Dell: Rekord för laptops ger $65 fair value

Guidance for the fourth fiscal quarter included a sequential revenue increase of 3.5% at the midpoint (typical seasonality is 5.5% at the midpoint) and slightly higher operating margin dollars versus the third quarter. While explicit guidance was not provided for fiscal 2022, Dell is cautiously optimistic that the demand environment for IT spending is improving. The company also believes it may be on the cusp of achieving investment-grade credit quality, which is up to the agencies, and will continue to prioritize paying down its obligations.

Business Strategy and Outlook | Nov 25, 2020

Born out of Dell's 2016 acquisition of EMC, Dell Technologies is a pre-eminent vendor of IT infrastructure products and services. Although Dell Technologies has substantial exposure to commoditized markets and carries considerable financial leverage, we believe synergistic opportunities across its brands should drive success as businesses migrate to hybrid cloud IT infrastructures. Dell Technologies' business centers around PCs and peripherals, servers, storage, networking equipment, as well as software, services, and financial services. Its brands include Dell, Dell EMC, VMware, Secureworks, and Virtustream. The company returned to the public market in late 2018 through a reverse merger of the VMware tracking stock, DVMT.

The company's largest revenue streams of commercial PCs and servers are in cutthroat pricing environments that rely on services and support to generate profit. We expect the overall PC market to continue consolidating toward an oligopoly and for consumer-based profits to come from high-end and gaming PC sales. While storage is a challenging marketplace, we believe flash-based arrays and hyperconverged infrastructure provide avenues for rampant growth. We posit that the company's majority ownership of VMware and other cloud-centric software brands provides growth catalysts as firms augment hardware with software-based solutions. After the acquisition of EMC, we view Dell Technologies as an end-to-end IT infrastructure provider that is supplementing hardware prowess with emerging software and cloud-based solutions. We're optimistic about its ability to upsell VMware and other cloud-based solutions, especially in high-growth areas of hyperconverged infrastructure and software-defined networking, but we do expect competitive markets to challenge the company's overall profitability.

We think that Dell Technologies' debt burden may affect its ability to invest in the development and sales of future innovative products. Public shareholders have very little influence on the company's strategy and rely heavily on CEO Michael Dell and Silver Lake Partners making value-accretive decisions.

Economic Moat | Nov 25, 2020

We believe Dell Technologies is without an economic moat. The company is a leader in most of its significant operating segments, and portions of its business are moaty, in our view, as evidenced by our narrow moat rating for VMware, which is 81%-owned by Dell Technologies. However, Dell Technologies derives most of its revenue from challenging commoditized markets that affect its ability to generate excess economic return on invested capital. The amalgamation of various technology brands into an end-to-end product portfolio for the IT environment provides Dell Technologies with substantial cross-selling and upselling opportunities as it broadens its product portfolio to encompass the overarching market shift to hybrid cloud environments. Altogether, we expect difficult pricing environments for servers and PCs to inhibit consolidated operating results as Dell Technologies attempts to move forward as a unified company.

Dell Technologies' three reportable segments are its infrastructure solutions group, or ISG; client solutions group, or CSG; and VMware. In fiscal 2020, net revenue of $92 billion was split as 37% from ISG, 50% from CSG, and 14% from VMware. Additional revenue was provided from Dell Technologies' other business that include Secureworks, Virtustream, and Boomi. Fiscal 2020 non-GAAP operating income of $10 billion was split among the reportable segments as 39% from ISG, 31% from CSG, and 31% from VMware (Dell Technologies fiscal 2020 GAAP operating profit was $2.6 billion). In fiscal 2020, products represented 77% of revenue, with a 23% gross margin, whereas services were 23% of revenue and had a 60% gross margin.

The ISG segment is the result of the largest technology-related acquisition after Dell purchased the storage behemoth EMC for $67 billion in 2016. Along with storage solutions, the ISG segment sells servers, networking, and hyperconverged infrastructure, or HCI, equipment, as well as software, peripherals, and services. Dell is a leader in both the server and storage markets. Additionally, Dell Technologies is one of the leaders in the rapidly growing HCI market. Although we believe there are switching costs within a fraction of the total ISG offerings, like HCI and high-end storage products, the segment is not awarded a moat due to the competitive environment within largely commoditized markets weighing on its performance.

