I'm posting this on Friday afternoon before a long holiday weekend for a reason, smarter people than I have written on this topic so not much of the below is new but I wanted to memorialize some thoughts as part of my process.Last October, Dell and Silver Lake (their PE backers) announced the acquisition of EMC in a cash and stock deal worth $67B. Dell is a private company and wants to stay that way, so the stock part of the merger consideration is a bit tricky. EMC owns 81% of VMWare, a software company that sells virtualization technology that helps large enterprise servers share resources and become more efficient, the remaining 19% stake is publicly traded under the VMW symbol. But Dell is a recent leveraged buyout, and they didn't have the available financing to buy both EMC and their stake in VMWare simultaneously, so instead of paying cash for all of EMC and their 81% stake in VMWare, Dell is issuing a tracking stock that represents 65% of EMC's 81% interest in VMWare to former EMC shareholders to bridge the funding gap, but still get to control VMWare.
In Dell's own words (Denali is Dell's parent company):
Shares of the tracking stock, Dell Technologies Class V, started trading recently in the when-issued market under the symbol DVMTV and will start trading regular way as DVMT after the deal closes on 9/7/2016. Each share of DVMT represents the same economic equivalent of each share of VMW, there will be 223MM shares of DVMT outstanding compared to just 80MM of the regular VMW common shares, meaning the tracker should be more liquid than the real thing, an odd situation.Q: Why is a tracking stock being used to finance the acquisition of EMC?A: The Class V Common Stock will afford EMC shareholders the opportunity to benefit from any value creation that may result from any revenue synergies of the Class V Group with Dell. Collectively, EMC shareholders indirectly own approximately 81% of VMware as of the date of this proxy statement/prospectus. Upon the completion of the merger, EMC shareholders will receive shares of Class V Common Stock that will be publicly traded and that are intended to track, in the aggregate, an approximately 53% economic interest in the VMware business (assuming no change to the percentage economic interest of EMC in the VMware business prior to the completion of the merger and that EMC shareholders either are not entitled to or do not properly exercise appraisal rights).Owning EMC’s interest in the VMware business is a fundamental part of Denali’s strategic rationale for this transaction. VMware’s success is important to the business strategy of a merger combining Dell and EMC, and Denali believes it will be in the best interests of its common stockholders after the merger to retain a large economic interest in the VMware business. Additionally, given constraints on the amount of cash financing available for the transaction, the issuance of the Class V Common Stock enables Denali to pay a higher purchase price for EMC than it could in a transaction consisting entirely of 100% cash consideration.
While neither DVMT or VMW have any material voting rights, the two stocks are significantly different in that DVMT is exposed to Dell's highly leveraged balance sheet as DVMT is a share class of Dell Technologies (the merged Dell and EMC) not VMWare. After the deal closes, Dell will be levered about 6 times and their debt is rated below investment grade, Dell's stated plan is to deleverage (as they did following their 2013 buyout) over the next 18-24 months in order to re-achieve an investment grade rating. Their debt facilities do allow for some share repurchases but I would expect those to come second to the initial de-leveraging.
The big question is what discount should be applied to the DVMT tracker for taking on the additional balance sheet risk? I think most scenarios where Dell ends up in serious financial trouble so does VMWare. Several have speculated that Dell is really interested in VMWare over the rest of EMC, VMWare's software will be a key differentiating factor in Dell's enterprise business going forward. If one falters the other will, Dell is in complete control of both. The circumstance where Dell's balance sheet could be an issue for DVMT is a near term slowdown in their business that puts a wrench in the de-leveraging plan. What discount is that risk worth? I'd vote a 15-20% discount is fair for DVMT, it's currently trading at $43.90 and VMW at $72.88, or a 40% discount. I don't have a strong opinion on VMW's valuation but its trading for a forward P/E of ~17x or fairly close to the market as a whole for a company that's generating mid-single digits topline growth.
How does this structure get fixed long term? Dell has the option to swap VMW shares for the tracker, but likely won't do so for both tax reasons and they don't want to give up control. The more likely scenario is after paying down debt from the EMC transaction, Dell might come back for the tracker and VMW shares in another deal. Dell's initial management buyout was scrutinized for being unfair to minority shareholders, so the prospect of Dell doing it again to VMWare is another possible reason for a high discount rate. Either way, 40% seems too high and is worthy of a small position.
Disclosure: I own shares of DVMT