Description

Dell Technologies Class V when issued (aka the VMware tracker) DVMTV is trading at a 41% discount VMW class A shares.  Given that both share classes effectively have no vote and the tracker will likely be more liquid than VMW, this discount seems way too steep for effectively an identical security carrying Dell credit risk. The Dell/EMC deal closes on Wednesday Sept. 7th.

Business Description:  VMware is a leading provider of virtualization software for data centers.  The company is ~80% owned by EMC, which is being acquired by Dell.  In order to afford the transaction Dell offered $24.05 per share in cash and .11 DVMT shares per EMC share.  DVMT is a tracking stock.  That means technically it is part of Dell, but, it’s performance is supposed to “track” the performance of a portion of EMC (now Dell’s) stake in VMware equal to 58% of the company.

Investment Thesis:  The VMware tracker is trading at a 41% discount to publicly traded VMware class A shares.  We think this discount is far too wide as most trackers trade at about a 15%-20% discount to the underlying.  We recommend going long DVMTV and short VMW in equal proportions.  Or just buying some DVMTV outright if you don’t have the flexibility to pair.

Everything you need to know about the tracker/EMC deal is here:

https://www.emc.com/collateral/corporation/dell-emc-class-v-common-stock-faq.pdf

https://www.sec.gov/Archives/edgar/data/1571996/000119312516613323/d73946ds4a.htm#rom73946_35

What are the disadvantages of a tracker that could cause a discount?

1)  You don’t get voting rights on VMware’s board.  However, because EMC has always owned a controlling stake in VMware including super-voting class B shares the voting rights of existing public class A shares have always been virtually worthless (only 3%).  

2) You have credit risk in Dell, not VMware.  The tracker is a class of Dell stock.  So in the event of a Dell bankruptcy, the VMware tracker would not be entitled to its share of VMware, but instead just its fraction of the equity component of the Dell estate (the tracker is 4% of the equity) of which VMware would be an asset. This is a real risk and the tracker deserves some discount for this. The new Dell is going to have a solid $54 billion in gross debt and $45.5 billion in net debt.  But Dell did $3.2 bil in adjusted EBITDA in the FY ended Jan 2016 and EMC 2016 estimates were running around $6.9 bil.  So in aggregate you should be looking at a business doing  in the ballpark of $10.0 bil in EBITDA (before any cost cutting).  So we’re 4.6x net levered.  Not great, but not a disaster.  Pro forma interest expense is running around $2.9 billion.  EMC alone was on pace to do $5 billion in free cash flow in 2016, and Dell had FCF of around $1.8 billion in the FY ended Jan 2016 so the debt could be paid down at a decent pace too.  Interest coverage should be no problem at all.  In any case, the debt markets certainly don’t seem concerned.  The Dell 7 1/8th senior unsecured due 06/15/2024 and issued in June is trading at 108.675 for a yield to maturity of 5.356%.  Certainly not indicative of a company that is going to find itself in distress in short order.  

3) Often trackers are less liquid than the stakes they track.  In this case, however, there will be many more DVMT shares outstanding (223 million) than VMW class A shares (79 million).  We actually expect the tracker to be more liquid than the class A shares.   In sum, none of these factors seems to justify a 40% discount to the VMW class A shares.  Dell will be pretty levered after this transaction, but not enough to justify a 40% discount for the tracker.

VMware itself remains a very good business (the best in EMC’s so-called “Federation”).  Its server virtualization software dominates the market, though the market has matured and we should expect single digit growth from here for that part of the business.  However, VMware now aims to virtualize the entire data center and indeed multiple data centers allowing companies to keep their old data centers while migrating new workloads onto “public clouds” provided by Amazon, Microsoft, and Google.  It is early days, but if VMware successfully addresses this market (and so far it is – it is already 8% of revenue) it will have many more years of growth ahead of it.  The tracker implies a valuation of less than 10x earnings for VMware which is very attractive for such a quality business.

Most trackers are eventually spun off from their parents as separate companies and ultimately we expect that to happen here.  It could be up to five years away though as Dell will want to be absolutely certain that any spin would be tax free.

Risks:

·         Dell credit risk is the big one.  We need to be sure Dell/EMC is generating enough cash to pay down debt.  The company’s plan is to pay down debt quickly.

·         Weird trading dynamics in the next few days when DVMT is actually issued.  There will be a lot of arbitrageurs and shareholders of EMC who get small distributions of DVMT trading around.

·         Dell has stated it wants to buy some of the VMware tracker.  It has no incentive to get the price of the tracker up while it is trying to buy.  

Catalyst

Deal closes and some selling pressure from arbs abates/ some VMW longs trade into the discounted tracker.

Dell makes progress paying down debt post deal.