Dell Technologies' storage products (18% of fiscal 2020 revenue) include traditional and next-generation products, as well as services and support. While most revenue is derived from selling traditional arrays, the company boasts a leadership position in the nascent technology of all-flash array storage. IT professionals are increasingly installing the more expensive all-flash arrays or hybrid arrays over mature hard disk drives because of performance, capacity per size, and lower power consumption. Expeditious data growth and low latency requirements created a requirement for next-generation storage products, and the ISG group has capitalized on being an early mover in the all-flash array market. We expect storage innovators, like NetApp, Pure Storage, and Hewlett Packard Enterprise, to also benefit from the secular trend of increased storage demand, and we believe that Dell Technologies’ research and development and massive salesforce will be able to sustain its leadership position as it cross-sells its high-performance storage products into other Dell Technologies product families. We assign a no-moat rating to NetApp, which is a pure-play storage provider and Dell Technologies’ rival.

Although we believe that Dell Technologies benefits from hyperscale public cloud vendor agreements, which offer Dell EMC storage solutions within their cloud environment, we expect the large public cloud providers to favor white-box storage solutions, as is the case with antiquated storage technology, over the longer time horizon. In our view, Dell Technologies has ample opportunities to remain the top provider of on-premises and private cloud storage in hybrid cloud environments and also benefits from selling unique software and services. We believe that customers will typically repurchase high-end storage from their existing suppliers because of compatibility concerns in changing vendors, if past performance and services met the customer’s demand. However, we expect an eventual commoditization of storage technology to cause Dell Technologies to rely on cross-selling storage with other products like servers and HCI.

Servers and networking represented 19% of Dell Technologies' fiscal 2020 revenue. Mainstream servers and HCI equipment sales dwarf the revenue from networking switches and firewalls in this portion of the ISG segment. Most of Dell Technologies' servers are mainstream x86 servers, and the company is not focused on providing servers into the lower-margin hyperscale cloud market. The company benefited from a strong IT spending environment, purchasing scale, and passing along higher component costs to customers, and we believe Dell Technologies can upsell artificial intelligence, machine learning, and analytics capabilities for higher end products, in addition to the value of its services and support. While we believe that Dell Technologies benefits from being able to sell end-to-end product portfolios for data centers, ISG's largest revenue stream is based on commoditized technology. In turn, we do not believe the servers and networking businesses exhibit moatworthy characteristics. We assign a no-moat rating to HPE, one of Dell Technologies' main server and networking equipment rivals.

HCI, the combination of computing, storage, networking, and virtualization, is an emerging technology that IT professions are embracing because of its scalability and the convenience of discrete items merged into a single resource. We believe that HCI will continue to be embraced in locations like remote offices, retail locations, and factories as edge computing continues its rapid growth. Instead of sending data back to a centralized data center, which becomes cumbersome for high-bandwidth items and real-time data analysis requirements, HCI allows for rapid processing within a localized site, while still being part of the larger network. Because of the integration of multiple aspects of IT technology built into a single appliance, we believe HCI becomes a crucial piece of a network and that customers will scale up with their incumbent manufacturer to ensure compatibility and limit disruptions. We expect a rapid growth trajectory for the technology and believe that Dell Technologies can continue its leadership position in HCI though its dominance in the individual pieces that make up the systems. A key selling proposition is Dell Technologies’ ability to sell turnkey solutions that contain VMware virtualization. We believe the ISG segment's HCI products create switching-cost barriers, but these products represent only a fraction of ISG total sales.

Dell Technologies' CSG segment sells Dell-branded computers, monitors, and peripheral products to the consumer and commercial markets, in addition to software, support, and services. Respectively, the commercial division represented 37% and the consumer division 13% of Dell Technologies’ consolidated net revenue in fiscal 2020. Because of the commoditized nature of the computer and accessory markets, combined with headwinds from increased smartphone usage and software-as-a-service-delivered applications not necessarily requiring computer hardware upgrades, we do not believe Dell Technologies' CSG segment exudes moat characteristics. We similarly assign no-moat ratings to the other leading PC vendors, HP and Lenovo.

