Dell-HP Bidding War: The Real Story

08/31/2010 9:25 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Why are the tech giants willing to pay nearly $2 billion for a data storage company that isn't turning a profit?

On the surface, bidding a couple of billion dollars for a company that hasn't made an operating profit in the past five years looks nuts.

Dig deeper, though, and the battle between Dell (Nasdaq: DELL) and Hewlett-Packard (NYSE: HPQ) to buy data storage company 3Par (NYSE: PAR) doesn't look nuts—it looks insane. 3Par's sales are projected to hit all of $235 million for the fiscal year that ends in March 2011. Earnings before interest, taxes, depreciation, and amortization, or EBITDA, are projected at just $21 million.

On August 26, Dell proposed paying $1.5 billion for 3Par. Later in the day, Hewlett-Packard bid $1.7 billion. Each bid came to roughly 80 times EBITDA for 3Par. Then both raised those bids the next day, Friday, with HP ready to pay nearly $1.9 billion.

Aren't these companies certifiable?

If you're even asking that question, you don't understand where we are in the economic cycle and how that's driving company strategy in the technology sector. This isn't an age for valuation, in which companies carefully figure out how to get the best value for the money they're about to spend. This is the era of cash as a bludgeon.

Money: It's the Gas, Gas, Gas

Cash-rich companies are looking to club their poorer competitors over the head with dollars. At worst, the result of this spending will be a competitor that is unable to climb off the canvas for years. At best, such spending might crush a competitor forever.

Put the Dell-HP contest over 3Par into competitive context, and it starts to make sense despite the insane valuation awarded to the storage company.

Once upon a time, Dell was the top dog among the makers of personal computers. Then Hewlett-Packard began an aggressive strategy of acquisitions that not only moved it into the top position among PC-makers but also built new strengths for the company in services, storage, and smart phones (Hewlett-Packard hopes, at least).

By the time Dell noticed the changes in its marketplace, it was forced to play catch-up.

Nothing sums up that competitive deficit better than Dell's response to Hewlett-Packard's May 2008 purchase of Electronic Data Systems, a giant information technology services provider, for a tad less than $14 billion. That purchase vaulted Hewlett-Packard to number two behind IBM (NYSE: IBM) in the IT services market.

When Dell tried to catch up in September 2009, the best acquisition it could come up with was the much smaller Perot Systems for about $4 billion.

Beating Up on Dell

The shift in relative market power during the past five years has been stunning.

Hewlett-Packard has always been larger than Dell in terms of revenue, but the gap has widened. In 2005, Dell had 56% of Hewlett-Packard's revenue. In 2006, Dell's revenue was up to 61% of Hewlett-Packard's revenue. And then the slippage: To 54% in 2007, to 51% in 2008, and then a slight recovery to 53% in 2009.

Technology companies have the power to turn slight changes in revenue into huge moves in earnings. And no one who understands that will be surprised to discover that Dell's relatively small slippage in the size of its revenue relative to Hewlett-Packard's resulted in a massive move in relative earnings between the two companies.

In 2005, Dell, despite much smaller revenue, recorded operating earnings 20% greater than HP's. 2006 saw a huge plunge: Operating earnings at Dell were just 65% of those at HP. In 2007, the drop got worse: Dell's operating earnings were just 36% of those at Hewlett-Packard. They slumped to 32% of HP operating earnings in 2008 and 2009.

NEXT: Why Dell Needs to Make a Deal

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Dell Needs a Deal

Dell's 3Par bid is an attempt to break this pattern with a disruptive acquisition. By owning 3Par, Dell could sell its own storage systems rather than reselling those made by EMC (NYSE: EMC). And that would give Dell an entry into the market for storage systems built around cloud-computing technologies, which store data online rather than on a user's hard drive.

And Dell almost certainly thought that it had the turmoil involved in the August 6 departure of Hewlett-Packard CEO Mark Hurd to its advantage. Maybe HP was distracted. As it turns out, maybe not.

And Hewlett-Packard is determined not to give Dell any chance at a turnaround in the companies' relative fortunes. With $15 billion on hand at the end of July, Hewlett-Packard has plenty of cash to bury Dell. $1.9 billion? Pshaw! That's roughly 13% of cash in the bank.

Of course, Dell isn't exactly without resources itself. The company finished July with $12 billion in cash.

Hewlett-Packard's latest bid comes out to $30 a share. That's about twice what 3Par was selling for before all this started. And there's no reason it can't go higher. Further, if anybody at Dell or Hewlett-Packard starts to think this isn't a good long-term use of their company's cash, all they have to do is look across the technology sector to Intel (Nasdaq: INTC).

By relentlessly reinvesting its cash in new chip-making technologies and new chip factories, Intel has relegated competitor Advanced Micro Devices (NYSE: AMD) to nearly permanent second-class status. For 2009, AMD made a gross profit margin of 44%; Intel's gross margin was 63% that year, and in 2010, it has climbed even higher.

How do you catch up when your biggest competitor is making 20 percentage points more in profit margin than you are? You don't.

Following Intel's Lead

By the way, Hewlett-Packard's gross margin lead over Dell is significant—23% to 17%—but it's not in Intel's class. You don't think the folks in Palo Alto, California look down the valley to Intel's headquarters in Santa Clara and dream?

In the era of cash as bludgeon, what does a company like Intel do? It finished June with $18 billion in cash on hand. There's no way that crushing Advanced Micro Devices further would yield a reasonable payoff on invested capital.

So Intel is doing what similarly cash-rich companies—Cisco Systems (Nasdaq: CSCO), for example, with $39 billion in cash—that have crushed their competition are doing: Bludgeoning their way into new markets.

In Intel's case, it's cell phones.

On August 26, Bloomberg reported that Intel was close to a deal to buy the wireless business of chipmaker Infineon Technologies (OTC: IFNNY). Estimated price: $2 billion.

Intel's chips may be everywhere in the PC and server markets, but the company is a bit player in cell phones. Buying Infineon's cell phone unit would make Intel a player immediately.

Infineon makes processors used in Apple's (Nasdaq: AAPL) iPhone and in Samsung Electronics' (OTC: SSNHY) Galaxy S phone. Intel recently signed agreements with Nokia (NYSE: NOK) and LG Electronics aimed at eventually getting its Atom chips into phones from those companies. The $430 million in revenue that the Infineon cell phone business made in the third quarter (ending June 30) of its fiscal year would open a lot of doors for Intel.

And Intel seems determined to use its cash to make it impossible for makers of cell phones not to flock to its door. On August 19, Intel announced that it would buy security software company McAfee (NYSE: MFE) for $7.7 billion. The theory among analysts is that the deal would give Intel the ability to bundle enhanced security with its processors. That doesn't seem like a high-demand item among cell phone buyers or makers right now, but Intel's strategy with its PC chips has been to add enough built-in functions to differentiate them. I wouldn't be surprised to see the company follow the same strategy in the cell phone market.

And to spend the cash to make it happen somewhere down the road.

You've got to say this for Intel, Hewlett-Packard, and Dell: They aren't sitting around planning strategies for just the next quarter or two.

At the time of publication, Jim Jubak did not own or control shares of any company mentioned in this column in his personal portfolio. Cisco Systems is in his Jubak's Picks portfolio.

Jim Jubak has been writing Jubak's Journal and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of the 2008 book "The Jubak Picks" and the writer of the Jubak Picks blog. He's also the senior markets editor at MoneyShow.com.

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