Value Investors Club / VMWARE INC -CL A (VMW)

Description

Summary Thesis: DVMT is a tracking stock that references VMware (VMW). DVMT trades at a 29% discount to VMW and represents an cheap way to "create" VMW, a first-class business with a fortress balance sheet, big market shares and recurring revenues that we think is absolute cheap and has several near-term catalysts. At $90, VMW trades at 13.8x P/E (net of $20/share in cash) and is a cash machine generating $6/share in FCF per annum (8.6% FCF yield) and is still a growth story with top line growing +7-8%. DVMT offers the ability to "create" VMW at a 29% discount. At $65 on DVMT, you create VMW at just 9x P/E or a 13% FCF yield on a "look through" basis. We believe DVMT is conservatively worth $90/share (+38%). In terms of catalysts, both VMW and DVMT are repurchasing shares which is accretive, but one critical underappreciated fact is we believe there is potential for the DVMT:VMW share ratio of 1:1 (currently) to increase as DVMT repurchases and retires shares (DVMT holders would own >1.0 VMW share over time, e.g. ratio increases to 1.1). Finally, we like hedging DVMT with a short risk position in the 5yr Dell CDS @ +240bp with logic being its correlated and a cheap way to hedge tail risk (see below for more). We believe the market consensus is wrong with respect to sustainability of VMW's growth because new products are more than offsetting the decline in their legacy business, with new product penetration at less than 5% of their existing customer base (new product sales increased 50-150% YOY in 4q16 and now constitute 33% of total licensed booking, up from 22% in the prior year).

Background: DVMT is tracking stock that references VMware. DVMT was issued to EMC shareholders

as merger proceeds to track 65% of Dell’s 81% pro-forma ownership in EMC’s subsidiary, VMware.

VMware is a mature technology company that generates sustainable cashflow and has recently

experienced a resurgence in earnings growth due rapid adoption of their new technology offering.

VMware trades like a value stock with 2017 P/E multiple (13.8x) and FCF yield (8.6%), and the current

entry point creates future growth for virtually free.

VMware is the market leader in an on-premise virtualization, a software technology that enhances

resource allocation between hardware and a user’s operating system on a private cloud. It offers services

such as server virtualization (vSphere), storage virtualization (vSAN), networking and security

virtualization (NSX). VMware owns roughly 85% of dollar share and 60% of unit volume in their market.

50% of revenues are generated within the United States with the other half scattered across EMEA, Asia,

and LatAm. The market is composed of a few large players—Oracle, Red Hat—that VMware has

outcompeted for the last decade. It’s estimated that VMware serves 95-99% of Forbes 2000 companies

globally. The business model has 80% recurring revenues based on their licensing contracts and

maintenance services. Prohibitive financial and operational switching costs protect against accelerated

customer attrition and the success of new product lines helps slow declines in their legacy technology.

The company generates mid-80s gross profit margins, adjusted EBIT and Net Income margins in the low-

30s and mid-20s, and unlevered FCF margins in the low-30s.

The market has mispriced VMware’s ability to grow its product suite and generate sustainable cashflow in

a business environment that is slowly transitioning to the public cloud. A saturated virtualization market

has weighed on their valuation and the multiple implies flat to low-single digit growth. VMware continues

to outperform this expectation. License billings growth, a leading indicator of revenue growth, has

accelerated over the past three quarters and reached 14% YoY at the end of 2016. NSX is growing at 50%

YoY, while vSAN increased 150%, together representing roughly 35% of total billings. High growth off a

material base has allowed VMware to surpass the inflection point where license growth from new

products exceeds legacy declines. This dynamic will help the company sustain recent earnings and

cashflow growth moving into the low double digits in the near to medium term. A recently announced JV

between VMware and AWS, the terms and strategy of which have yet been disclosed, could generate

further upside that you are creating for free.

The company typically invests it’s cashflow in acquisitions or stock buybacks and has favored buybacks in

the recent future. On FY 2016 earnings call, the company announced an additional $1.2bln program that

will retire approximately 3-3.5% of company shares and 12-14% of the free float in 2017 depending on

valuation.

VMware currently trades at 90 and has $20/share in cash that accretes $6/share p.a. after capital

expenditures. Earnings growth of around 9-10% will push EPS from 4.40 to around 4.85. If the buyback

retires 12m shares (avg. cost of $100/share) that creates another 13c and gets EPS to 4.97. Under this

scenario FCF/share is around 6.00. Relativizing this against market comps, 10% FCF growth companies

typically trade at an EV/FCF 16-18x. Pro-forma 2017 cash net of investment gets you to a 11.5x EV/FCF

valuation for VMware. If you haircut the valuation range 2x to create a margin of safety on growth

expectations and broader equity market valuation, the VMware stock price range is $107-119/share.

