UK's student loan book sale

Earlier this month (6 Feb 2017) the UK Government announced it will commence the process to sell a part of the pre-2012 English student loan book through securitisation. The plan is to sell the loan book which entered repayment between 2002 and 2006, with the reminder of pre-2012 loan book to be sold over the next 4 years. A bunch of investment banks are working towards bringing the initial tranche to market and the sale is expected to close in the second quarter of 2017.

There has been a lot of press over the last few days – mostly negative for the Government and its plans. But what caught my eye were the numbers.

The total pre-2012 English loan book stands at ~£45.4bln as at April 2016; and the Government expects to raise £12bln through the sale of this loan book over the next 4 year. This equates to a ~74% discount to the outstanding loan book. Given these numbers, this opportunity is worth a look. 

Valuing the student loan book is not easy. This is not your typical fixed income instrument where you have a defined cash flow and you apply a discount rate based on your cost of capital after taking account of credit and interest rate risk. These student loans are income contingent where repayment is triggered based on the income of the borrower. Broadly, each student pays 9% of the difference between his/her income over a set threshold. Currently, for the pre-2012 loans, this threshold is £17,495; therefore, a borrower earning £25,000 would pay £675.45 per annum. On top of the income contingent nature of these loans, default rates tend to be very high – current average default rate on the loans granted between 2002 and 2006 is ~50%. The high default rate reflects the fact that there is no credit or other checks needed to be eligible for these loans which means that almost any student enrolled in any university course is eligible. Before getting to my estimate of value for the 2002 – 2006 loans, here is a brief table showing the key terms for these loans:

Key terms of the English student loans granted between 2002 and 2006

Type of loan	Income Contingent -current annual repayment threshold - £17,495
Payment terms	9% of income above annual threshold
Annual Interest rate set on 1 Sep each year	Retail Price Index (RPI) in the previous March, or 1% above the base rate, whichever is lower. It is worth noting that as the graduates only pay 9% of the income above threshold, interest rates only change the duration of the loan and not the amounts repaid.
Cancellation	Any outstanding balance on the loans taken between 2002 and 2006 is cancelled when the borrower reaches the age of 65; the loans are also cancelled upon death or disability of the borrower
Collection process	For most borrowers, payments are collected by the HMRC through the UK tax system by employers taking amounts from their salary through the Pay as You Earn (PAYE) system. Borrowers who are self employed pay through the tax self-assessment process by filing returns with the HMRC. Borrowers living abroad pay direct to Student Loan Company

Valuation

There is some data available from the Student Loan Company (SLC) which I have used to estimate future cash flows and to value the loans which entered repayment between 2002 and 2006. It is by no means easy to do and requires some big assumptions. I see this exercise as a bit of homework before I can get my hands on the pitch book from the banks when they bring these loans to market. By doing some homework and knowing the difficulties / assumptions required in valuation, I should be better prepared to review the sales pitch from the Government and its advising banks when it becomes available.

Data available from the SLC

The SLC has some good data from which can get the following information for each repayment cohort:

a)       number of students paying their loans each year;

b)       number of students who were liable to repay each year (borrowers become liable to repay the April after graduating or otherwise leaving their course and are required to make payments if their income is above the threshold);

c)        implied default rate (number of students repaying divided by number of students liable to repay);

d)       total amount outstanding (liable to repay) at the end of each year;

e)       total amount paid each year;

f)        average amount paid by each paying student (total amount paid divided by number of students paying);

g)       income threshold for each year;

h)       interest rate for each year; and,

i)         implied average income per paying student (on the basis that each paying student pays 9% of his/her income above the income threshold, this can be calculated as – [(f) average amount paid per paying student divided by 9% plus (g) income threshold per year]

The below tables show the trend in above variables, from the first year when they entered repayment, for each of the repayment cohort currently earmarked for sale. 

Projecting future cash flows                 

Projecting cash flows for these student loans is more art than science. I have used the following variables to arrive at my projected future cash flows for each repayment cohort:

1.       I have assumed that the number of students repaying will fall by ~10% each year for the reminder of the payment period. The trend over the last 5 years for each repayment cohort indicates that the number of students repaying has fallen by ~10% each year.

2.       I have assumed that the implied annual income per paying student increases by 1% each year. Again, the trend over the last 5 years is consistent with this assumption.  

On the basis that the repayment cohorts above are fairly mature – these repayment cohorts include students who would have finished their education between 2001 and 2004 – I believe that the last 5 year trend in number of students repaying and implied annual income should be a reasonable estimate to use in projecting future cash flows. For example, if the average implied income over the past 10 years has been ~£28k and growing at ~1% over the past 5 years, it is unlikely to change materially in future given the amount of time it has been since the student graduated and any uncertainty should be to the upside.

