Friday, September 2, 2016

Dell Technologies Class V: New VMWare Tracking Stock

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):
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.
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.

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

32 comments:

  1. Where do you get a discount of 40%. DMTV price / VMW

    But Dell says the economic interest is 53% of VMW...Don't you need to take this into account?

    ReplyDelete
    Replies
    1. DVMT and VMW have the same economic basis; DVMT holders have a 53% interest in VMWare, VMW holders have a 20% interest in VMWare, and Dell keeps the remaining 27%. Hope that helps clarify.

      Delete
    2. Thanks, will VMW still be public then?

      So DVMT has an economic interest but not shareholder rights? Dell and other VMW shareholders have "control"....

      Where is the buyback the guy below is referring to?

      Delete
    3. Also, since this is DVMT is an economic interest at discount to the real stock, Couldn't we assume we are buying VMW today at 10x earnings. Isn't it the same thing?

      Delete
    4. VMW will still be public. Correct on the rights, although VMW shareholders have very little as well, Dell has 97+% of the voting rights in VMWare. The buyback is at VMWare, they'll be buying back VMW stock, but Dell has hinted that they'll be in the market (eventually) for DVMT shares too. If the discount stays this wide, I'd expect them to do something, it would become a bit of a reputational concern. But of course VMW could come down and close the discount that way too.

      Buying VMW at 10x earnings through DVMT is a fair way to think about it.

      Delete
  2. The interesting point that pushed me over the edge in deciding to buy EMC (and basically DVMT) over and above the large discount given to the tracker is the fact that VMWare is going to buy back $1.2b of the their publicly traded float (20%) after the closing of the merger agreement. Likely resulting in share price improvement in both tracker and parent.

    If Dell gets into trouble he's probably going to either sell his VMware stake or force VMware to pay the payable owed to EMC and potentially dividend a larger amount back to him. In fact, VMware could probably fairly easily take on additional debt equal to $15b. In a scenario where he takes a cash special dividend from both cash on hand and from recently issued bond, as well as, the note payable of $1.5b from VMware to EMC he could potentially receive more than $22b. Also Dell owns a few other ancillary assets, including $SCWX which are worth at current market prices more than $870m.

    It's definitely possible they'll get into trouble and if they do they'll have many fire extinguishers ready.

    All that being said I'm not super long EMC or anything.

    ReplyDelete
    Replies
    1. Good thoughts on the other assets and protections in place. At a certain point earlier this year you could buy EMC at a discount to the cash component and could have gotten DVMT for free, but at this point in the proceedings I thought it made more sense to just buy DVMT when-issued. Thanks for the comment.

      Delete
  3. How is 0.111 of emc stock calculation would be now because initially it 1 emc share=0.111*vmw+20.05.

    ReplyDelete
    Replies
    1. Sorry, I don't follow your question. Each holder of EMC received 0.111 of DVMT, but DVMT is the economic equivalent to VMW, there's not a relationship between amount of DVMT received per EMC share and VMW.

      Delete
  4. Employee were suppose to get 24.05 as cash per emc share and 0.111 of tracking stock. Now the net value of emc was going to be 33.10 when vmw was 81.22. Can you explain how much they should get now in net

    ReplyDelete
    Replies
    1. Yes, it was a cash and stock offer as you mention. The headline $33.10 number assumed that DVMT wouldn't trade at a discount to VMW which was an aggressive assumption at the time. In reality you received the $24.05 in cash and now the 0.111 shares of DVMT is worth $5.33 (0.111 x $48) because DVMT is trading at a discount to VMW for a total of $29.38. But that discount is the opportunity I'm highlighting, I would argue that the 35% discount is too big for the tracker versus the VMW common stock.

      Delete
    2. Is any of the cost basis of the EMC stock transferred to the DVMT position?

      Delete
  5. would I have been better off just selling my shares.

    ReplyDelete
    Replies
    1. I haven't closely tracked the merger arb spread since the deal was announced, but the tracking stock is at a great enough discount that I wouldn't sell them now with the general disclaimer that I'm just a random guy that's not a financial advisor or anything.

      Delete
  6. Is any of the cost basis of the EMC stock transferred to the DVMT position?

    ReplyDelete
    Replies
    1. Sorry, I'm not sure as I bought DVMT not EMC and I'm not a tax expert. My best guess would be only if your EMC cost basis is above the cash received in the merger? Maybe others that know the answer will chime in.

      Delete
  7. Employee were suppose to get 24.05 as cash per emc share and 0.111 of tracking stock. Now the net value of emc was going to be 33.10 when vmw was 81.22. Can you explain how much they should get now in net

    ReplyDelete
    Replies
    1. The tracking stock (DVMT) closed today at $50.34, multiple that by 0.111 is $5.59 per share of EMC, add that with the $24.05 in cash for a total of $29.63. But that will move around with the value of DVMT and I don't know if there are any special stipulations for employee stock plans.

