Description

Summary:

Dell Technologies is a technology hardware, software and services businesses that also owns majority equity stakes in several publicly listed software companies (principally VMware).  While Dell has been written up in various forms/related entities on VIC over the years, following the DVMT transaction in late 2018 that simplified and improved alignment in the ownership structure, the company is once again yielding a significant mispricing – this time in Dell’s new publicly listed Class C common shares.

From a sum of the parts standpoint, the new public Dell Technologies trades at roughly a >40% discount to the fundamental value of its operating business and publicly owned equity stakes.  However, given that the vast majority of the debt at the core operating entity (i.e., Dell+EMC businesses) is non-recourse under most scenarios (more detail on the nuances later on), the equity of the core operating business is implicitly being valued at approximately negative $10bn today, despite producing more than $3bn of annual levered free cash flow.

We believe this heavily discounted valuation exists today as a result of several key overhangs.

Following the DVMT transaction that created new Dell at the end of 2018, the shareholder base has been under transition without a natural home:

• The higher-growth VMWare assets and mature core Dell business each appeal to different natural investor bases, hindering both from being properly valued within the combined entity.
• Given the limited current public float and controlled ownership structure, the stock is also restricted from inclusion in indices relative to its overall size.
• The company’s headline leverage remains elevated (particularly compared to the sector), constraining the universe of potential investors.
• There was technical pressure following the closure of the DVMT transaction as a result of the transaction structure and change in shareholder base.

Additionally, complexity in analyzing the company creates overhangs for investors properly valuing the company’s equity:

• The company has a very short public history to evaluate in its current form.
• The corporate structure and capital structure are complicated and can create investor misunderstandings, particularly in how to treat the company’s leverage.

However, we believe the current mispricing is likely to be temporary, with a number of potential catalysts to help realize fundamental value in the next 12-24 months.

• Dell will be able to spin their public VMware shareholdings on a tax-free basis starting in 2021 (5 years after the EMC acquisition), helping to remove the current significant “holding company” discount and allowing the appropriate investor base to own each asset.
• Given organic free cash flow generation, Dell is likely to significantly de-lever over that timeframe (targeting IG rating), helping to remove the current leverage investor overhang and opening up capital allocation options (e.g., buybacks, dividends) that could help improve the current discounted valuation
• One of Dell’s owners is private equity firm Silver Lake.  Given the finite lifespan of its fund vehicles (including some in an SPV meant to temporarily extend the life of one of its funds), Silver Lake has an incentive to realize value rather than let these overhangs persist indefinitely.  It was reported that transactions between Silver Lake entities prior to the IPO assumed an $80 value for Dell, well above the current valuation.  
• The company has continued to operate well and optimize their cost structure, and as its public history in current forms grows, should garner more investor attention on a standalone basis.
• The trade can be structured as a “core Dell” stub trade (e.g., Long DELL while shorting out the implicit VMW exposure) in order to isolate the current holding company discount.  Alternatively, if you find VMWare attractive on a standalone basis, a long DELL investment provides a highly discounted way of expressing that view as well.

Background:

It’s helpful to run through key events in Dell’s history in understanding how they arrived at their current structure and the owners’ incentives.

Dell was founded in 1984 and initially went public in June 1988.  Michael Dell retired as CEO in 2004, ceding the CEO title to Kevin Rollins.  Following several years of issues, Michael Dell return as CEO in 2007 and has remained in the role since.

Following several decades as a public company, and given a heavily discounted public market valuation, Michael Dell partnered with Silver Lake Partners to take the company private in a transaction that closed in October 2013.

In September 2016, Dell completed the acquisition of EMC, a storage business that also owned a majority stake in virtualization software business VMware.  As part of this transaction, Dell created a complicated holding structure with a public tracking stock (ticker: DVMT) that was designed to track the economic value of a separate holding company under Dell Technologies that held Dell’s public stake in VMware equity.  However, given the debt above this holding company at Dell Technologies, and that the DVMT structure allowed for a few potentially unfavorable conversion mechanisms which would enable Dell to exchange assets other than VMware to DVMT holders under certain scenarios, the DVMT shares traded at a significant discount to VMware.

