VMWare Tracker offers a decent upside potential

The Dell – EMC merger has been well covered in the financial press since the merger was announced last year. I have written on it in March this year. As there is a whole host of information in the public domain I will keep the background very brief and focus on the specifics – i.e., analyse if VMWare tracking share offers a value opportunity now.

A very brief summary of the story so far

Dell and EMC have now merged, resulting in EMC being taken private. Dell paid cash consideration for EMC’s core business, but issued a tracking stock for most of EMC’s stake in the publicly listed VMWare. Broadly, EMC holds 81% of VMWare, and the tracking stock issued by Dell tracks 53% of the VMWare economics with 28% of the economics retained by Dell. The public hold the remaining 19% in VMWare common.

The VMWare tracking stock has now been listed and trades under the ticker: DMVT.

What’s the point of raising this now given the merger is all done and dusted?

Just look up the VMWare stock price and compare it to the VMWare tracker. When I last checked, VMWare tracker was trading at a 35% discount to VMWare common. As each VMWare tracker tracks a VMWare common, the 35% discount appears steep. It makes sense to check this situation out to see if the VMWare tracker is mispriced.  

Is the VMWare tracker mispriced?

To identify if the VMWare tracker is mispriced, two questions need answering:

1.      What is the value of VMWare common? – as the tracker tracks the underlying VMWare common stock, its value needs to be based of the intrinsic value of VMWare common. One needs to have some sense of the value of VMWare common and the comfort that it is not overpriced.

2.      What is the right discount for the VMWare tracker? – tracker’s like this one always trade at a discount to the underlying common. Based on comparables identified by Evercore (see the Merger Agreement), it appears that the discount on other trackers have been ~10%. But one needs to check the details for this tracker, identify key risks & terms, and get a feel for quality.

Broadly, the aim is to assess if the market’s current pricing of the VMWare tracker gives rise to a situation where the probability of upside significantly outweighs the probability of downside.

VMWare value

VMWare is currently trading at ~$73 a share. I think the price is about right.

·         Morgan Stanley & Evercore, who acted as EMC’s financial advisors for the merger, estimated VMWare’s intrinsic value in the range of $71 - $88 under various scenarios. (see the Merger Agreement for the detailed financial opinion and valuation)

·         Using the 5 year Free Cash Flow to equity projections for VMWare as disclosed in the Merger Agreement, and applying a discount rate of 11% for VMWare’s cost of equity (which is on the higher side), I get a DCF value per share of $77.

·         For a company forecast to grow at ~9%-10%, VMWare doesn’t trade at a too steep a multiple:

o    12.2x FY17 forecast FCF & 11X FY18 forecast FCF;

o    15x FY17 forecast P/E and 13.4x FY18 forecast P/E;

o    8.4x FY17 forecast EV/EBITDA and 7.6x FY18 forecast EV/EBITDA.

Overall, I am comfortable that the current share price is not excessive and there is some potential for upside if some of the projected merger synergies discussed in the Merger Agreement come true. 

What is a reasonable discount for the VMWare tracker?

Although the VMWare tracker tracks 53% of the underlying VMWare economics, its value cannot equate to 53% of VMWare common. Trackers always trade at a discount, and if you believe Evercore per the Merger Agreement, comparables trade at a discount of 10%. So why the 35% discount on this one?

I have set out both the negatives (reasons for a steeper than 10% discount) & positives (reasons why the discount could narrow from the current 35%) below.

Principal reasons for a steeper than 10% discount

1.      Lack of alignment of interest – To me this is the biggest and most concerning of all the risks. When I look at situations like this, I like to see management being personally exposed to the newly created merger security and having a material amount of personal wealth riding on its success. If you flip through the Merger Agreement, you struggle to find reasons why the Dell common stock owners (principally Michael Dell & Silver Lake) need to care for the VMWare tracker. None seem to hold any of the VMWare tracker – they do have a lot of personal wealth riding in the newly merged Dell-EMC business via their ownership of the Dell common stock, but that is not the same as owning and being directly exposed to the VMWare tracker. You could argue that as Dell is directly exposed to 28% of the VMWare economics, control’s VMWare, and expects a lot of benefits for the newly merged Dell-EMC business by being connected with VMWare, they have a lot riding in ensuring that VMWare as a business succeeds. However, for reasons listed below, I feel that VMWare as a business could succeed without the VMWare tracker getting the upside from this success. Personally, I would have liked it better if Michael Dell and Silver Lake were personally exposed to the success of the VMWare tracker.

2.      VMWare tracker will be exposed to the Dell-EMC credit risk. Dell has borrowed shedload to fund this deal (in excess of $50bln). Post deal, the group is expected to have a debt to free cash flow ratio of about 6x, resulting in junk-grade status. However, the group will generate a decent amount of free cash to be able to service the debt and deleverage. They have a stated aim of getting back to investment grade status in 18-24 months and given historic and forecast cash flows, this should be achievable. However, if the group goes under, the VMWare tracker will be worthless as the creditors enforce on Dell’s 81% VMWare stake. Broadly, you could find the VMWare business doing well, but still lose out on the VMWare tracker if Dell-EMC don’t succeed.

3.      The VMWare tracker only has 4% of the votes in the merged group. Basically, the tracker has no control or say. This pretty much kills the possibility of an activist taking a significant position in the tracker and fighting the case for the tracker holders. 

