Top Pick for 2013: Dell, With a Twist

 | Jan 03, 2013 | 3:00 PM EST
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Only because it's fun to do, I like to make a stab at a top stock pick each year. Last year, the choice was easy: Bank of America (BAC) was trading at less than $6 a share, at a $60 billion market cap and a fraction of tangible book value. While it was my top pick for 2012, I really suggested that Bank of America would be an excellent multi-year investment, as is often the case with troubled business. 

Mr. Market liked Bank of America in 2012: Shares appreciated 104% during that time. Despite trading at $12, Bank of America could still advance another 100%, although that may perhaps take two years or more. That's why I moved out of the common stock late in 2012 and into the Class A warrants, which expire in 2019 and have a strike price of $13.30.

For 2013, I am going to anoint Dell (DELL) as my top pick. Despite a rather decent operational year, Dell shares declined by 30% in 2012. Dell's business is in a transition as the company becomes more like today's IBM (IBM) with a focus on service, rather than the old IBM, which focused on hardware. IBM has been transforming itself for the past decade. Dell has been at it for less than five years. For the current fiscal year that will end this month, Dell will likely have generated around $2.5 billion in free cash flow. Not bad for a company in transition that has an enterprise value of $16.5 billion.

Trading at $10.60, Dell shares are an attractively priced equity holding for the multi-year investor. Given that waiting period, my top pick in 2013 is actually a derivative on Dell's common stock. Specifically, I am referring to the January 2015 $7 Dell call options, which can be bought today for around $4.10. For a premium of about $0.60 (inclusive of commissions), you get an option on Dell for 24 months. In other words, Dell shares need to trade for just over $11.25 within that time for you to break even on your bet. At $11.25, the options would have an intrinsic in-the-money value of $4.25. If you were to buy the common instead, you would realize a gain of 5%. Add in the annual dividend of 3%, and the total return is around 8%.

So what does the opportunity cost of forgoing the 8% gain on the common and holding the option get you? Dell is estimated to earn $1.67 for the fiscal year ending Jan. 31, 2014. At a very conservative forward earnings multiple of 10, Dell is worth $17 a share. Historically, Dell's free cash flow has exceeded its earnings per share, so on the basis of a cash-flow valuation, 10x free cash flow probably gets you a $20 stock. And Dell is furiously buying back its own stock, so per-share earnings without much sales growth could very well exceed analyst estimates. Founder Michael Dell has personally bought around $500 million worth of Dell shares for himself over the past several years.

And let's not forget the 3% yield, which is nothing to sneeze in today's negative real interest rate environment. Given Dell's excess cash flows, the dividend is not going away, and it could in fact increase over the coming year. A higher yield would attract income investors to the stock.

So against all this, let's say Dell trades at $15 a year from now. A holder of the common stock would experience a very attractive 45% total return inclusive of the dividend. The aforementioned call option, on the other hand, would have an intrinsic value of $8 (the $15 stock price less the $7 strike price) -- an appreciation of nearly 100%. In fact, since the call option would have a year to expiry, it would trade at slightly more than $8.

Let's say Dell shares remain flat in 2013 but really get going in 2014 and trade for $20 in two years. The common-stock holder would have a 100% return, while the option would be worth $13, for a gain in excess of 200%. Again if Dell shares do absolutely nothing for two years, the common-stock holder would be up 6% via the dividend, while the option holder would have a total loss of 10% over two years. Given the upside scenario from the call option, I'd say the risk/reward profile of a 10% loss against a potential 100% to 200% gain is a bet well worth making, especially when the underlying asset is a high-quality company with a cash-rich balance sheet that is buying back tons of its own shares. 

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