Dell’s Dividend: Why Now?

June 19, 2012

As you may know, a few weeks ago Dell reported remarkably disappointing earnings of 43 cents a share on a comparable basis versus 55 cents in the year-ago quarter, which caused the price to decline sharply. In my view, taking DELL’s substantial cash position into account and even allowing these bad results to be indicative of the future, the company remains dramatically underpriced. Even so, the most disturbing development of the quarter was the negative cash flow from operations, which has not occurred at DELL since the third quarter of 2008, although based on the last few years the first quarter seems to be Dell’s weakest in terms of operating cash flow. Furthermore, the cause of the negative cash flow comes primarily from investments in working capital, which I tend not to place a great of weight on.  Another contributing factor to the decline was a $100 million increase in research and development, which some finance professionals believe straddles the line between expenses and capital investments anyway.

However, last week the company also announced that it was instituting a modest dividend, perhaps intended to supplement or replace the billions in share buybacks the company has accomplished over the recent decade. In fact, Dell has repurchased at least $2 billion in stock in every year since 2001 apart from 2008 and 2009, with a peak repurchase of over $7.2 billion in 2006, and totaling $30.6 billion in net repurchases (repurchases minus issuances) between 2001 and 2012. This figure is significantly greater than Dell’s current market cap.

However, these repurchases have not had their desired effect on the share price, which is nowhere near as high as it was when the repurchasing began. When the dividend was announced, the price received a small boost which seems to have evaporated in subsequent market action. Perhaps this serves to expand the shareholder constituency, as some market participants are restricted to dividend-paying stocks, but those constituents are in the minority and probably would not represent much in the way of marginal buying given Dell’s current unpopularity in the market. This leads us to wonder why Dell should choose now to initiate a dividend.

The conventional wisdom pertaining to dividends is that in addition to returning excess money to shareholders, they also provide information to the investment universe. A regular dividend is something that the company is usually willing to defend even in the event of a downturn, and indicates that a company has a baseline level of earning power that investors can rely on. On the other hand, a company with profitable investment opportunities would be better served reinvesting its cash flow into growth projects, and so a dividend suggests that the company has definitely moved beyond the growth phase and into the mature phase, where growth is likely to be limited to the overall growth of the sector and ultimately the GDP of the target markets. Of course, anyone familiar with Dell would not be surprised by this revelation; Dell’s return on assets according to Yahoo finance is a little over 6% (although setting aside the large cash balance would improve it to about 9%), and its reinvestment rate is lower than its depreciation rate and much lower than its free cash flow. By contrast, share buybacks have the perception of being temporary and perhaps indicative that the company’s free cash flow is nonrecurring (although many, if not most companies nowadays do at least repurchase the shares that are granted through stock options).

Dell has joined Cisco as being a company that has repurchased vast amounts of stock while its share price has declined. However, the question is whether this is a defect in the theory of share repurchases. Basic financial theory holds that a company is worth the money it has plus the present value of the money it will have (positive or negative). In this sense, a share buyback would have the same effect as a dividend; it reduces the value of the remainder of the company by the size of the buyback, and the effect on the share price depends on the price/book ratio and other factors. Aswath Damodaran, author of Damodaran on Valuation: Security Analysis for Investment and Corporate Finance, a useful toolkit of standard valuation techniques, adds the further complication that the market may not value the cash of a company at its face value. He writes that if the market believes that the cash is just sitting there waiting to be wasted by management, shareholders will value it at a discount, making a repurchase (or dividend, presumably) a good move, while if the cash is a strategic asset that will be deployed in value-creating expansion projects, the cash will be overvalued and therefore returning it to shareholders is a decision that would be punished.

In Dell’s case, according to the latest 10-K filing 80-90% of the company’s cash is held outside of the United Stated, presumably to save on repatriation taxes. I have the impression that the market places very little value on it at all, at least unless a repatriation tax holiday is declared. This view may be irrational, considering that the US corporate tax rate is unlikely to rise, so at least 65% of that overseas cash can be counted on.

However, for those of us who reject the efficient market hypothesis there is the additional twist of the value effect of share repurchases. The decision of how to return money to shareholders should depend on whether the stock is cheap or expensive. If the stock is cheap, a repurchase would theoretically benefit the remaining shareholders more. Effectively the company is repurchasing assets that has a market cost of capital of 16% or more (based on the P/E ratio of 6, and that is before adjusting for cash) when the justified cost of capital is far lower. If, however, a stock is fairly priced, management would be better served, or at least equally served, by employing dividends. And of course if the stock is overpriced, management’s best move is to arrange a stock-for-stock merger, as with AOL-Time Warner.

So, from that perspective, and given my view that Dell is underpriced, now is a bad time to divert $500 million, which is about what the proposed dividend will come to in a year, from the repurchasing budget to the dividend budget. If anything, repurchasing would be more effective now at the current price than a higher one. I still think Dell is underpriced even if the decline in earnings is persistent, and this dividend decision won’t push me into selling it, but I still think that now is not the time for a dividend.

Disclosure: At the time of this writing, author owned shares of DELL.

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