The problem is that this deal dumps about $16 billion in debt on Dell's existing obligations (the company only had about $5.3 billion in debt as of Q3 2012). This excludes Microsoft's $2 billion subordinated loan (interest/principal only paid after other obligations are met). This is meant to be paid off from Dell's operating cash flows during the term of the loan ($1.3 billion in operational cash flows in Q3 2012).

This means that Dell cannot make any "tough decisions" that could adversely affect it's short-term cash flow position (after an initial grace period). More importantly, this puts pressure on Dell to ensure that the PC business (~70% of revenues) does not fall off a cliff while the enterprise business ramps up, and that may depend more on Windows 8's prospects than on Dell's execution. If the PC market does see the bottom fall out (and I expect this to be the case within the next 24 months), Dell would be under enormous pressure to cut costs, because of the outstanding debt obligations. This would translate into widespread layoffs (could already be a planned cost rationalization move), and would also make it difficult to fund or integrate acquisitions to build scale in the enterprise segment.

Given these dangers, I'm not entirely sure if this deal was driven by a long-term strategy. I suspect that Michael Dell was wary of investor activism or hostile takeover attempts in the near future, which would have put his control of the company in jeopardy. This deal looks to be more about ownership control and less about engineering a turnaround.

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