      Delete
  8. Good idea. The discount was and is still too large.
    Had some experience in voting and non-voting shares in the telecom companies in Brazil in the 90's and 2000's. Main issue with non-voting stocks there was that you could get screwed by controlling shareholders when they sold their controlling stakes in voting shares, where they would maximize the premium for those stakes and non-voting shares wouldn't get tag along rights.
    Did you ever look at TERP:US, a yieldco with a distressed parent. Similar case with Atlantica Yield/Abengoa.
    Best

    ReplyDelete
    Replies
    1. Good points, but it's not like the VMW shares have significant rights so there's equal opportunity for Dell and Silver Lake to abuse minority shareholders in both classes, another reason there shouldn't be a 30+% discount between the two.

      I took a brief look at TERP when everything was happening with SUNE and I got a headache, in hindsight I should have powered through it. Thanks for the other idea.

      Delete
  9. Do you think that the discount can narrow in the coming weeks...read somewhere but don't know how?

    ReplyDelete
    Replies
    1. Hard to say, I hope some of the discount will close in the coming weeks/months to ~20% from 30+% now, but there will likely be a persistent discount for years until the structure is resolved via a share swap or another merger/buyout.

      Delete
  10. Hi MDC, appreciate your article which I just ran into.

    I just wrote one this weekend on SeekingAlpha on the same note, I'd love to get your thoughts/comments.

    http://seekingalpha.com/article/4005612-dell-technologies-vmware-tracking-stock-offers-compelling-arbitrage-opportunity

    ReplyDelete
    Replies
    1. I like your write-up better than mine, thanks for the link.

      Delete
  11. Thank you both (MDC and Francisco). This is the level of detail I've been looking for. Can either of you weigh-in on what the target discount should be (I've heard 10% and 20%)? How is DVMT different from other historical tracker stocks and their discount rate? -mace

    ReplyDelete
    Replies
    1. I think a 15-20% discount is appropriate today, historical tracker stocks are closer to 10-15% discount, DVMT probably deserves a little more given the new debt load at Dell Technologies following the EMC buyout. Overtime as Dell deleverages, the discount between DVMT and VMW should decline as the Dell credit risk becomes less of a concern. Thanks for reading.

      Delete
    2. Reading is easy... thanks for writing! Are there other public M&As that you are bullish on? I think EMC was undervalued, in part, due to the complexity of the transaction (cash, tracking stock, VMW percent ownership). I liked the Baker Hughes/Haliburton deal earlier this year as well, especially with the $3.5B penalty-clause as a safety net. Did you like BHI in 2016? Maybe there are others out there? -mace

      Delete
    3. I never really looked at Baker Hughes/Haliburton, last week I went to a luncheon where Jeffrey Ubben of ValueAct was the speaker, he pitched the BHI's current situation well but to be honest its outside of my strike zone. I don't focus much on M&A specifically, was more attracted to DVMT for the awkward resulting merger security that resulted from the deal. Those seem like a better pond to fish in rather than straight merger arb, I'll leave that to the professionals who scour merger agreements.

      Delete
  12. Hi MDC, I really liked your post. I have written on the same situation - http://humblevalueinvestor.blogspot.co.uk/2016/10/vmware-tracker-offers-decent-upside.html
    Let me know what you think. I agree that the tracker seems mispriced, but I think there are a few valid reasons to be concerned. I think a better way to play the situation - risks less of your capital - is a long dated call option on DMVT.

    ReplyDelete
    Replies
    1. Great post. I didn't investigate buying call options as I actually bought DVMTV at the time and don't believe there were options available, but it seems like a good strategy here with the obvious risk that it could take longer than anticipated for the discount to close. For instance Dell getting back to investment grade in 18-24 months would go well beyond those calls. I also would nitpick on the lack of alignments, yes Dell and Silverlake don't have economic interest in DVMT, but they have substantial economic interest in VMW and the VMW software being used to sell Dell products going forward. At some point in the future DVMT = VMW unless some tiny scenario where Dell goes bankrupt and VMW skates by although much of VMW's economic future is now pegged to Dell's success, so outside of it happening in the next 6-12 months, I don't see it being a likely scenario. But great post, its more complete than mine.

      Delete
  13. Any thoughts on the price/spread today? It seems to have widened over the last month

    ReplyDelete
    Replies
    1. It's only widen a little right? Seems like it's been around 30% plus or minus a couple points since the transaction happened, but I haven't tracked it that closely. The takeaway for me on DVMT has more been the forced selling that occurred prior to the deal taking place that created the coiled spring after, but also still confused why anyone would buy VMW over DVMT at this wide of a spread. I just own a small amount as I can't fully explain what VMW does, but comfortable holding at a ~30% discount for now.

      Delete