EMC/VMW parent/stub trade. 

 

EMC owns owns 82% of VMWare, or .156 shares of VMW for each share of VMW.  Using the most conservative calcuation of net cash at EMC ex VMW ($.75 a share), with VMW closing at 79.29, one can create the EMC stub for $7.29.  This trade would be executed by shorting .156 shares of VMW for each share of EMC bought.  One could also buy the EMC converts if one were so inclined in lieu of stock.  By way of disclosure, I own both and am net long as these kinds of trades tend to work better in down markets.  

 

By way of the numbers, as you see from the number section above, based on calculations, it would appear as if one can create the stub at just over 6x next year's EBIT, 8.5x GAAP earnings, and 7.89 FCF.  The main difference between the two is amortization of acquisition related intangibles, on a tax adjusted basis.  NOTE: While many on the street use a pro-forma number that adds back stock compensation expense, I do not do so as these are real and on-going expenses.  One either needs to include these or make sure to sufficiently increase the number of shares outstanding.  As the expenses recur, I prefer not to add back the expenses as I am looking to try to lock in on a true on-going profit number. 

 

I am not, and I am not going to pretend to be well informed about the the fundamentals of VMW or EMC.  My position is based on what I perceive to be a valuation that provides a meaningfull margin of safety with a business that seems sufficiently strong. 

 

As for the companies, VMW is the leading virtualization company.  Stated differently, this is cloud computing, or where software doesn't reside on each person's personal computer but rather at the server level.  1/2 its business is service/maintence, and as it is investing heavily in sales and marketing, it can probably be quite a bit more profitable over time.  It's operating profits are projected to be up 78% in 2011 from 2009.  It trades at north of 70x projected next year's earnings.

 

85% of EMC's its revenue is from information storage with the balance evenly split between content management, and RSA Security.  RSA security may be familiar to many as it is the system where users carry tokens where they need to enter an ever changing number from the token to log into RSA protetcted web sites. 

 

In information storage, EMC provides storage and back-up solutions.  The company is a core partner in helping companies safely protect and secure their data.  EMC's core innovation in the 1990's was that storage didn't have to attach to the mainframe or each server but rather to the network.  This was a much more effecient and lower cost approach. 

 

On the negative side, competition is increasing.  Organic growth is slowing and was down meaningfully last year, suggesting increased correlation with the economy.  Organic growth should be up this year.

 

On the positive side, software/maintence/services are roughly one-third of the business.  EMC is a dominant player accross its product categories with a huge installed base.  Roughly one-third of its business is international, about one-third of the business is services, and storage as a business is not disappearing.  Finally, I believe that profitability can decline by 40% before the stub starts to become expensive.  

 

 

Risks.  One risk is that VMW keeps going up, in which case EMC could continue to struggle or fail to keep up.  To address this risk, one might hedge at less than 100%.  On the other hand, if the market goes way down, this trade probably works quite well as parent/stub trades do tend to be negatively correlated with the market.  Second, while I think the stub price should be $11-$12, in line with other tech stocks (although I think tech stocks are cheap), capital required to carry this trade is not low.  For the moment, I don't feel this matters given where interest rates are.  Third, does EMC make on-going acquisitions that do not generate a favorable return on investment.  Does EMC buy an increasing number of shares at a price dilutive to value.  Finally, competition and new product innovation will be the main challenges faced by the company.

 

(This is neither an offer or soliciation to sell or purchase nor a recommendation.  The author makes no commitment to update this write-up with news updates or trades the author may make in the names including close-out of the position.  The author may or may not trade one or both sides of the trades on an-on-going basis.)

 

market revaluation of the stub.

 

Perhaps over time, possible spin-off of VMW.

 

Market goes down nicely. 

 

Market volatility which might provide an opportunity to trade the stub.