There are enoughabsurdities on the surface of Carl Icahn's pseudo-proposal for Dell that you don't need to think deeply to find more but I guess you could. One thing that might bother you if you let it is the old slicing-the-pie-to-make-more-pie thing. Why should funding Dell with more debt and less equity, and running it with less cash, make it more valuable? Icahn's plan involves paying shareholders $16 billion in cash in exchange for reducing Dell's net asset value by $16 billion; the total value of what the shareholders own (Dell shares -> cash + shares) should really stay the same.
This is an argument against all corporate finance structuring and nobody really believes it, though some people come close. Obviously you can make a company more valuable by financial engineering!1 There's some debate, though, over which sorts of engineering actually work. LBOs? Definitely. (I mean, probably.) Levered recaps? Sometimes, sure. Preferred-stock-funded recaps? Umm. Maybe!
Just some random warrants? No come on that's nuts.
Anyway here is Icahn's proposal to throw in some random warrants on top of his random tender offer. It is ... random? Here it is, be warned, it's shouty:
UNDER OUR REVISED PROPOSAL DELL WOULD SELF TENDER FOR 1.1 BILLION SHARES OF DELL STOCK IN EXCHANGE FOR $14 PER SHARE PLUS ONE TRANSFERABLE WARRANT FOR EVERY FOUR SHARES PURCHASED IN THE SELF TENDER OFFER. EACH WARRANT WOULD ENTITLE STOCKHOLDERS, FOR A PERIOD OF 7 YEARS, TO PURCHASE A DELL SHARE FOR $20.00 (THE “WARRANT”). BASED UPON THE ASSUMPTIONS AND CALCULATIONS SET FORTH ON EXHIBIT 1, WE BELIEVE THAT THE TOTAL VALUE TO TENDERING STOCKHOLDERS WOULD BE APPROXIMATELY $15.50 TO $18.00 PER SHARE, AS COMPARED TO MICHAEL DELL/SILVER LAKE’S OFFER OF $13.65 PER SHARE. Because Icahn and Southeastern have agreed not to tender their shares, if you choose to tender, a minimum of 71% of your Dell stock would be purchased at $14 per share, PLUS the Warrant. If others like us believe the future of Dell is bright and determine to hold all their stock, then obviously more than 71% of your shares would be accepted if tendered.
So a threshold question is: how much does it cost Icahn to offer this warrant? That, roughly, is how much it's worth. If the answer is zero then the answer is zero, y'know?2
I guess the answer isn't technically zero, though, as Icahn is effectively giving up some Dell upside if the warrant thing happens - he's not getting any warrants; he's just keeping his shares, now a bit diluted by these warrants in implausibly-high-stock-price scenarios. So I guess we should try to figure them out. A blurry exhibit to his letter computes the possible value of the deal: for each share you tender, you get back:
- $9.99 in cash,
- .29 shares of Dell, and
- .18 Dell warrants.
Or something? Like I said the exhibit is blurry. Here is my effort to replicate his math:
How much is that 0.1785 warrant worth? Well, it's a warrant to buy Dell at $20, and since here you are effectively selling Dell at $14 (because you are, by hypothesis, tendering), you probably don't think that's a very good deal? It's a weird system; your choice is:
- if you think Dell is worth a lot, you should want the warrant,
- but the only way to get the warrant is by tendering to sell your shares at $14,
- which you should do only if you think Dell is worth less than $14? Plus the warrant value I mean.
Anyway here is a toy decision model, based on Icahn's own P/E-based hypothetical valuations for Dell and his own warrant valuation assumptions. He uses a $2.90 FY2015 EPS and a range of P/E multiples from 5.5x to 7.2x; I've included some lower numbers too:3
The upshot is that you should tender if you think the stock is worth less than $14 (if you're valuing the warrant at its intrinsic value, i.e. assigning it zero value in below-$20 stock price scenarios), or if you think it's worth less than about $15.33 (if you're valuing it using Black-Scholes and a somewhat silly set of assumptions). That is, more or less, you should only tender if you think the warrant is worthless: Icahn's lowest price scenario assumes a $15.95 stock price, and if that's right then you should keep the stock rather than trading it for cash and warrants. So this warrant is sort of an odd sweetener: if you ascribe much value to it, then you should turn it down.
But the warrant is transferable, so you could want out of your stock but still ascribe some value to the warrant since someone will probably buy it, at least for a few pennies.
There's a broader benefit, though. The argument against selling Dell - against selling anything - has always been "hey, you never know, the stock might go way up one day." That's not an entirely persuasive argument in general? Like: also it might not. But option valuation is pretty much formalizes how much "hey, you never know, the stock might go up one day" is worth. And the answer, using customary assumptions, is always a positive number. Through some cute sleight of hand, Icahn can add that positive number to the value of his tender offer. Before you got some cash and some stock that might be worth a lot one day. Now you get some cash, some stock, and a separate placeholder for, like, the possibility that that stock would be worth a lot one day. That seems a bit like double-counting, but after all that placeholder comes with an official-looking, Black-Scholes-calculator-generated value. Okay!
I guess you have to appreciate the creativity. Icahn's levered recap idea was basically: if you want some super levered Dell, I'll cash out about 70% of the shares and let the remaining 30% ride on a much more levered company. The warrant idea is: let me add a bit more levered upside with warrants. Sure. Even if you don't share Icahn's optimism, the warrant probably transfers at least a little bit of value from his stock to your weird tender-offer package. Is that enough to convince shareholders to turn down a sure $13.65? I dunno. But if it's not I'm sure Icahn will think of something else.
1.Just Wikipedia it: "The Modigliani–Miller theorem ... states that, under a certain market price process (the classical random walk), in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed." So all you have to do is relax those assumptions and, voilà, the value of a firm is affected by how it is financed. All of those assumptions are relaxable, with taxes being one of the biggest: debt is more tax efficient than equity. This is less true in the Dell case since they've got all that overseas cash to repatriate: distributing borrowed money to shareholders is tax-efficient, but distributing balance sheet cash is not.
2.Or: if the equity upside in Dell is worth $X, divided amongst the shareholders, then if you divide the equity upside in a different way, by taking some of it from the shares and giving it to the warrants, does that create more upside?
3.The Black-Scholes valuation stuff is pretty squonky too. I've tried to follow Icahn's assumptions but he does some dilution adjusting for the warrants that assumes that all of the shares outstanding today will still be outstanding. But that can't be right if the tender succeeds? I did my own, probably wrong, dilution adjusting and got different numbers but honestly it doesn't matter, trying to Black-Scholes value these warrants with dilution adjustments is like nine levels of false precision. They're worth some number, but you cannot know what it is.