4.      Dell is allowed to move assets around, including the VMWare stake belonging to the VMWare tracker – for example, it looks like they are able to take away/transfer all or part of the VMWare stock from the tracker by replacing it with an equal value asset. This obviously is not what the VMWare tracker holders are buying into in the first instance.

5.      VMWare currently don’t pay a dividend. But even if they did, Dell are not obliged to pass this one to the VMWare tracker holders. However, they do need to ensure that any dividends attributable to the VMWare tracker is assigned to the tracker’s value – my reading of this is that if they use the cash from any dividends, they will owe the VMWare tracker an equal amount as a payable. However, this is not the same as the VMWare tracker holders being guaranteed their share of any dividends declared by VMWare.

6.      If Dell buy out the 19% VMWare common, effectively taking VMWare private, VMWare tracker would have no market comparable, and could effectively be left in a limbo.

      

      For the above reasons, I feel that the VMWare tracker merits a higher discount than the 10% seen for other trackers / comparables. However, I don’t think that the discount needs to be as high as 35% for the reasons listed below.

Positives for the VMWare tracker

1.      It is possible that a lot of the downward pressure on the VMWare tracker at present, given it only just got listed, is being exerted due to forced selling by institutions (former EMC holders who got handed over a bunch of tracker shares which they don’t want or cannot hold or don’t understand). It is not uncommon for institutions to be restricted from holding something like this and spin-offs / mergers do often create forced selling. To the extent there are forced sellers out there, it obviously creates an opportunity for a value buyer and one would expect the discount to narrow once things settle down.  

2.      Some of the governance risks I have listed in the negatives above are offset in part by the Capital Stock Committee whose main objective is to look after the interests of the VMWare tracker holders. Broadly, Dell has created a committee of directors known as the Capital Stock Committee, and the Dell board of directors will not be permitted to take certain actions with respect to the VMWare tracker without the approval of the Capital Stock Committee, including with respect to any changes to the policies governing the relationship between the Dell-EMC group and the VMWare tracker group. The Capital Stock Committee will consist of at least three members, and be independent under the rules of the NYSE. For these independent directors approximately half of the value of any equity compensation will consist of VMWare tracker or options to purchase VMWare tracker. The existence of an independent Capital Stock Committee, with some alignment of interests with the VMWare tracker holders, offers a degree of protection from governance risks listed above.

3.      If Dell do manage to deleverage and get to investment grade rating in 18-24 months as stated, and if no governance concerns come up in the meantime, this will be a net positive for the VMWare Tracker and should narrow the discount quite a bit. At least the credit risk is much reduced.

4.      Dell’s debt facilities permit up to $3 billion of repurchases of VMWare tracker, this amount may increase over time based on Dell’s net income and other factors. Dell has stated its interest in pursuing a repurchase of the VMWare tracker once it achieves its stated objective of reducing indebtedness and achieving investment-grade rating over the next 18-24 months. This augurs well for the VMWare tracker.

5.      Finally, VMWare tracker should create substantial liquidity and increase the ability to gain exposure to the underlying VMWare business. Currently there are 80m VMWare common held by public. The listing of 223m VMWare tracker increase liquidity substantially.

      In summary, I think that the VMware tracker doesn’t merit a narrow 10% discount seen for comparables but neither does it merit the steep 35% discount priced by market. I think a ~20% discount seems more reasonable.

      

     How to trade the situation?

     Given this is a new issue, and there is still quite a bit of uncertainty attached, I don’t think buying VMWare tracker direct is the way to go. Options offer a better much better risk/reward. Buying call options over VMWare tracker puts lower amount of capital at risk and adds a tone of gearing to amplify the return in the event the discount narrows and/or VMWare common increases in price.For example, a April 2017 call option on the VMWare Tracker with a strike price of $50 can be purchased for a $3.90 premium. If the discount on the tracker narrows to 20% by April 2017, assuming VMWare common stays at current levels, the VMWare tracker would be up at $58.4, giving a 115% return and 2.15x multiple on capital for a six month hold (364% return annualised). Even if the discount only narrows to 25%, the return would be 22% for a six month hold (49% return annualised).

      

      As discussed above, there are clearly downsides to the trade but I think that the probability of an upside outweighs the downside. Buying long-dated call options over the VMWare tracker offer a decent play with lower levels of capital at risk given you are only exposed to the option premium. 

      Afterword

      I wrote of the arbitrage opportunity offered by the VMware tracker back in March17. Back then, the VMWare tracker was priced at an implied discount of ~53% against the underlying VMware common. A simple strategy of going long EMC share then would have resulted in a return of 10% over 6 months (21% annualised); and a strategy of buying Oct 16 EMC calls at a $24 strike price which were selling for a $3.65 premium would have resulted in a return of 47.5% over 6 months (117% annualised). The beauty of this situation is that it still has the potential for a decent upside, which is not unusual for special situations like this.

     As I write this blog, I am reminded of Joel Greenblatt (one of my favourite value investors) and his fantastic book - You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits. Joel wrote this book back in the late 90s and it is as relevant today as it was back then and will continue to be so for a long time yet. In it, Joel peppers us with real life examples of special situations (spin-offs, mergers, reorgs etc in which he invested) and provides practical advice to profit from them. Joel is a great investor and I highly recommend this book if special situations are of interest to you. Joel is better remembered for another one of his book – The Little Book That Beats The Market. But to me, You Can Be a Stock Market Genius is even better, and that is saying something given that The Little Book is also a fabulous book.