3.       I have assumed that each repayment cohort will pay for 30 years from the year it entered repayment. I believe this is a conservative estimate – e.g. these loans pay till the borrower turns 65 and assuming an average age of 25 when the borrower becomes liable to pay, these loans should pay for 40 years from the year they entered repayment.

4.       The other key assumption required to forecast cash flow is the income threshold for each year. This variable has a significant impact on the cash flows as the payments are set at 9% of borrowers’ income above the income threshold. This is a difficult one to predict and I am sure will be a key focus for investors when they see more detail on the sale. This will be a political hot potato for the Government – for example, freezing the annual income threshold could maximise the proceeds from sale as there is less uncertainty for the investors but will likely invite severe rebuke for the Government; similarly, any uncertainty on this variable (e.g. if a future socialist Government is able to increase this threshold materially to the detriment of the private investors but playing well to its constituents) will mean reduced proceeds. Based on last six year trend, average increase has been ~2.5% and I have used this as the basis for my cash flow forecast.

5.       Interest rate is another key variable which is difficult to forecast. As discussed earlier, this is the lower of RPI or base rate plus 1% each year. Given the low base rate in the UK over the last several years, this rate has hovered around the 1.5% mark over the last several years and is at 1.25% at present. I have assumed a rate of 1.25% for my forecast cash flow. As discussed above, the interest rate does not impact the amount of cash a student has to repay but only impacts the duration of the repayment – e.g. the amount repaid each year is fixed at 9% of the income earned above the income threshold with the interest being added each year to the outstanding balance. On the basis that I am assuming cash flows coming in for the next 30 years only, interest rate should not impact my valuations and any uncertainty should be for the upside.

Using the above variables to project cash flow for each repayment cohort and discounting cash flow at a rate of 10% gives a present value of ~£1bln for 2002 – 2006 repayment cohort, implying a discount of 75% to estimated £4bln outstanding amount on these cohorts. 

The assumptions I have made in arriving at the above valuation are fairly conservative and provide a decent chance for an upside. If the Government does decide to sell these loans at a ~74% discount, it definitely merits a detailed look. The other point of interest will be how the securitisation is structured – e.g. will it be by repayment cohort where earlier years merit a higher discount than later years, or will it be by quality of borrowers.

From the UK Government’s perspective one could ask why sell at such a heavy discount?; clearly these loans should be worth more than 25p in a pound to the Government given its low cost of capital. Apparently, for the Government, immediate cash is worth more than cash coming in over a number of years in future; this is because it can then use this cash to fund near term needs (like making more student loans) instead of borrowing which impacts on its commitment to reduce public sector net debt in the near term. 

It appears that we have a situation where the seller is selling for reasons other than pure economic value which should present an opportunity for the buyer. 

Bank of Cyprus (LSE:BOCH)

Investing in the shares of distressed European banks requires tremendous courage – success requires a decent dose of luck and good timing, in addition to picking the right horse. The big discounts to tangible book value reflect the very high risk of future dilutive equity issuance owing to the massive challenges faced by these banks on their NPLs. Investing in the NPL book or entering into a 3^rd party servicing agreement to run down the NPL book offers significantly better odds of success. However this is more for the Hedge Funds and PE houses given their deep pockets and resources. For an individual investor, I still believe that a basket of carefully picked distressed stocks offers a decent chance of success (of my 3 picks so far – Eurobank and Deutsche have returned 2x and Millennium BCP has tanked; for an overall return of ~35% in under a year). And now, I want to add Bank of Cyprus to my basket.

Bank of Cyprus is the largest bank in Cyprus with ~41% share of the loans and ~30% share of the deposits. It currently trades at just under 50% tangible book value.

Investment thesis

FY16 could be the year that turns a corner for BoC –
- it is set to make its first net profit after six years of losses;
- it has now fully repaid its €11.4bln loans to the troika and is able to pay dividends in future;
- deposits are returning;
- the trend in NPLs and 90DPD formation is reversing;
- it has an enviable net interest margin of 3.5% and cost to income ratio of 42% both of which should support pre-provision income; and
- the Cypriot economy has shown better than expected recovery supported by a growing tourism sector and a resilient business services sector and this is reflected in the falling unemployment rates, improved credit ratings and the fall in government bond yields.

