DELL Stock: Valuation Implies 88% Upside Potential (NYSE:DELL)

Thesis

Dell Technologies (NYSE:DELL) looks too cheap to ignore. The stock trades at 2023 forward P/E of 7.7, forward P/S of 0.3, and a forward FCF yield of 15.7%. Investors might ask: is the valuation justified? A few weeks ago, Warren Buffett bought an 11% stake in competitor HP-implying that value investors see potential for the industry.

In my opinion DELL is significantly undervalued. I feel investors are underappreciating the company’s financial numbers and strength to sustain strong cash-generation for years to come. To test my thesis, I value DELL based on a Residual Earnings framework. My calculation indicates that DELL might be 100% undervalued. I give a Buy recommendation for DELL’s stock with a target price of $94.36/share.

About DELL

Before I dive into the numbers, let’s draft a short company description: DELL Technologies Inc is a computer company based in Texas. The company designs, develops, manufactures and distributes a colourful portfolio of computer equipment (including PC’s, tablets, printers, televisions, cameras, etc.) network servers, data storage solutions, and software. DELL is recognized to offer quality products at reasonable and competitive prices. DELL is the largest producer of computer monitors and the third largest PC-vendor in terms of unit sales worldwide. DELL has approximately 165,000 employees and serves customers worldwide.

Dell’s Business Strength

DELL is arguably well positioned to generate considerable cash-flow and net income for many years, thereby driving outsized shareholder returns. I would like to support my thesis with 3 arguments: First, the company’s legacy branded PC hardware business has shown considerable growth in the past few years, growing revenues from 43.2 billion in 2018 to 61.4 billion in 2021, representing CAGR of 17.4%. Moreover, the pandemic has truly underscored the importance of PC for productivity and accelerated the digital transformation of companies. In fact, 2021 was the best year in DELL’s history recording record revenues of more than $100 billion, record cash flow from operations of $7.1 billion and record net income of $4.6 billion.

Second, DELL is also active in growth verticals such as the multi-cloud ecosystems, data servers and software solutions. As of 2021, DELL’s infrastructure & Network solution services accounted for approximately 35% of the company’s total revenues.

Finally, DELL also sustains a favourable long-term business outlook through consistent innovation. In fact, DELL is consistently spending more than 3% – 5% of revenues on R&D, or between $2.5 and $5 billion in absolute numbers. And according to the company’s annual report, most of the R&D expenses are allocated to software solutions with focus on machine learning.

Record Financial Year 2021

DELL’s financials look appealing. For the year 2021, revenues were $107.03 billion, up 15.8% year-over-year. The company achieved a gross-profit margin of 27.5% as compared to 21.7% one year prior. Notably, Net-Income was recorded at $4.89 billion, or $5.46/share. Cash from operation was $1.05 billion

In 2021, management declared an initial quarterly dividend of $0.33 per quarter or $1.32 per year, implying an annual dividend yield of 2%. In addition, in Q4 DELL also announced a $5 billion stock buyback. As a long-term target, Dell aims to distribute between 30% – 60% of free cash flow to shareholder. Dell ended the financial year with $9.47 billion in cash and cash equivalents and $27.96 billion in total debt. For reference, DELL’s current market capitalization is $33.82 billion.

Valuation

I will use a residual earnings framework to challenge DELL’s stock price. Specifically, I will challenge the growth rate and speculation, which is currently build into DELL’s market valuation by highlighting the difference of the value that can be accounted for (book value + NPV from residual earnings) and the current share price. Unless otherwise noted, all data is taken as of May 12, 2022, and my analysis is based on the following assumptions:

• Revenues: I use the consensus analyst forecast as available on the Bloomberg Terminal.
• Margins: I used the consensus analyst forecast as available on the Bloomberg Terminal.
• Beta for CAPM calculation: I modeled a three-year regression against the S&P. Risk free rate: I used the U.S. 10-year treasury yield as of May 12, 2022.
• Cost of Equity is based on the CAPM framework, calculating 9.3%; Cost of Debt is taken from the latest trading data after tax equal to 3.5%.
• Cost of Capital is based on the WACC model, calculating 7%. However, I adjust to 8% to reflect a conservative valuation and current low investor confidence.
• Tax Rate: I extrapolate the FY 2021 implied effective tax rate into the future
• I do not model any share-buyback and/or dividends.

