Description

In a market that’s very difficult to make sense of, risk/reward and downside protection has become just as important as upside optionality. Although not a typical VIC idea I think EMC represents one of the most compelling risk/rewards in the market currently.  

For background DELL is acquiring EMC for $24.05/sh in cash & 0.111 shares of VMW tracking stock. As of the close today  (24.55); if one were to assume a 20% discount to NAV for the VMW tracking stock the spread is trading 15.0% gross and 41.9% annualized to a 6/30/16 close. Given the precipitous sell off in VMW shares since deal announcement (~45%) VMW tracking stock’s contribution to total deal consideration is only ~14%. With that in mind and comfort in VMW’s valuation at current levels I’m in favor of going long EMC outright without hedging out VMW exposure. I’d note that in a deal break scenario there will be speculation of a potential buy-in (more on this below), and there will also likely be a VMW rally from the technical unwind, and deal overhang lift, so I think there is more harm than good in shorting VMW at current levels.  You also get to participate in any upside in the share (every $1.00 in VMW is ~$0.11 in deal consideration). It is important to understand the VMW tracking stock and the discount to NAV dynamic, as this will truly be a unique asset. The Internet tracking stocks from the early 2000s are not relevant here as this is a tracking stock alongside a public security with no fungability/path to asset stock conversion. The best precedence in the market currently is the Liberty complex (LRDK/CHTR, LMCA/SIRI) which have been trading in a range of ~8-15% discount to NAVs. While those are current HoldCo structures whose primary asset is a single public security in both instances you have voting rights & you’re investing alongside the greatest capital allocator of all time in John Malone. There is also a path to resolution with SIRI buying LMCA and CHTR buying LBRDK at some point in the future. Given that backdrop the VMW tracker will likely need to trade outside of 15%. Michael Dell did indicate he intends to increase his VMW stake over time. While they ultimately need to collapse the structure at some point Silver Lake has indicated they do not need to do anything for a while which will assume the status quo for the next couple of years & warrant a NAV discount of ~20%.

There are two ways for this deal to break: 1) DELL is unable to secure financing for the transaction and 2) Failure to receive Antitrust Approval. The later is the easier concern to dispel. The merger is largely complementary in nature with EMC’s storage & virtualization segments & DELL’s primary focus in severs and PCs. The storage market is fragmented and competitive with IBM, HPE, NTAP, Fujitsu and Hitachi all present. EMC has ~30% global share in storage vs. ~7% for DELL. They are also largely focused on different customers with EMC focused on the enterprise customer & Dell on the mid-to-small size. In terms of EMC’s broader spectrum of IT products & services they ultimately compete with many of the largest tech companies in the world. According to the preliminary proxy filing have been made in Australia, Brazil, Canada, China, the EU, India, Israel, Japan, Mexico, Russia, South Africa, South Korea, Switzerland, Taiwan, and Turkey. The gating item from a regulatory review perspective will likely be MOFCOM which all in should take ~4-5 months.  While we are unaware of when this was officially filed at this point- the companies originally guided to a May-October close, so I would expect MOFCOM to be filed shortly (if it hasn’t been already).

That leaves us with the biggest hurdle for deal closure- financing. The credit markets have no been receptive to LBO paper with SWI recently pricing at 95 OID and SLH likely to come below that.  The good news is there is very little hung paper on banks balance sheets right now, and you had the likes of Jamie Dimon personally assure EMC’s BOD of the ability to secure finance for this transactio. Although the credit markets have tightened substantially since October when this was initially announced as is the norm in merger announcement there is committed financing. DELL obtained $4.25B of committed equity financing from Michael Dell, MSD, and Silver Lake Partners as well as debt financing commitments for up to $49.5 billion in the aggregate from Credit Suisse, J.P. Morgan, Barclays, BofA Merrill Lynch, Citi, Goldman Sachs, Deutsche Bank, and RBC Capital Markets. As the deal was coming together last September Jamie Dimon personally assured EMC’s BOD of the ability to finance this transaction. The debt is broken out in several tranches: $8B senior secured term loan B, $3.5B senior secured term loan A-1, $3.5B senior secured term loan A-2, $2.5B senior secured term cash flow, $3.0B senior secured revolving facility, $16B senior secured bridge facility, $9B senior unsecured bridge facility, $2.5B margin bridge facility and $1.5B VMW note bridge facility.  In addition, each of DELL and EMC has agreed to make available a certain amount of cash on hand (at least $2.95 billion, in the case of Denali, and $4.75 billion in the case of EMC) at the closing of the merger for the purpose of financing the transactions contemplated by the merger agreement.

