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Southeastern Asset Management, known for smart, contrarian stock picking, would suffer from the thinly priced Dell buyout. The deal would represent the latest in a recent string of disappointing outcomes for the prominent value-investing shop, and it raises the odds that Southeastern adopts a more aggressive stance.
Southeastern, run by Staley Cates and Mason Hawkins, owned more than 130 million shares at the end of September. (That's 7.5% of Dell, making Southeastern the second largest shareholder behind only billionaire founder Michael Dell). Southeastern established the position in the third quarter of 2005 and bought the lion’s share when the stock traded between $40 to $20. The stake was highest in the first quarter of 2009, totaling 168 million shares, when Dell fetched $9.59 a share.
Doubts about Michael Dell’s ability to transform the eponymous company kept the stock price depressed. Before the buyout chatter—Dell and his partners say they’ll pay between $13.50 and $13.75 a share in a $24.4 billion deal—the shares traded near $10.
Assuming Southeastern traded perfectly since 2005, buying at the lows and selling at the highs, Forbes estimates the buyout could conservatively mean almost $1 billion in losses. Sanford C. Bernstein estimates Southeastern is on the hook for more than $20 a share on a cost basis. This puts the loss at considerably more than $1 billion. A Southeastern spokesman declined to comment.
As recently as a few months ago, Southeastern said Dell was worth closer to $20 a share. The large difference between that valuation and the takeout price could force Southeastern to assume an activist position. When considering that Dell sold at $18 a share a year ago, Bernstein analyst Toni Sacconaghi says he would be surprised if there’s no shareholder lawsuit over the low price (at just eight times earnings). It does raise an uncomfortable governance issue, whether this is a fair shake for Dell's external investors. The buyout is unquestionably cheap, and it leaves only Michael Dell and his PE partners to prosper in any future IPO or sale. Southeastern, given its long-term investing horizon, would probably prefer a leveraged recapitalization or another deal structure that would allow it to remain involved. Presumably so would other investors who bought when shares traded considerably higher than today's low level.
So, standby for a shareholder revolt. Can Southeastern lead it? The asset-manager certainly has a history of agitating for change. For example, Hawkins and Cates, along with billionaire investor Carl Icahn, last year led a shake-up at Chesapeake. Other activist episodes didn’t end as well, though. Hawkins and Cates a decade ago failed to prevent AXA Financial from selling itself to MONY Group. Another example: Olympus, the scandal-ridden camera manufacturer, repelled efforts by foreign investors to change the company after it admitted to multiyear fraud. “Obviously, when there’s all these fake segments and fake books and stuff, that's just unbelievable,” Cates said from Southeastern’s Memphis, Tenn., offices in December. “We spent a lot of time thinking that with the powers of truth and right on our side, we could change out the board and kinda get a new-day-looking deal, like the way Chesapeake looks. That went nowhere. So we just punted.”
They sold, but Southeastern still booked a profit. That’s what makes the situation with Dell different. Southeastern will lose money because of a CEO very familiar to the firm. Hawkins and Cates long defended Michael Dell’s plans to reinvent the PC-maker. They pooh-poohed fears that the computer company had lost a step. Dell’s decision to complete the transition away from the glare of public scrutiny reflects the business’ difficult position. Still, it would leave investors like Southeastern in the red.
How bad could the paltry buyout price be for Southeastern? “It’s unfortunate, but it’s not fatal,” says Michael Lipper, who runs Lipper Advisory Service. At a $1 billion, the loss would represent 3% of Southeastern’s total assets, making it a painful situation.
Determined to maintain a strict buy-and-hold strategy, Southeastern can seem obstinate. For sure, long-term contrarian stock picking can pay off. Proof: Longleaf Partner’s 7% 15-year return easily beats the S&P 500’s 4.7%. And Southeastern's strategy seems straight from a Ben Graham text. Southeastern, founded in 1975 by a group that included Hawkins, aims to return 10% plus inflation each year. It looks for stocks fetching at least a 40% discount to its estimate of intrinsic value. (Other top holdings today include: Loews, Aon and Directv.) Annual turnover is low, and the investors keep stocks for at least three to five years. Hawkins and Coates place great emphasis on partnering with company management they like and look for executives with significant insider ownership. Ironically, it’s Michael Dell’s 14.1% stake (225 million shares as of May) that should allow him to take the company private.
Dell is the latest in a stretch of bad picks, a streak lengthy enough to cast an unpleasant shadow on Southeastern. The firm would surely survive the buyout, but it adds another gloomy chapter. Says Lipper, “The question to my mind is, How did this happen? This is not a one-off situation.” Aside from Chesapeake, Olympus and Dell, Southeastern also missed on Allied Irish Bank, Level 3 Communications and Consol Energy.
Already, the past few years unnerved some Southeastern shareholders. Southeastern’s assets are now $33 billion, from $42 billion at the end of 2007. The company’s largest mutual fund, Longleaf Partners (LLPFX), scores just a 4.1% five return, compared to the S&P’s 500 4.8%. A far cry from the meaty returns from the 1990s and early 2000s, a period in which Southeastern earned spots on Forbes’ rolls of best mutual funds and Morningstar named Cates and Hawkins stock-picker of the year.
If you think the problem of a cheap buyout is restricted to two wealthy investors from Memphis, consider that a considerable bulk of Southeastern's assets come from pension funds and 401(K)s. And right behind Southeastern is T. Rowe Price. The giant asset-manager holds roughly 4% of Dell. Yes, the buyout stands to hit Southeastern hardest, but its effects would be felt in portfolios and nest eggs across the country.
Reach Abram Brown at abrown@forbes.com.