In December 2018, Dell completed a transaction restructuring and simplifying its corporate structure, resulting in DVMT holders receiving a combination of cash and shares in the overall Dell entity, effectively resulting in an IPO of Dell.  As a result, public Dell shareholders now have an economic interest in the same entity as the private equity holders, resulting in a much greater alignment of interests than in the previous tracking stock structure (although the private equity holders continue to retain voting control through their share classes).

The corporate structure at present is shown below.  Please note this chart does not reflect VMWare’s announced acquisition of Pivotal (with the minority public float receiving cash and Dell Technologies receiving VMWare shares), which will result in Dell Technologies ownership of VMWare increasing slightly.

Business Overview:

“Core Dell” is organized into two primary segments described below:

Client Solutions Group (“CSG”) – ($43.2bn FY19 Revenue, $2.0bn FY19 Op Inc)

Offerings by CSG include branded hardware (PCs, notebooks, peripherals, etc.), as well as third-party software and peripherals.  Dell’s CSG business is more skewed towards commercial customers than its primary competitors HP and Lenovo, and this his been a more attractive market than consumer in recent years, and CSG’s direct model also differs from peers.  CSG also offers attached software, peripherals, and services, including support and deployment, configuration, and extended warranty services.

Infrastructure Solutions Group (“ISG”) – ($36.7bn FY19 Revenue, $4.2bn FY19 Op Inc)

EMC's Information Storage segment and the existing Dell Enterprise Solutions Group were combined in fiscal 2017 to create the Infrastructure Solutions Group.  The segment now contains a broad portfolio of storage solutions and server products, as well as a smaller networking product portfolio. ISG also offers attached software, peripherals, and services, including support and deployment, configuration, and extended warranty services.  The business has a roughly 50/50 US/International revenue exposure.

Outside of the “core” segments, Dell also owns majority controlling stakes in several publicly listed subsidiaries that are consolidated for reporting purposes.  VMWare represents the vast majority of value of these subsidiaries and is presented as a separate segment in Dell’s financials.

VMware (ticker:VMW) – ($9.1bn FY19 Revenue, $3.0bn FY19 Op Inc)

VMware primarily provides virtualization and other infrastructure software to primarily commercial customers.  VMware’s portfolio includes offerings that allow organizations to manage IT resources across private clouds and complex multi-cloud, multi-device environments in three key categories: software-defined data center; hybrid cloud computing; and end-user computing.  The business has a roughly 50/50 US/International revenue exposure.

Pivotal (ticker: PVTL) and SecureWorks (ticker: SCWX) are the other owned and controlled public subsidiaries, though of a far smaller scale than VMWare.

Pivotal provides developer tools and a cloud platform for application development.  Following a disappointing earnings report and resultant sharp decline in the PVTL stock price, VMWare recently agreed to acquire all of Pivotal through a transaction in which the small public float would receive cash, while Dell Technologies would receive additional VMWare shares in exchange for its PVTL ownership.  As a result, Dell’s ownership of VMWare will increase from 80.7% to 81.1% upon the deal closing. SecureWorks is a security software provider, though given its small size is really material to Dell in aggregate.

Valuation:

As shown below, markets are currently implying a negative value for the equity in Dell’s core operating business.

Given the effectively non-recourse debt structure, in assessing the fair value of Dell’s public stock I break the analysis into two pieces: the value of Dell’s operating businesses (“Core Dell”) and the value of it’s owned public equity stakes.  In valuing Core Dell, I use an EBITDA multiple of 7x based on peer valuations for similar mature technology businesses. In addition, I triangulate this against the unlevered free cash flow yield implied at this valuation (approximately 10%), which on an absolute basis conservatively assumes modestly declining cash flows over the long-term.

Integrating this valuation of Core Dell with the value of Dell’s owned public equity stakes then yields the overall target price for Dell stock:

On a consolidated basis (e.g., inclusive of VMWare and other equity stakes), the company looks attractively priced as well given the combined growth profile, though not to the same extreme degree of the Core Dell Stub.