Zero-Growth Scenario

To challenge the market’s current valuation of DELL, let us first calculate what the company should be worth if the business would stop growing. Accordingly, I extrapolate the company’s most recent EPS into infinity and apply a conservative discount rate of 8%. I add the result (NPV of earnings) to the company’s current net book value per share of -2.26. Conclusion: even for a no-growth scenario, DELL should be worth almost 88% more.

Now, keeping everything as is, what growth rate would justify the current negative speculative value of -35.31 / share? We can reverse engineer the equation to solve for growth rate, calculating -7.7%.

Thus, the market accredits DELL a terminal-value EPS growth rate of -7.7% per annum. Is this reasonable for a company that has a cyclically adjusted historic growth of 3.85%? I strongly doubt it. For reference, DELL grew revenues 16% in 2021 and management expects to grow at a CAGR between 3-4% going forward.

Base-Case scenario (GDP growth)

For this scenario, investors are advised to base their estimates on the EPS analyst consensus forecast until 2025 and apply nominal GDP growth as DELL’s terminal value growth rate (I use this as my base-case valuation). With these assumptions, the calculation returns a fair value of $94.36/share.

Investors might question if the stock’s under-valuation is dependent on a specific WACC and TV growth combination. The answer is no. In fact, no matter how you model the valuation, DELL appears to be considerably undervalued.

Multiples

Investors might also want to consider a valuation based on multiples. If we apply a 30% discount to the 2-year historical average EV/EBITDA (x7.9) to DELL’s 2021 EBITDA of 9.21 billion, and adjust for the company’s net debt, we can derive a share price of $58.66. personally, I don’t like multiples valuation. I find them very imprecise, speculative and lazy. Therefore, please take my multiples-analysis only as a pro-forma reference price.

Risks

Although I strongly believe that DELL is undervalued and significantly de-risked at current price levels, investors should note the following downside risks to my target price.

First, DELL’s business results are exposed to business cycles in the computer industry and especially to cycles in PC hardware sales. Many market participants, including myself, believe that PC hardware and equipment sales will slow significantly in late 2022 and early 2023.

Second, DELL’s legacy business is operating in a relatively mature and competitive market. While DELL might have a strong market presence, the company might not have the best technology (Microsoft) or the best brand equity (Apple). Investors should monitor competition and if competitive forces pressure DELL’s financials more than expected, be prepared to adjust the valuation accordingly.

Third, DELL has significant exposure to China, both on the demand and the supply side. Thus, investors should monitor the current economic situation in China, including the Covid lockdowns in Shanghai and other cities.

Finally, investors should note the current negative market environment including geo-political tensions, economic slowdown and rising real yields. If the market sells off significantly, DELL’s share price performance will likely suffer in lock-step. And as we all now, not only can stock prices be dislocated from fundamentals, but also drift apart further. Moreover, mis-valuations can persist for a long time.

Conclusion

Although I expect a significant slowdown in consumer sentiment going into the second half 2022/first half 2023, and PC hardware and equipment sales should decrease accordingly, I very much like the long-term risk/reward for DELL. In fact, I think it is a mistake trading short term concerns, if the long-term outlook remains unchanged. DELL has strong earnings power and the company’s cash flow engine should sustain the creation and distribution of significant shareholder value for years to come. That said, the stock appears considerably undervalued. Based on a residual earnings framework, I calculate a base-case target price of $94.36/share. I initiate my coverage on the stock with a confident buy recommendation.