Security: Dell Jan 17 2015 10.00 Call
Date of first purchase: October 29, 2012
I am buying call options on Dell expiring January 17, 2015, because I think the business is substantially undervalued and the expected value of its LEAPS is very attractive. Each option is $1.58 and the strike price is $10. In my estimation, the intrinsic business value of Dell is likely $22 to $28 per share, or approximately $38 billion to $49 billion for the whole company. This compares to a current stock price of $9.24, or a market capitalization of $16 billion. So, with $6.2 billion of net cash and $2.9 billion in average owner earnings since 2007, the entire company is on sale for less than $10 billion, 3.4x its proven earning power. This sale price is a 75% discount to the bottom range of its true value.
The margin of safety here has grown considerably wider in the past six months. Price competition in the consumer PC business and exogenously weaker demand weighed down the company’s last two quarters. Management then lowered its year-end earnings guidance 40%, a level matching its average earnings but below last year’s record results. Dell’s market price subsequently declined nearly 50%. Two things likely worry the marginal investor: Either the company’s legacy business of selling PCs has become an albatross, or Dell faces a prolonged transition to becoming a higher-margin supplier of end-to-end IT solutions.
The marginal investor is asking a particular question, heavily influenced by his fixations and aversions: Where will Dell trade in the next 12 to 18 months? To answer this question he fetishizes management guidance, known catalysts to changing business conditions, and near-term growth projections that only go upward. To arrive at a “valuation” for the business, he applies a multiple to next year’s earnings expectations, a method anchored to current sentiments and to what multiples investors have applied over time. Above all else, the marginal investor is impatient. He is unwilling to own a business over the next 12 to 18 months if that means experiencing volatility.
What would you need to know before you formed an opinion about becoming an owner of Dell at today’s prices? You would need to know approximately what Dell is worth. That question begets many other lines of inquiry. Notably, Dell’s likely ability to meet its future obligations, how good a job its managers are doing operating the business, and whether its earnings are likely to be higher in 5 to 10 years than they are today. But you do not substitute easier questions that in themselves or their answers overemphasize popular impressions or currently circulating stories. A business analysis of Dell shows that its strategy is laudable and working. Dell is targeting shareholder value creation, instituting a dividend, aggressively repurchasing shares, and focusing on long-term growth in operating earnings and free cash flow. Things are not going as quickly or smoothly as the temperamental investor would endure, but just as a patient, long-term owner would think. Successful business transformations are not without competition, stumbles, or stock price fluctuations.
I am thus purchasing Dell’s LEAPS because the significant margin of safety in the company’s equity greatly favors the probability of gains versus the potential for loss at expiration. The pricing and expiration date of the options should allow ample room for error or adversity if I have wrongly appraised the true worth of owning Dell or if the business’s strengths do not soon outshine an exaggerated focus on its recent hiccups.