As one of the largest sellers of PC units, the CSG segment faces tough competition from HP and Lenovo. We believe that the PC market is consolidating around the top three vendors, who we expect to outpace the market as a whole; however, we expect the PC market to remain a challenging selling environment. Margin-accretive options like attaching services and support, as well as selling nascent trends like PC-as-a-service, provide Dell Technologies opportunities to expand its strong presence in the commercial PC market. In the consumer segment, appeasing a growing demand for high-end devices and gaming computers has remained a concerted effort. Dell and its competitors enjoy the impact of Microsoft Windows’ refresh cycles, and we like the migration to higher-margin products and services; however, we believe market competitiveness between the top three companies for important business accounts thwarts any semblance of a moat around the CSG division.

A key aspect of the EMC acquisition was gaining the majority ownership of virtual machine leader VMware. As of November 2020, Dell Technologies owned about 81% of VMware's outstanding equity interest. Morningstar maintains coverage of VMware separately, and the following section is closely aligned with our VMware equity research report. We designate VMware with a narrow moat, which we attribute to customer switching costs. As the dominant player in machine virtualization, VMware has an extensive installation base in mission-critical enterprise data center servers. In our view, customers are likely to stay with VMware because of knowledge of its product ecosystem as well as the risks and complexities associated with changing virtual machine providers.

VMware's revenue stream consists of selling software licenses and supplemental services that include software maintenance and support offerings. Including vendors such as Microsoft that bundle free virtual machine capabilities with other server offerings, we estimate that VMware still owns 60%-75% of the market. The server virtualization market can be considered saturated, and we expect VMware's market share to remain stable. We note that VMware is diversifying itself away from server racks with products like NSX that enable VMware to capture network virtualization and security customers, vSAN for hyperconverged networking, and Workspace One and AirWatch are considered best in class for network edge management and monitoring. We believe that VMware will further interweave itself into customers' networks via products for the nascent networking trends of hyperconverged infrastructure, hybrid cloud virtualization, and containerization.

Over the previous decade, VMware's software being installed throughout enterprise server racks created a barrier to changing vendors. VMware created a widespread virtual machine and hypervisor market and then flourished with its first-mover advantage. We believe networking teams are reluctant to change vendors because of VMware's superiority in feature suites, user-friendly graphical user interfaces, and potential network disruption. Moving to a VMware alternative requires significant overhauling of an enterprise's network backbone. We believe that VMware's customer stickiness is reinforced through its ecosystem of virtual machine products, including virtual storage, security, and routing. In our view, potential disruptions to displace VMware within networks is not worth the risk to enterprises, and we believe VMware's customer support, services, and user-friendly design provide it with an advantage over competing open-source options.

VMware's largest advantage could be its ability to offer one interface for a company's entire networking infrastructure. Many companies have struggled with migrating to public clouds but want to reap the benefits of outsourcing workloads. Conflicting private and public cloud software systems and the desire to keep certain items in private clouds for speed, security, and cost concerns have been problematic to many enterprises attempting to fully adopt public clouds. Most IT professionals are accustomed to using VMware on-premises or in their private clouds but were not afforded the same familiar interface in public clouds. VMware's hybrid cloud efforts, through partnerships with cloud providers, gives IT teams a sense of familiarity between private and public clouds. We believe enterprises will continue to pay for VMware software while expanding operations to public clouds because of commonality between existing VMware product entrenchment and new offerings.

VMware is well-ingrained in mission-critical pieces of networking operations, and we believe its burgeoning product offerings will be on customers' short list of potential vendors during network upgrades. To protect its moat as technology evolves, VMware is expanding from its dominant position in machine virtualization into adjacent markets of hybrid clouds, hyperconverged infrastructure, and containers. We assess that VMware will not command such dominant market share as it enjoys in server machine virtualization; however, the company's strategic plan is sensible for continued growth.

Dell's EMC acquisition also included RSA Security, Pivotal, and Virtustream. Dell sold Pivotal to VMware in 2019 and sold RSA to a group of investing firms in 2020. Dell Technologies' other businesses segment includes Boomi and Secureworks. Collectively, as of fiscal 2020, these businesses represent almost 3% of Dell Technologies' net revenue. We do see semblances of switching costs forming around some of Dell Technologies' nascent cloud-based software platforms, but the impact is too small to affect the company's consolidated rating.