Within the comp range it would trade between $119-131.

Moving to DVMT, the tracker trades at a 29% discount to VMware for three main reasons:

 As Dell Class V shareholder your rights are limited at Dell Technologies and non-existent at

VMware. VMW Class A holders are afforded standard shareholder rights.

 In the event Dell sold VMware, DVMT shareholders receive after tax-proceeds versus pre-tax

proceeds for VMW shareholders.

 Within the Dell capital structure, Class V shares are issued out of Dell Technologies and

structurally subordinate to Dell creditors. VMware is an unrestricted subsidiary and in the event

of a Dell default is not party to any existing Dell obligation.

The current discount is oversold. It is difficult to quantify the value of reduced shareholder rights but we

believe recent actions and the governance created post-issuance align DVMT holders with Dell. DHI

Group bought back $324m shares held in treasury before canceling the $1bln program, Dell Technologies

has announced a $500m Class V share repurchase program that will be directly accretive to DVMT

holders, and Michael Dell owns $20m shares personally recently adding to his position in January. DVMT

holders are represented by a conflicts committee to represent and protect their rights. Upon a Dell IPO,

Dell can convert DVMT shares into Dell common equity at a 0-20% premium to DVMT market value

depending thus eliminating the tracker. For Dell to publicly jam DVMT holders after issuing the tracker to

finance his acquisition of EMC seems unlikely.

The prospects of a VMware sale also seem low. VMware represents Dell’s best business opportunity and

he has reiterated that Dell’s distribution channel could create another 1bln (12.5% growth) of revenue for

the brand. It is worth more as part of the Dell family than not. Furthermore, EMC purchased VMware in

2004 for $635m, at an equity valuation of $38,000m, that creates a large capital gains liability. The tracker

was created to avoid that. Under Section 355 of Internal Revenue Code, a business can spin off a

subsidiary tax-free after 5 years of ownership. It is unlikely after designing a complex acquisition structure

to maintain ownership in VMware, Dell would crystallize a tax gain before having the option to avoid

taxes through a spin.

Dell credit risk represents the most tangible difference between DVMT and VMW. Dell used $43bln of

debt to finance the EMC acquisition. Pro-forma debt retirement of $5.2bln post-Q3, Dell is 5.4x levered

through Dell Inc. The current default probability is 3.82% and Dell Inc. 5 yr Sr. CDS trades @ 240bps at

100bps running. The interesting part about Dell CDS is that the reference obligation remained Dell Inc

post-merger, which is the most junior part of the capital structure after the equity. This unsecured debt

represents the thin 5.1-5.4x levered tranche at the bottom of the stack. Therefore, if the equity tranche

(DVMT) was vaporized through a Chapter 11 process, Dell Inc. bonds would likely get 0 recovery as well.

With additional asset sales and $5bln FCF generation p.a., there is a much higher probability Dell gets

upgraded to IG in the next 18 mths than files for bankruptcy. However, Dell CDS is an inexpensive way to

hedge out this tail risk and illustrates the disconnect between the equity and credit markets.

Finally, we believe the discount will tighten with the recent DVMT buyback program. $500m shares

should retire an 3.5% of outstanding shares without reducing the 53% of VMware that the tracker

references. Additional buybacks are possible in the future but for now appear low priority given the focus

on debt retirement over the next 18 mths.

We think DVMT could reasonably trade to 90 over the next 6 months, which would imply a 16-25%

discount to VMware’s base case valuation range. Valuation will be driven by 3 catalysts:

 Continued debt retirement at Dell funded by asset sales and FCF generation and indications

from credit ratings agencies that an IG upgrade is on the horizon

 Stock buybacks at both the VMware and Class V shareholder level juicing EPS growth and

helping narrow the discount

 Stable cashflow growth from VMware that will result from continued adoption of NSX and vSAN

technologies

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Valuation will be driven by 3 catalysts

1) Continue debt retirement at Dell funded by asset sales ($10bn announced) and FCF generation and Dell achieving its stated goal of having investment grade ratings within 18-24 mos from merger close....which would equate 12-18mos from today

2) Stock buybacks at both the VMware and Class V shareholder level (DVMT) juicing EPS growth and helping narrow the discount

3) Stable cashflow growth from VMware that will result from continued adoption of NSX and vSAN technologies

show sort by

			2017	2018
Price:	90.90	EPS	4.97	5.45
Shares Out. (in M):	112	P/E	13.8	12.0
Market Cap (in $M):	37,400	P/FCF	11.5	9.9
Net Debt (in $M):	-6,500	EBIT	2	2
TEV (in $M):	30,900	TEV/EBIT	11.7	10.9