dell

Post-PC: Wall Street Likes the View

 

The conventional PC business is now on the decline and yet share prices for of key players Microsoft and HP are moving up. Why?

In an April press release, IDC painted a bleak picture for the PC. Compared to last year’s first quarter, worldwide shipments of PCs are down 13.9%, the “steepest decline ever in a single quarter”. US numbers are about the same: -12.7%. On a graph, the trend is unmistakable:

Is this a trend Wall Street likes?

When you consider Microsoft, it seems so. In a corporate blog post titled Windows 8 at 6 months, the company proudly claims to have “recently surpassed the 100 million licenses sold mark for Windows 8.” This is an interesting number. A quarter ago, MS announced it had sold 60 million licenses, meaning that only 40 million were sold in the last three months. That’s a 33% drop…hardly a rousing success. (The “licenses sold” phrase requires caution, it doesn’t only mean “sold with new PCs”, there are also updates to existing machines, with or without enthusiasm for the new Windows OS.)

“Ignore the Windows 8 numbers and IDC analysis”, says Wall Street. While the tech-heavy Nasdaq climbed only 6.6% in the last 60 days, Microsoft shares went up by 21%.

The same apparent illogic holds for Hewlett-Packard. Last week, the largest PC maker disclosed its second quarter numbers. Compared to the same quarter last year, they’re not exactly pretty:

Revenue down by 10% to $27.6B
Operating Margin at 5.8%, down by about 20% (HP prefers “down 1.4 points”)
EPS (Earnings Per Share) at 55 cents, down 31%

Zeroing on HP’s PC business, things look worse:

Revenue down by 20% to $7.6B
Operating Margin at 3.2%, down 44% (“down 2.2 points” sounds better)

As one would expect, Wall Street reacted, and HP shares went…up. By 17.8% the day after the announcement:

What was the good news for investors? Resorting to one of the usual bromides, HP “handily beat Street expectations” by posting Earnings Per Share (EPS) of $0.55 vs. a projected $0.30 to $0.40.

As discussed in the December 16th Monday Note, Chapter 2 of the Turnaround Artist Manual prescribes exactly what we’re seeing: Drastically lower expectations within days of taking on the job. “Things are worse than I was told. We’ll have to touch bottom before we bounce back…'”

Following the script, HP CEO Meg Whitman called 2013 a “fix and rebuild year”. Everyone should expect a “broad-based profit decline”. But a 17% rebound in the stock price can’t be explained solely by a collective sigh of relief when the actual numbers aren’t as bad as the CEO had led everyone to expect.

(In its earnings release, HP still calls itself “The world’s largest technology company”. I guess they think smartphones and tablets aren’t “technology”, but PCs and printers are…)

As quoted in a VentureBeat post, Whitman thinks that the other US PC maker, Dell, is in no better shape:

“You saw a competitor, Dell, completely crater earnings,” Whitman said in response to a question. “Maybe that is what you do when you are going private. We are setting up the company for the long term.”

Ironically, and without a hint of self-awareness, she accuses Dell of playing the Setting Artificially Low Expectations game:

She implied that Dell did that on purpose, since Michael Dell is motivated to repurchase shares in the company as cheaply as possible, and deliberately lowering earnings is a good way to get the share prices to fall.

 Actually, Whitman must envy what Dell is attempting to do: Get out of the PC clone Race To The Bottom. Because PCs make half of Dell’s revenue, getting out of that hopelessly commoditized business would cause trouble if done in public. Going private allows Dell to close the curtain, perform the unappetizing surgery out of view and, later, return to Wall Street with a smaller company endowed with a more robust earnings engine, focused on higher-enterprise gear and services.

This helps explain the apparent paradox: Wall Street doesn’t like HP and Microsoft shares despite their lower PC numbers but because of them. Investors want to believe that future earnings (the ones they count on when buying shares today) will come from “Post-PC” products and services instead of being weighed down by shrinking PC volumes and margins. In particular, those who buy HP shares must believe that the company will sooner or later exit the PC clone business. For Microsoft, the bet is that the company will artfully manage a smooth transition to higher Enterprise and Entertainment revenues and their fatter margins.

I’m not in fond of the “Post-PC” label, it lacks nuance and it’s premature. The desktop and laptop machines we’ve known for more than three decades may no longer be the sole incarnations of our personal computing – our affection, time, and money have shifted smartphones and tablets – but the PC will continue to live in our offices and homes.

Regard Lenovo, the Chinese company that seized on IBM’s PC business when Big Blue decided to exit the race. They’re doing quite well, posting a record $34B in revenue for this year.

There is life left in the PC business, just not for US incumbents.

JLG@mondaynote.com

 

Dell Buyout: Microsoft’s Generosity

 

To perform painful surgery on its business model, Dell needs to take the company private. Seeing challenges in raising the needed $22B, Microsoft “generously” proposes to contribute a few billions. Is this helping or killing the deal?

The news broke two weeks ago: Dell wants to go private. The company would like to buy back all of its publicly traded shares.

The Apple forums are abuzz with memories of Michael Dell’s dismissal of Steve Jobs’ efforts to breathe new life into Apple in 1997:

What would I do? I’d shut it down and give the money back to the shareholders.

Is it now Michael’s turn to offer a refund?