Capital Structure:

Dell’s capital structure as of the last quarter is as follows:

As shown above, the vast majority of the debt sits at the “core” Dell entities.  While the entities that own the VMWare shares are guarantors of this “core” debt today, with an easily achievable small decrease in leverage Dell gains the ability to distribute/spin these shares, meaning for practical purposes the debt is effectively non-recourse to the VMWare shares (of course excluding the limited number of VMWare shares securing the small margin loan).  Within the “core” Dell debt, three specific tranches have restrictions that specifically prohibit a spin or sale of Dell’s VMWare stock holdings: the Term Loan A, Term Loan B and HY Unsecured Notes.

The TL A and TL B credit agreement (https://www.sec.gov/Archives/edgar/data/1571996/000119312516706567/d238698dex101.htm) includes a restriction on asset sales and restricted payments, including distribution of VMW shares.  However, this restriction is lifted if leverage falls to 3.75x or less (see 6.08(a)(xiv)) on a core basis pro forma for a spin, which given the current deleveraging path and optionality around using VMW cash flows/balance sheet, should be easily achievable by 2021 when a tax-free spin becomes possible.  A similar dynamic exists with the HY Unsecured Notes, as the indenture (https://www.sec.gov/Archives/edgar/data/1571996/000119312516611855/d73946dex414.htm) includes similar asset sale and restricted payments constraints that are lifted if leverage falls to 3.75x or less (see 4.07(b)(16).

These restrictions also fall away if the company achieves IG status (which management mentioned at their investor day this month they could potentially reach in the next 12-18 months), though given the 3.75x pro forma limit should be much easier to reach, that’s the more relevant constraint for flexibility around their VMW stake.  Dell should have significant flexibility in achieving this modest reduction across a variety of scenarios, particularly given the significant balance sheet flexibility they have at VMWare in order to dividend cash up to parent if necessary.

Please also note that “core” debt balances used throughout exclude the debt allocated to Dell Financial Services based on a 7:1 leverage ratio of DFS Financing Receivables.  The majority of this DFS debt is comprised of non-recourse securitizations with the financing receivables as collateral. Cash flow numbers are also adjusted, as operating cash flow is penalized for the working capital increase when these receivables are initially created, while the proceeds from securitizing these receivables shows up as a financing cash flow.  

Key Risks:

Economic exposure - Both Core Dell operating business and VMware have exposure to broad economic activity and could be impacted by a recession.  While the recurring element of the software model and replacement-driven nature of part of the hardware business would help buffer such an impact, economic activity and employment will have a meaningful influence.

Leverage – While the leverage at Core Dell is effectively non-recourse, they’ve made significant process in terming out the duration, and the strong cash flow generation should help them de-lever quickly, leverage today is still high on an absolute basis.

Structure – While the ownership structure has now become much more economically aligned between public and private holders, public holders have more limited voting rights in order to influence outcomes.

VMware public float – To the extent the investment is structured with a VMware hedge, it would be exposed to Dell acquiring the public float in order to own 100% of the business.  While given the dramatic valuation disparity and likely negative market reaction to doing so leaves little rationale for such an action, it is a risk to investing in the stub.

Trade wars – As with almost all technology hardware businesses, given a global supply chain and customer base, Dell has exposure to potential tariff risks should trade wars materialize.

Catalyst

While the company has avoided discussing any intentions around separating assets for legal and tax reasons, they should be able to separate VMware tax free starting in 2021 based on the timing of their acquisition of EMC.  There may also be opportunities for them to do so even earlier (e.g., by combining VMware shares with a small operating business), though it’s necessary to weigh the potential discount such a structure would receive from markets versus the timing benefit.

Furthermore, following the recent restructuring, Dell now has significant flexibility to upstream cash flow from VMware to its parent through a recurring or special dividend, potentially bolstered by increased leverage at VMware (at which there is minimal leverage today).

Dell is also expected to significantly de-lever based on its own cash flow generation, both widening the pool of potential public investors that could participate in the company, as well as facilitating a future separation of assets such as VMware.  It’s also conceivable that as Dell de-levers on a consolidated basis and matures as a public company, markets may find the combined growth profile of the business attractive and accord it value more akin to its peers.

As part of the DVMT transaction, Silver Lake also transferred part of their investment in Dell to a newer fund vehicle (using market-implied pricing), and created an SPV to hold part of the investment that remained in their old fund.  While the exact lifespan of these vehicles is private, given the already lengthy duration of their investment, it would not be surprising to see Silver Lake seek an exit of some sort in the coming years.