Going over par for 3PAR?

Dell’s second quarter result has been over-shadowed by its tussle with larger rival Hewlett-Packard (HP) for data storage provider 3PAR. Dell initially announced that it planned to purchase 3PAR for $18 per share, representing a massive 90% premium to the stock’s previous price. The size of the premium raised the prospect that Dell was overpaying, but HP clearly didn’t think so judging by its subsequent counter offer of $24.

Dell subsequently fought back with a marginally better offer at $24.30 on Thursday, only for HP to almost immediately trump it again with a cheque for $27 per share. The latest top offer values the company at around $1.7 billion. Given the price that both companies are willing to pay for 3PAR, the bid is clearly more about long term strategic direction, rather than simply the stand-alone value of 3PAR itself.

3PAR is a leading company in the field of data storage and specifically as that relates to cloud computing. 3PAR would complement Dell’s previous acquisition of high-end storage product company EqualLogic and provide Dell with a foundation from which to launch a solid cloud computing offering.

Cloud computing is the next major evolutionary stage in corporate computer usage, similar to the shift from huge mainframe computers to client servers that occurred in the 1980s. It essentially uses the internet to provide data storage, software applications and other tools to a user. The key difference is that the user doesn’t actually have the particular application installed on their desktop.

“Dell delivered a robust second quarter result, with sales of $15.5 billion coming in comfortably ahead of expectations for $15.2 billion.”

Cloud computing is becoming more popular because it enables companies to avoid the capital expenditure required to continually upgrade and maintain software and data storage capabilities. This in turn reduces the need for in-house IT expertise and the cost of a cloud service would typically result in considerable cost savings for a large organisation.

Dell and HP are intensely interested in this because they recognise that it is a high growth area and both companies want to expand their product offering. In Dell’s case this is specifically aimed at continuing to reduce the company’s dependence on the fickle consumer market on which its business has its foundations. Dell has already gained significant ground in this area and its commercial business currently accounts for around 81% of group sales.

Demand within the corporate sector is still subject to the vagaries of the business cycle. But following a long period of inaction through the GFC, many companies are now re-starting their IT upgrade cycle and this is likely to drive a wave of demand through the next 12-24 months. Moreover, if Dell is able to gain a slice of the service rather than solely hardware market, its earnings will become less cyclical and therefore more valuable to investors.

The strategic value of a particular deal can justify a higher price, but at the end of the day the ability to extract value will always be impacted by the price paid. As such, we will carefully assess any revised offer that Dell produces and especially so if they are successful. Dell is competing against the deeper pockets of HP though, so HP is the more likely victor if value concerns go out the window and the two go toe-to-toe. Indeed, Dell’s $0.30 increase to HP’s previous offer indicates that management is losing its appetite to go much further and anything over $27 is probably out of reach.

In the meantime, Dell delivered a robust second quarter result, with sales of $15.5 billion coming in comfortably ahead of expectations for $15.2 billion. This represents 22% sales growth in comparison to the same period last year, driven by strong demand for servers and networking, storage and services products from the company’s corporate customer base. These elements of the business saw a mammoth 43% sales growth, assisted by the Perot acquisition.

The strong top line result unfortunately didn’t flow through to the bottom line. Dell’s adjusted gross profit margin of 17.2% fell short of an expected 17.7% due to the twin evils of rising component costs (memory, LCDs, hard-drives etc) and falling PC prices. Nevertheless, management still delivered 15.5% earnings growth from $472 million last year to $545 million.

Management also reiterated previous full year guidance for sales growth of 14-19% and adjusted operating earnings growth of 18-23%. The second half performance should benefit from some margin recovery as the component cost pressures are expected to ease.

Turning to the charts, Dell has continued to decline in line with the downtrend in place since April. The most recent low printed was at US$11.34 on August 24. The move lower saw the RSI touch oversold levels, which is an indication of an exhaustive move to the downside.

We would however anticipate buying pressure to emerge over the near term, which could potentially result in a move higher to test resistance at the 50 period moving average (green line) at US$12.80. Downside support is underpinned at the May 2009 low of US$10.59.

The weekly chart reveals the downtrend in place since August 2005. Respect of the 39 week moving average (green line) at US$13.89 suggests weakness over the broader term, which could result in a test of the US$10.00 region. A convincing break above the 200 week moving average (red line) at US $18.86 would change the longer term trend to the upside.

Dell will remain held in the Fat Prophets Portfolio.