Description

VMW holders could get $250 - $350 of value in <3 years.

Summary:

While the stock has rebounded the last two days, the articles, sell side, etc have all said ¨good business but stay away due to uncertainty¨.  I believe the uncertainty will fade, and earnings will beat significantly.

VMWare´s EV/EBIT multiple has been all over the map due to sentiment about ownership and growth rate.  Data points:

·      Dec 2012 (my short writeup). 30-35x.  Earnings expected to grow 20%+ (although declined 2013 to 2014)

·      Mid 2015 before Dell acq annnoucement:  20x

·      Early 2016 post Dell acq announcement:  12x

·      Today:  15x forward (15.7x consensus), at 10% consensus growth rate

I believe the consensus of 10% earnings growth is too low, and should be 20% over several years.  

Finally, I still believe a reverse merger is likely eventually and that will require paying VMWare minority holders a nice premium.  Which drives the high end of the value range. But its not necessary to work.

Driver 1. Uncertainty Fade / Multiple Rerate

A Enterprise SW 10% grower at VMWare´s size should be at least mid 20s forward EPS net cash (20x EV/EBIT).   Stock  trades <12x for Price (cash adjusted)/FCF for CY 2019, well below the market.

EMC was seen as benevolent, and the multiple was higher, so the current share structure is not an impediment.  But the fear that Dell will screw VMWare holders is.  Which makes no sense to me because:

1)   Key reason:  SilverLake needs to exit.  Which is better with a high multiple and the resultant liquidity

2)   VMWare employees are shareholders.  

3)   Did MSD + Silverlake steal Dell?  EMC? If you could choose today to go back in time and invest in public Dell and EMC (stripped of much of VMWare stake) and force them to stay public, as opposed to invest in the S&P, what would you do?   EMC had no other options and the storage business has been very weak for them.

4)   Dell is majority owner in Secureworks (SCWX) and soon Pivotal, both publicly traded stubs.  Screw one and they all trade poorly.  Treat them all well and they all trade poorly.

At some point, someday, sentiment will turn.  

2. Earnings Beat and a higher rerate

While the core business (ESX/vSphere) has slowed down, it is a very good steady state business having lost what share it will lose.   There have been many competitors try and fail to gain significant share (Cirtix, Microsoft, OpenStack), although they have kept a recent lid on pricing.

While units may not grow much if at all, I believe VMWare is substantially under pricing and competition such as Microsoft is providing room to raise. I´d be surprised if VMWare rank and file didn´t see the opportunity ahead and thefore had concerns about the reverse merger.

Two key pricing examples:

2a: vSphere  (the primary offer, likely the majority of profit):

In 2017, Intel raised the price of CPUs with many cores.  Because VMware prices vSphere per CPU, then more cores per CPU mean SW license costs stay flat while in reality the customer is getting more processing power, in effect a price cut.

For a VMware license that is $6K or more per CPU over 3 years, Intel had a lot of room to say ¨we´ll offer 20% more cores, you pay no more SW fee to VMWare,  and we split the value with you.¨   While $6K sounds like a lot, it works out to $20 per VM/year at 20 cores per CPU, which is not much.

Microsoft went to per core pricing in 2016, like much of the industry, except for some of Red Hat.  However Red Hat has defeatured some products and charges extra.  Try buying RHEL and seeing what the add ons costs, its like an LCC airline.  Much less so with VMWare.

So…while MSFT changed…why did VMWare not react in 2017?  I can theorize but but not sure the reason is important.  Its money on the table and there are a lot of ways to recapture some.

2b: Service Price

I think Services is underpriced across the board.  Am example is the upgrade for Production (24x7) support from Basic 12x5 costs only 6% more.  Compare that to Red Hat (RHEL for VD) which adds 60% for 24x7.  Or even a Dell Server where same day can add 20-30%. 

Pricing Summary

Given VMW´s low 30s op margin, a little pricing can help a lot. Easy to make the case that Op Income $ doubles.  Since I don´t know when that will occur (to be honest – if it ever will), I just assume EPS growth at 20%/year over next few years.

3. Reverse (Downstream) Merger:

I believe a reverse merger is still a strong possibility in the next couple of years.  The key reason is MSD-SilverLake VMWare shares are held at EMC Hold Co.  Selling would require Hold Co to pay capital gains (>$8B tax today, more as VMWare grows) before any cash is returned to the investors and is taxed a second time.

The Downstream merger eliminates the double taxation by trading shares of EMC hold co with shares of New Co (VMWare), with VMWare shares being eliminated from the HoldCo structure.  The only big RM was done by Seagate and Silverlake in 2000, a great case study, and saved $6B of taxes which got split 60/40 between shareholders and the acquiring company (Veritas SW).  For VMWare minority shareholders, I assume Dell EMC would be able to share the upside.  In fact would have to, to facilitate a deal, and make sure the resultant multiple is good for an exit by Silverlake.

I´m really not sure why a RM didn´t happen now.  Maybe investor personalities.  I do believe the HW market is doing well for Dell per IDC data (outside Storage), and given the leverage, the MC could easily be 2-3x higher if Dell´s strength in servers continues, so that coudl be it.  Also, if Dell EMC Core eventually IPOs, then there is no guesswork as to the valuation which would help a reverse merger.  Still...I figured enough of a premium to VMWare minority holders and DVMT holders would have solved any issues.

Other:

I completely skipped a review of various products (NSX, VSAN) or new markets (HCI especially).  Happy to discuss in the comments section.  Obvious to say I don´t see any thesis killers, but not sure is worth the added space.

Risks:

Unclear when pricing decisions will happen.  Would it be post a reverse merger?   If anything, could elongate the time required to fully play out.

Catalyst

Earnings

Potential rerating if Pivotal, another Dell-controlled entity, trades well post IPO this week