Pivotal provides a cloud-native architecture for application development and IT operations. In December 2019, VMware completed the acquisition of Pivotal from Dell Technologies. Businesses can accelerate their application development by having continuous delivery of any application across the public and private clouds. We believe this rapidly growing business is an important asset to Dell Technologies via VMware as companies utilize a hybrid cloud model and require application development and continuous uptime across various cloud platforms. Pivotal and VMware have collaborative product offerings, and we believe this enriches Dell Technologies' presence outside of on-premises and private clouds. Although we believe that Pivotal could create switching costs through its software becoming ingrained within networks, the technology's nascence and possible open-source or customized software threats make us hesitant to assign a moat source.

Secureworks is an intelligence-driven cybersecurity company that uses a threat research team to study hackers' tactics to create models and then protect companies with real-time threat analysis from machine learning. The firm is a respected managed security services vendor, and we believe Secureworks benefits from VMware being under the Dell Technologies umbrella. The two entities have sold security for virtual instances, and we expect more product partnerships to be announced as security and cloud-based computing continues its rampant growth.

Virtustream is a cloud software and infrastructure-as-a-service provider. The company offers cloud services, with a focus on running complex and mission-critical applications. While we believe that Virtustream can provide Dell Technologies possible upselling opportunities alongside hardware and software sales, we see the cloud provider market as an extraordinary challenging business model against the likes of the hyperscale cloud providers.

Dell Technologies' Boomi provides a platform to connect applications and data across clouds and on-premises. Boomi ties together different application endpoints and manages data through an entire end-to-end workflow platform. By simplifying the IT infrastructure through completing the heavy lifting via an intuitive product, we view Boomi as a possible cause of future switching costs; however, the products are not mature enough to determine whether Boomi will make a material impact on cloud-based infrastructure or if hyperscale cloud providers will offer similar experiences. We believe Boomi creates cross-selling and upselling opportunities across other Dell Technologies products.

Fair Value and Profit Drivers | Nov 25, 2020

We are maintaining our fair value estimate of $65 per share, consistent with an enterprise value/adjusted EBITDA of 10 times and an adjusted price/earnings of 9 times for fiscal 2021.

We project that Dell Technologies' revenue will rise at a five-year revenue compound annual growth rate of 2%. By product line, we project the ISG segment to slightly grow, which includes storage and servers. We model a low single-digit five-year CAGR for storage, primarily driven by flash array demand, data proliferation, and software-defined networking. We model a slight yearly decline in CSG revenue in the long run, which includes PCs. We project VMware growing around the double-digit range due to strong demand for VMware's hybrid cloud ecosystems and networking solutions, in addition to cross-selling opportunities. We expect the other businesses (Secureworks, Virtustream, and Boomi) to contribute revenue growth during the same time period due to cloud-based software adoption across IT teams.

In our view, Dell Technologies should be able to maintain gross margins in the low 30% range, up from the mid-20% range in fiscal 2018 and fiscal 2019 through increasing product cross-sales and upsells, especially through adding software suites. In our view, Dell Technologies has substantial cross-selling and upselling opportunities as well as collaborative development efforts that will lower operating expenses as a percentage of revenue. In turn, we model operating margin to expand into the mid-single digits in fiscal 2025 from negative 0.2% in fiscal 2019.

Risk and Uncertainty | Nov 25, 2020

We think Dell Technologies has a very high fair value uncertainty rating. In our view, the company's sizable debt balance and dependence on revenue from challenging commoditized environments could encumber its growth trajectory via nascent technology trends. In turn, the company may not be able to effectively cross-sell its brands. Investors should be wary that public shareholders have very limited voting power and rely on CEO Michael Dell's vision.

With the ISG segment, pricing typically drives customer behavior around servers and industry-standard storage. We expect flash-based storage to demand a premium but believe an eventual commoditization of this technology could erode margins. An unknown surrounding storage is whether the impact of the next innovation phase will be as revolutionary as flash versus disk drives. We expect that the hyperscale public cloud vendors may move toward hybrid cloud by selling solutions like storage and computing outside of their public domains. In addition, ISG's networking competitors are also moving toward selling a more holistic suite of products for a digital infrastructure that could affect pricing and upselling opportunities. VMware, a key cog in IT infrastructure, operates as an independent entity and has key partnerships across the IT infrastructure landscape that could affect Dell Technologies' ability to sell an entire product ecosystem.

