When Standard and Poor’s downgraded Dell to junk in September 2013, it cited the slump in the PC business, the pricing pressures in the sector, and the proposed buyout of the company by founder Michael Dell and private equity firm Silver Lake Management. They’d heap new debt on the company whose sales at the time had dropped 8% from a year earlier, and whose net profit had plunged 32%. But at least it still had a profit.
But OK, instead of investing in cutting-edge products and services that could move the company forward, it’s the perfect time for Dell and its investors to embark on the largest tech deal ever, a masterpiece of financial engineering, the $67 billion buyout of data-storage company EMC.
Standard and Poor’s, which affirmed Dell’s current junk rating of BB+ but put EMC on CreditWatch negative, figured that the deal would be funded through a mix of debt issuance, including perhaps $40 billion in leveraged loans, equity from current owners and the Singaporean wealth fund Temasek, some cash on hand, and the issuance of a flimsy tracking stock – similar to issuing old bicycles – to track VMware’s stock price. Details have not been disclosed.
Wall Street loves it. A whole slew of financial advisors are in on the deal, on both sides. The $40 billion in leveraged loans alone could rake in $500 million in fees, Business Insider reported. Total advisory and financing fees could exceed $700 million. Ka-ching.
And what multiple is Dell paying for EMC? Back in 2013, Michael Dell and his compadres were paying 5 times Ebitda (earnings before interest, taxes, depreciation, and amortization) for Dell. Now, to show the world just how crazy the M&A boom has gotten, and how valuations have soared, they’re paying 12 times Ebitda, according to Bloomberg’s math. At this valuation, things would get dicey even in a hot, high-growth industry for a healthy, growing, and profitable acquirer.
But Dell is none of these.
As a privately-owned company, Dell doesn’t publish financials via SEC filings. The holders of its debt securities receive quarterly reports that Dell doesn’t have to disclose. But the New York Times obtained the confidential report for Dell’s fiscal second quarter, ended July 31, 2015. And it was a doozie.
For the six months ended July 31, revenues dropped 7% from the same period last year to $27.5 billion. Gross margin dropped to 17.1%, down from 18% a year earlier. And its net loss jumped 35% to $768 million.
And in discussing the gross margin, Dell’s filing pointed to some of the struggles it is facing in the division that focuses on selling computers. It said that the margin shrinkage was “primarily driven by an overall market decline resulting in a decrease in desktop and notebook units sold, in conjunction with challenging pricing dynamics.”
Gross profit for that segment for the six months through July plunged 26% year-over year to $2.5 billion.
Cash flow, the single most important measure to see if the company can service its debts, plunged 37% to $733 million. But even that dwindling cash flow appears to be of dubious quality. The Times:
And in the latest period, Dell appears to have squeezed more cash out of sources than it might be able to repeat, such as by pressing its customers to pay more quickly. Cash flows also benefited from a large positive change in a line called “other assets.”
Alas, even as sales, profit margins, and cash flows are declining, Dell’s finance unit is funding more sales: total loans outstanding to its customers rose nearly 3% year-over-year to $5.17 billion. A sign that its customers are running out of money or falling behind? Or that Dell is using financing – perhaps even subprime financing – to stimulate moribund sales? We don’t know.
We do know what HP has been going through after its big acquisitions: business disruptions, lawsuits, declining sales year after year, morale problems, failed CEOs that then run for political office, investment in financial engineering rather than actual engineering, huge write-offs and losses every few years, and wave after wave of mega-layoffs.
But no deal HP has done comes close to Dell’s acquisition of EMC. That deal, the flood of junk debt it will disgorge, and all the problems it will cause are in a class of their own. That this deal is even taken seriously shows that the Fed-designed credit bubble that Wall Street cherishes so immensely and can’t conceive living without has reached peak desperation – before it all ends.
With so much Wall Street horsepower lined up behind it, funding for the deal will likely go through. But Dell is facing turbulence and air pockets as it tries to sell its new junk debt. Read… Junk Bond Issuance Collapses as “Distress Ratio” Spikes
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