The next catalyst to re-rating EMC shares higher will be DELL coming to market with some of this debt and the market’s willingness to absorb it. The PF company will be the largest privately-controlled integrated technology company. The combination has largely complementary product portfolios, sales teams, and R&D strategies with leadership positions in severs, storage, virtualization and PCs. Management guided to north of $1B in revenue synergies and implicitly ~$300M+ in cost synergies.  Given EMC’s FCF profile, and Michael Dell’s turnaround of DELL in the past two years assuming this comes in the mid-to-high single digit range I would expect their to be appetite amongst credit investors. Dell said it intends to focus on delevering in the first 18-24 months following the closing of the transaction and to maintain its IG debt ratings (Dell’s TLB is rated BBB/Ba1).  Pricing is emerging on Dell’s pro rata loan package. The pro rate loan includes a $3.5B 3-year A-1 term loan; a $3.5B 5 year A-2 term loan; and a $3B five-year revolver. Pricing on the three-year tranches and revolver open at L+200 while pricing on the five-year tranche opens at L+225. Commitments are due on 2/10. The A-1 and A-2 term loans and revolver will be covered by a first-lien net leverage ratio maintenance covenant. The consensus for retail marketing of the institutional debt is to occur in 2Q. Given the total amount of supply that needs to come to market over the next ~5 months or so I’d expect Dell to begin marketing the separate tranches to broader market at various points in time.  Dell can likely issue up to ~3 turns of investment grade paper so in theory it would be close to $25-$30B of investment grade. The balance will likely be HY paper that will come at ~8-10%. Once the first tranche is priced the “spread” will begin to reflect a more appropriate probability of deal closure.  

I’m very confident in deal closing which is why I’m recommending EMC to begin with. That said what I think is most important/relevant in framing the discussion is to get comfort in the downside scenario, if the deal were to break. As I mentioned above the deal can only break for one of two reasons: 1) Financing 2) Antitrust. In the event DELL is unable to secure financing EMC is entitled to a reverse termination fee of $6 billion or roughly ~$3.10/sh. In the event that the deal is blocked by the regulatory bodies EMC shareholders are entitled to a reverse termination fee of $4 billion or roughly ~$2.06/sh.  So in all likelihood if the deal were to break EMC will receive ~$3.10/sh in cash and have several strategic options to look at it to increase shareholder value.

It’s important to mention that before the DELL transaction was consummated, as a result of shareholder pressure from Elliott, EMC was in the process of a strategic review. Many thought an EMC buy-in of VMW was the most likely outcome, followed by a levered recap, or a spin of VMW outright. Given EMC has shown the willingness to go through essentially an LBO process why would management not be comfortable levering up themselves to 2-3.5x gross debt/EBTIDA (to keep IG rating) and buy back shares.  Including the break fee EMC will be in a net cash position of ~$11.5B. Assuming a net debt/EBITDA position of ~1.5x EMC could raise close to $20B in debt to buyback stock. Depending upon interest rate assumptions this would be accretive to EPS in the high 20%-low 30% range.

I think the second most likely scenario would be a buy-in of remaining ~19% of VMW EMC does not currently own. While this has been discussed in the past the $6B reverse termination fee and VMW’s depressed stock price would make it much more plausible than a buy in at $100/sh which was discussed over the summer. The average NTM EV/Sales multiple for public infrastructure software acquisitions over $1bn since 2011 is 3.9x (median 3.6x). Assuming a 3.6x takeout EMC could pay ~$70/sh or a ~40% premium to current levels. EMC controls 97% of the voting rights for VMW shares so in theory this could be viewed in the vein of a minority squeeze in where they offer a 15-20% premium initially and subsequently bump an additional 5-10%. Dependent upon synergy assumptions (5-10% of OpEx) the buy in would be ~15-25% accretive to EMC EPS.  There would also likely be a re-rating of the shares as a result of the new business mix.

 EMC comps currently trade ~10x earnings ~6x EBITDA and an ~11% FCF yield. In either of the above deal break scenarios it’s tough to see EMC trading much lower than ~$24/sh based on current market valuations. This is what ultimately gives me confidence in the downside scenario. As a result of the historically large termination fee EMC may be in a better position if it were to execute on its standalone strategic plan and either buy in VMW or do a levered recap; then go through with the DELL transaction. Although as a result of technical pressure and positioning EMC shares could potentially test $20/sh on the day of deal break, the broader event community will likely buy this quickly. It’s important to mention that Elliott still maintains a board seat and would not be content with management and the rest of the board sitting on their hands if this deal were to break.

Finally I’d also highlight that there are some interesting trades to look at cross cap structure here as well (including potentially any of the high yield debt Dell issues outright).  DELL CDS was trading ~275 prior to deal rumors (and is trading ~555 last). To the extent this deal closes CDS will likely widen out to ~800 so you can continue to buy CDS here (or as a hedge against a long EMC can short CDS).

 In terms of timing the preliminary proxy was filed on 12/14/15. Based on filing precedence we could see a definitive version filed in the middle of this month, which will allow for a shareholder vote in the middle of March. The companies have guided to a close between May and October of this year. Assuming the credit markets cooperate I think you could realistically see a close between the middle of May and the end of June but will use 6/30 for conservatism as a result of MOFCOM review.

Catalyst

DELL should start coming to the credit market at the end of this month- which will give investors confidence in the ability to raise the $49.5B necessary to fund the transaction. We should also see an amneded proxy this month which will give better insight into timing and the eventual shareholder vote.