Now we hear that Microsoft wants to lend a hand, as in “several billion dollars”. The forums buzz again: It’s just like when Bill Gates came to Jobs’ rescue and invested $150M in the Cupertino company, thus avoiding a liquidity crisis.

The analogy is amusing but facile. Dell 2013 isn’t Apple 1997. A look at Dell’s latest financials shows that the company still enjoys a solid cash position ($14B) and a profitable business (3.5% net profit margin). It’s profits may not be growing (-11% year to year), but the company is cash-flow positive nonetheless ($1.3B from the latest quarter). There’s no reason to fold up the tents.

As for Microsoft’s involvement: The Redmond company’s “investment” in Apple was part of a settlement of an on-going IP dispute. Microsoft avoided accusations of monopoly by keeping alive a highly visible but not overly dangerous adversary.

So what is Dell trying to accomplish by going private? To answer the question, let’s step back a bit and explore the whys and hows of such a move.

First, we have the Management Buyout. Frustrated with Wall Street’s low valuation, executives buy back their company “on the cheap” and run it in private for their own benefit. This rarely ends well.  Second-guessing the market is never a good idea, and the enormous amount of money that’s needed to pay off shareholders puts the execs at the mercy of bigger, smarter predators who turn out to be the ones who end up running the company for their benefit.

A good reason for going private is to allow a company to shift to a radically different business model without being distracted by Wall Street’s annoying glare and hysterics. This is what Dell is trying to do. They’re not shutting down shop, they’re merely closing the curtain.

Is it necessary to privatize for such a move? For an example that never came to pass, recall Bill Gates’ suggestion, in 1985, that Apple should get out of the hardware business and, instead, license the Mac operating system. At the time, the average revenue per Mac exceeded $2,500; a putative Mac OS license would have sold for $100. The theory was that Apple would eventually sell many, many more OS licenses than it did Macs.

The pundits agreed: “Just look at Microsoft!”.  Apple would jump from one slowly ascending earnings curve to a much steeper one.

Now picture yourself as John Sculley, Apple CEO, going to Wall Street with the following message: “We heard you, we’ve seen the light. Today, we’re announcing a new era for our company, we’ll be licensing Mac OS licenses to all comers for $100 apiece. Of course, there’ll be a trough; licensing revenue won’t immediately compensate the loss of Mac hardware sales. We need am ‘earnings holiday’ of about 36 months before the huge software profits flow in.”

You just became the ex-CEO. Wall Street dumps your shares, effectively telling you to take them back and only return after your “holiday” is over.

As another example that didn’t happen but probably should have, imagine if Nokia CEO Stephen Elop had taken his company private in 2011. Instead of osborning its Symbian business, Nokia would have had the latitude to perform the OS gender change behind closed doors and reemerge with a shiny new range of Microsoft-powered smartphones.

I’ll hasten to add that these made-up examples are somewhat unrealistic: To engineer a buyout, one must raise amounts of money commensurate with the company’s current valuation. Around 1987, Apple was worth about $2B, a great deal of money a quarter of century ago. In early 2011, Nokia’s market capitalization was about $40B, an impossibly large sum.

Still, thanks to these buyout fantasies, we get the two key ideas: First, Dell wants to go private because it plans to alter its business model in ways that would scare nervous, short-term Wall Street shareholders; second, the required amount of money (Dell’s market cap is about $22B) is a potential deal-killer.

We don’t have to look very far for the changes Dell wants to make. Dell no longer likes its legacy PC business and has made efforts to reposition itself as an enterprise player (expensive iron, software and services). Going private will allow it to perform the needed surgery, stanch the bleeding, and reemerge with a much stronger income statement, rid of low-margin commodity PCs.

When we look at the money that needs to be raised, things become really interesting. Michael Dell’s 15.7% ownership of the company undoubtedly helps, but the $22B market cap is still a big hill to climb. Several buyout firms and banks got involved in preliminary discussions; one group, TPG Capital, dropped out, but another, Silver Lake, has persisted in its attempt to round up big banks and other investors with enough funds to vacuum up Dell’s publicly traded shares.

That’s when Microsoft walks in on the discussions and offers to save Private Dell.

Clearly, Microsoft’s money will help in the buyout…but will its involvement torpedo Dell’s intentions? The NY Times DealBook article makes the case for Microsoft propping up the leading PC maker:

A vibrant Dell is an important part of Microsoft’s plans to make Windows more relevant for the tablet era, when more and more devices come with touch screens.

This would give Microsoft some amount of control over the restructured Dell, a seat on the Board of Directors, perhaps, with ways to better align the PC maker’s hardware with Redmond’s software. Microsoft wants Dell’s reinvigorated participation in the “Windows Reimagined” business.

But note the phrasing above: “Dell is an important part of Microsoft’s plans…” Better vertical integration without having to pay the full price for ownership, the putative “several billion dollars” would give Microsoft a significant ownership, 10% or 15%. This is completely at odds with the buyout’s supposed intent: Getting out of the PC clone race to the bottom.

Or maybe there’s another story behind Microsoft’s beneficence: The investor syndicate struggles and can’t quite reach the $22B finish line. Microsoft generously — and very publicly — offers to contribute the few missing billions. Investors see Microsoft trying to reattach the PC millstone to their necks — and run away.

Hats off to Steve Ballmer: Microsoft looks generous – without having to spend a dime – and forces Dell keep making PCs.

JLG@mondaynote.com