The CSG segment's uncertainties rest in the headwinds facing PCs and peripherals, as we expect a competitive market to remain as computer purchases decline. In our view, SaaS delivered products and smartphone adoption could delay hardware refreshes. Also, Dell Technologies' competitors are following similar strategies of focusing on higher-end and gaming PCs for consumers alongside services and support for businesses. These similar strategies could erode prices for the traditionally margin-accretive add-ons.

Stewardship | Nov 25, 2020

We assign Dell Technologies a Poor stewardship of capital rating. The company's ownership structure gives public shareholders very limited power, and past deals and decisions may have created shareholder mistrust. In our view, stewardship could be improved if the company acts on its intentions to give public shareholders more power, executes on its strategic growth plan, and achieves its debt repayment targets.

Michael Dell, the current CEO and chairman of Dell Technologies, founded Dell Inc. in 1984. In 2013, Michael Dell and Silver Lake Partners, a private equity company focused on technology firms, acquired Dell Inc. in October 2013 and took it private. Upon completing the deal, Michael Dell controlled 75% of the firm.

In 2016, the private Dell purchased EMC for $67 billion. As part of the deal, EMC's 81% ownership of VMware enabled Dell to issue a VMware tracking stock, DVMT, which represented Dell's economic interest in VMware. In EMC's merger documentation with the SEC, the company stated that DVMT should trade at approximately a 0%-10% discount to the value of VMware, given DVMT's lack of voting power. DVMT actually traded at a discount of 25% of VMware, and that gap widened up toward 40% at times, and we believe shareholder mistrust was created through the deal that formed Dell Technologies.

Dell Technologies returned to the public market by buying out and retiring the DVMT shares and listing a Class C common stock. However, we believe the transaction was marred by shareholder distrust as investors felt the leadership team was initially presenting self-interested offers. Eventually, the company capitulated and increased its final offer to $120 per DVMT share versus the original $109 and agreed to a cash payout cap of $14 billion versus $9 billion. Additionally, to facilitate the deal, VMware agreed to pay out a one-time special dividend of $11 billion. VMware did form a special committee of independent directors to evaluate Dell Technologies' possible venues of returning to the public market, and we believe the special dividend was an acceptable choice versus a VMware reverse merger. Dell is exploring the option of spinning off its VMware stake. The spin-off would not occur until September 2021 at the earliest for tax purposes, and Dell expects that VMware would pay a special dividend to help facilitate the deal.

As of Dell Technologies' 2020 proxy statement, Michael Dell and his wife's trust (Susan Lieberman Dell Separate Property Trust) own about 75% of the total voting power and investment funds affiliated with Silver Lake Partners own about 20% of total voting power and MSD Partners, L.P. Class A and Class B shares have 10 votes per share and Class C common stock has a single vote per share. Because Michael Dell owns more than 50% of Dell Technologies’ total voting power, the firm is considered a controlled company per NYSE rules and it is exempt from certain corporate governance requirements such as requiring a board, compensation committee, and nominating committee made up of independent directors. However, as part of bringing Dell Technologies public, the company conceded that Class C shareholders can elect an independent director, independently from the holders of other outstanding share classes, starting at the 2020 annual meeting.

Because of Dell Technologies’ history and ownership structure, we remain skeptical about the company's cash allocation plans. If it proceeds as expected, prioritizing paying down its sizable debt balance, we believe the company's stewardship of shareholder capital is moving in a favorable direction for shareholders. In our view, Dell Technologies’ plan to not reward shareholders through dividends or share repurchases is prudent due to its capital structure, and we expect the company to use cash to reward shareholders or make acquisitions after its credit rating achieves investment-grade.

Although management mistrust may have occurred through past deals, we do believe that management's decisions make sense from a strategic standpoint. In our view, Dell's acquisition of EMC fueled the only true end-to-end IT infrastructure provider while gaining valuable ownership of VMware. We expect the company to continue to integrate Dell and EMC together with a more unified sales and development staff, and we believe Dell Technologies has a strong, distinct value proposition through its combination of hardware and software for hybrid cloud environments.