December 10, 2015 - 2:01pm EST by
2015 2016
Price: 59.00 EPS 4 4.10
Shares Out. (in M): 440 P/E 15 14
Market Cap (in $M): 26,000 P/FCF 0 0
Net Debt (in $M): -5,600 EBIT 0 0
TEV (in $M): 20,400 TEV/EBIT 0 0

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This is a short term trade idea in VMWare as the Dell/EMC deal continues to unfold. It won't boast a high return, but we believe it has limited downside with a likely near-term catalyst. Will be using rough numbers in this write-up since things are moving around, company figures themselves are inexact and the trade is not heavily numbers driven.

Since the announcement of Dell/Silverlake/MSD's acquisition of EMC to be merged with Dell, VMWare's share price has fallen more than 30%. Currently, VMWare is 80% owned by EMC, leaving a 20% public float. As part of the EMC plan of acquisition, Dell will take over 28% of VMC shares with 97% voting rights, EMC shareholders will get 50% of VMW in tracking stock with no voting rights, and public VMW shareholders will keep holding their public shares with 3% voting rights. 

VMWare's public shares have been hurt by the following factors:

- Overhang of a massive block of tracking shares which will likely get dumped by institutional shareholders at deal close, due to their preference to have actual governance and dividend rights in their large holdings (note that while VMW has much heavier HF ownership, EMC is largely long-only)

- Subsequent to the EMC announcement on 10/12, VMW announced it would form a 50/50 JV with EMC around EMC's Virtustream business, basically to extend VMW's virtualization expertise into the public cloud computing space. This is a money-losing venture from the get-go ($200-$300 mm operating loss) and would require large capital contributions from VMW (+$300 mm incremental). It is currently slated to be consolidated in VMW's financials for accounting purposes 

- Perception that Dell may abuse their control rights. The Virtustream JV has alarmed VMW investors that corporate decisions may not be being made in their best interest

- Management commentary on Q3 call that there was a "massive secular shift in the market" causing customers to pause their spending while they figure out whether they want to locate their systems inhouse or on the public cloud

We believe the buyer consortium will be motivated to fix VMW's share price in order to get the deal done.  Not only are VMW shareholders pissed, but EMC shareholders are disgruntled with the merger terms, since the big drop in VMW shares means the effective merger consideration isn't $33/share as originally announced, but closer to $30/share. (EMC is trading at ~$26.00 currently and ~$23.00 before deal rumours surfaced.) As leaked in the press, a number of EMC shareholders have proposed 1.) VMW do a share buyback of up to $3 billion, 2.) unwind Virtustream and 3.) revise tracking stock structure to be more shareholder friendly, or else they'll vote down the deal. Note that Elliot is in EMC stock (also VMW, but not as big), but they came out in support of the deal on announcement, so they'll probably have to sit back for a bit while the egg on their face dries.

With approx. $7B in cash on the balance sheet (though much of it reportedly offshore) and only a $1.5B note outstanding to EMC, VMW should be able to afford a big buyback, funding it with onshore debt if needed.

It also seems likely that Virtustream will get also revised somehow. Current reports suggest it could now be consolidated by EMC/Dell rather than VMW under a new structure. This is for optics only, but would make VMW earnings look better into 2016. Other possibilities include Virtustream being majority owned by EMC instead of 50/50. We're not sector experts, but if management commentary regarding how dire the situation is in the traditional virtualization market is correct, the JV is too important the company's future to scuttle as per the institutional investors' demands.

As to the tracking stock terms, it isn't clear what will happen there. Anything that happens here should be a net positive to VMW, but rewiring the transaction could push out the timeline and that's probably not something the buyers want.

There are also other scenarios, which are probably less likely, such as Dell going back to lenders to buy out VMWare or some other change in merger consideration (more cash, Dell takes a higher % of EMC's VMW shares). You never know. You can bet that bankers are furiously working behind the scenes to figure out what they can do to close this deal and collect their fees. On the other hand, a deal break should be very positive for VMW as breakup fees are on EMC. Gaming this out further, a topping bidder could emerge for EMC, but this seems unlikely with Oracle out of the picture. A third-party acquiror for VMW seems hard to do since EMC owns the majority of the shares and back-to-back deals are complex, unless it is a friendly PE shop. Still, we don't want to rule anything out.

We recommend a short-term long in anticipation of these positive catalysts. We see the downside from here as minimal, as there shouldn't be much news that could hurt VMW near term (though we don't necessarily see a reason to be long through the next earnings call), for a decent gain on an IRR basis if something happens in the next month to 2 months. 

VMW is trading somewhere around 14x 2016 EPS. That seems cheap on a historical basis and compared to mature software peers, but we don't have any special insight into how well the virtualization market holds up into 2016, since it feels like a transition year and management commentary was bleak. We would love to hear from others on the board if they have deep insight into the business. Regardless, VMW is solidly FCF positive and has an excellent balance sheet. Management indicated they will provide further guidance beyond HSD to LDD revenue growth for 2016 on their next earnings call.

What we think matters is that a share buyback, fix to the JV or other positive signs that Dell is willing to play nice with VMW will give the stock a nice pop. Very rough cut, a $3 billion buyback mechanically equates to a 12% gain if the multiple holds. Fixing the JV by deconsolidating it doesn't do much to EPS (+0.10), but might rerate the stock. And while we don't know how things turn out, there are probably other alternatives that will emerge, given there is a buyer that is motivated to get things done. Ultimately, though, there probably needs to be a few concessions to really move the stock, and we're hoping these happen in short order. Upside is probably capped by the negative sector commentary.

We recognize this is less fundamentals-driven and squishier than most ideas on VIC, but we see this as having low risk optionality. Risks include:

- Buyers decide the deal is fine as is and they can get the shareholder votes required

- Sector takes turn for the worse while we wait

- This is not a traditional merger arb, and there isn't a good way to hedge this

- EMC decides to make a distribution of some of their VMC shares before deal close(?)

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.


Share buyback announced

Revised VirtuStream JV terms

Revised tracking stock terms

Deal breaks (probably too far out to earn a good IRR)

Other change to EMC deal terms

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