Dell Buyout to Test Hawkins’ Buy-and-Hold Math After DropCharles Stein and Miles Weiss
O. Mason Hawkins and G. Staley Cates, having made Southeastern Asset Management Inc. the second-largest investor in Dell Inc., told clients last year the computer maker was worth more than its sliding stock price suggested when viewed as a private company.
Their math may soon be put to the test.
Dell, based in Round Rock, Texas, is in buyout talks with private-equity firms, two people with knowledge of the matter told Bloomberg News this week. A deal could end Southeastern’s seven-year ownership of Dell shares during which the stock declined by more than 60 percent.
“I’ve been arguing with them since 2006 that it wasn’t a smart investment and I didn’t like the way they did their research,” said Michael Lipper, the head of Lipper Advisory Services Inc. in Summit, New Jersey. “These people have very deep beliefs and nothing appears to shake them,” said Lipper, who says some of his clients have money invested with Southeastern.
Cates, the firm’s president, and Hawkins, chairman and chief executive officer, are buy-and-hold investors who tend to take large positions in individual stocks and stick with them for a long time. Southeastern has held Dell since the third quarter of 2005 and owned 7.5 percent of the personal computer maker as of Sept. 30, according to data compiled by Bloomberg.
The investment, along with declines in major holdings such as General Motors Co. and Chesapeake Energy Corp., held down returns in recent years as Hawkins and Cates, like other prominent money managers with strong long-term records, struggled to beat markets.
“Value investors are prone to marry their stocks and sometimes find it difficult to part with them,” Geoff Bobroff, a mutual-fund consultant based in East Greenwich, Rhode Island, said in a telephone interview.
Lee Harper, a Southeastern spokeswoman, didn’t return phone calls seeking comment on the company’s investment in Dell.
Southeastern started buying Dell in the third quarter of 2005 and built its stake to 130.9 million shares by the middle of 2007, when the price ranged from $19.91 to $41.54 a share. Southeastern’s stake varied in size after that, reaching a high of 168 million shares at the end of the first quarter of 2009, when the stock traded at an average price of $9.59 a share.
The company held 130.1 million Dell shares at the end of September last year, according to SEC filings. Southeastern said at the end of the third quarter that Dell’s shares in a conservative valuation were probably worth in the “low $20s,” according to a regulatory filing.
“We are measuring it mainly on intrinsic value, on what we expect them to do and how we would view them as a private company if we owned the whole thing,” Cates said during the firm’s annual meeting in May for Southeastern clients. “On that front, they have just blown away all expectations.”
To avoid selling the stock below what the company may be worth, Southeastern could participate in an LBO by contributing its current shares for equity in the privately held company, a step that would also reduce the amount of money the buyout firms need to raise. Mutual funds are allowed to hold as much as 15 percent of their net assets in illiquid securities, according to Bobroff, the mutual fund consultant.
Holding securities that don’t trade can complicate a mutual fund’s efforts to determine its daily net asset value, the figure that dictates how much investors pay to acquire shares in the fund and receive when they cash out, according to Bobroff. That may be less of an issue for Southeastern because its Longleaf Partners fund held just 30.9 million Dell shares as of Sept. 30, equaling about 3.8 percent of its $8.1 billion in net assets.
Southeastern held 99.2 million shares in separate accounts for the firm’s other clients, which range from pension funds, wealthy individuals and university endowments to sovereign wealth funds, according to regulatory filings. Such clients typically don’t raise the same valuation concerns about holding illiquid stock as investors in a mutual fund might.
“I could see them participating if they were so offered,” Lipper said of the possibility that Southeastern might join a leveraged buyout. “They are a believer in Michael Dell.”
Founded in 1975, Southeastern managed $32.7 billion in mutual funds and separately managed accounts as of Sept. 30, according to its website.
Hawkins and Cates are best known for running the Longleaf Partners Fund. The fund averaged gains of 12 percent a year for the past 25 years, compared with 9.7 percent for the Standard & Poor’s 500 Index. For the past five years Longleaf returned 0.3 percent annually while the benchmark climbed 1.7 percent a year.
“They are patient investors and they are not afraid of controversy,” Russel Kinnel, director of mutual-fund research at Chicago-based Morningstar Inc., said in a telephone interview.
The Longleaf fund turns over the stocks in its portfolio about one-third as often as the typical U.S. diversified mutual fund, Morningstar data show. The fund is also more concentrated than peers. Its top 10 holdings represent 56 percent of the portfolio, compared with 29 percent for peers.
Southeastern, which is based in Memphis, Tennessee, told shareholders in a 2005 annual report that its managers wanted to own Dell for a number of years, describing the company as “high-quality business,” whose executives had “proven operational and capital allocation prowess.”
The fund managers have continued to defend Dell as the stock declined. Hawkins told Southeastern’s shareholders at their annual meeting in May that Dell was undergoing a metamorphosis from a personal computer company to a services firm, and was becoming “the IBM for small and medium-sized businesses.”
“We will lay a lot of money that it will certainly outgrow IBM in the next decade,” Hawkins said of Dell at the May meeting.
Dell declined 68 percent from Sept. 30, 2005, through last week. The stock jumped 21 percent in the first two trading days this week, to $13.17, on news of the buyout talks.
Longleaf Partners also paid $213 million in 2011 to purchase options that entitle it to buy 25 million Dell shares for $15 each until Dec. 14, 2015. The options, which entitle the Longleaf fund to buy the Dell shares “in the money” at $7 each, had a market value of $154.7 million as of Sept. 30, according to regulatory filings. Dell shares closed at $9.86 each on Sept. 28, the last trading day of the month.
Founder Michael Dell is the largest owner of the personal-computer maker with 16 percent of the shares.
Dell was Southeastern’s sixth-largest stock holding as of Sept. 30, according to a regulatory filing. The biggest holding, Oklahoma City-based Chesapeake, the second-largest U.S. natural gas producer, has also had its challenges.
The stock fell 25 percent in 2012 after natural gas prices plunged and CEO Aubrey McClendon was questioned about potential conflicts of interest between his personal financial transactions and corporate duties.
Southeastern, Chesapeake’s biggest shareholder, wrote the company a letter in May 2012, saying the energy producer should consider selling itself. Southeastern also advised the company to spend less time meeting with analysts.
Based on the Chesapeake experience, Morningstar’s Kinnel said the money managers wouldn’t be shy about offering Dell its opinion on any buyout offer.
Longleaf Partners Fund held General Motors shares in the fourth quarter of 2007, when the carmaker lost 32 percent of its value, the managers wrote in a 2007 annual letter to shareholders.
Some of Southeastern’s holdings have fared better. Direct TV, the largest U.S. satellite-TV operator, has more than doubled in value since October 2008, according to data compiled by Bloomberg. The El Segundo, California-based company was the money manager’s third-largest holding as of Sept. 30.
The fund in 2012 sold Yum! Brands Inc. for a big gain after holding it for more than a decade, Morningstar analyst Gregg Wolper wrote in an October note. Yum is a Louisville, Kentucky-based fast-food company.
Wolper, in the same note, said of the fund, “It is appropriate only for investors who fully understand its strategy and have extraordinary patience and calm.”