The ~25% deleveraging in total assets since bail-in in FY13 - including the sale of all/most of its non-core assets - has made the bank a leaner more focused outfit.
Here are some graphs from the bank’s most recent investor presentation to illustrate the above points

Source: Bank of Cyprus investor presentation 11 Jan 2017

Potential upside

I don’t believe BoC’s shares offer value in the short-term; but over the long-term (1.5-3 years), they could do well. There are still significant challenges around NPLs (discussed in more detail below) and the market seems to be pricing in additional dilutions or hit to income owing to additional provisions or both. For the gap between price and tangible book value to narrow, the positive trend achieved over the last year/year and a half will need to continue for another year at least – in particular, the market will want to see positive net income and continuing reductions in 90DPD formation and NPEs. The recent trend in key metrics makes an entry at current price an attractive proposition.

Based on my projections for FY16, I expect the bank to make a Return on Asset of ~0.6% and Return on Tangible Equity of ~4.6% (ignoring the one of costs incurred in connection with the London listing and re-org). This assumes the bank taking provisions of ~70% against pre-provision income (consistent with provisions taken during 9M to Sep16). If the positive trend in 90+DPD formation and NPL’s continue provisions as a percentage of pre-provision income should come down. There is no doubt that provisions will stay high given the level of NPEs, but the bank should be able to generate a 1% ROA even where provisions stay as high as 50% of pre-provision income.

If the bank hits ROA of 1%, I calculate value per share of €0.052 (~169% upside to current price). Even in a scenario where provisions stay as high as 60% of the pre-provision, per-share value could rise to €0.041 for a 135% upside. The above assumes no growth in pre-provision income.

Downside risk

The biggest challenge is the risk of dilution owing to the bank having to rise additional equity to cover further write-off’s in the loan book. NPE’s currently stand at an alarming ~55% of gross loans with accumulated provisions covering ~42% of the NPE’s.

But the trend in NPE’s and 90+DPD formation has been positive, with both falling consistently over the past 12 months consistently every quarter.

Source: Bank of Cyprus investor presentation 11 Jan 2017

Based on my calculation, the bank will most likely need to rise additional equity if TBV falls by 
~€750mn; such a fall will take its capital ratio from the current ~14.5% to 10.75% which is the minimum required by the ECB for the bank. For TBV to fall by €750mn, the default rates would need to increase from the current ~55% of loan book to ~69% at constant coverage of 42%. To put this into context, At its peak in Dec14, NPE stood at 63% of gross loan with coverage at 34%; currently NPE is at ~55% of gross loan and coverage is at 42%. 

In the table below, I have calculated downside under 3 scenarios - if default rates rise to 63%, 69% and 80%. Per my estimates, even if default rates rise to 63% (last peak), the bank won't loose €750mn in TBV if allowing for 3 years' of pre-provision income and won't need equity issuance. Default rates need to rise to 69% for the bank's TBV to fall by €750mn; assuming the bank issues new equity at 35% discount to TBV, downside to current equity holders will be ~35% in this scenario. Default rates need to rise to 80% with loss given default going up to 50% for current equity to be wiped out.  
 

I think the current downward trend in NPE and 90+DPD formation, including the fact that the bank has achieved healthy recovery rates on restructured loans make the downside scenarios discussed above less likely.

Finally, there are a couple of elements that offer considerable upside with virtually no downside for a long-term investor. The first is the potential of Cyprus’s offshore natural gas fields. The recent auction of another block of concessions attracted the participation of some major international companies and recent drilling activity suggests that there could be decent level of natural gas offshore Cyprus. The second game changer is the possible reunification of north and south of Cyprus after more than 50 years of divide – both sides have recently held positive talks. The bank has significant property assets in the north which is currently valued at zero in the books and any reunification will mean the bank getting the assets back or being owed compensation for expropriation. None of the two elements above form part of my thesis but provide a decent upside if they come to fruition.

Millennium BCP (BCP:LIS)

Millennium BCP is the second biggest bank in Portugal with over ~18% and ~17.5% share of loans and customer deposits respectively. More than 72% of its assets are Portugal based, with the rest located principally in Poland, Angola and Mozambique. Like most European banks, and Southern European banks in particular, it has had a torrid few years, with concerns over capital adequacy due to mounting debt and NPLs. It has not yet managed to recover from two bank rescues by the state in 2014 and 2015 and concerns continue to exist over capital levels and risk of big write downs in future owing to NPLs. In spite of undergoing major capital increases in 2012, 2014 and 2015, its shares are down by ~65% year to date, and currently trade at ~26% Tangible Book Value (TBV).

Key Stats

Investment case

I believe that BCP’s share price is at or close to its trough and at ~26% TBV offers good upside potential with decent downside protection. My investment case is built on the following indicators:

Profitability showing a positive trend - Pre-Provision income has stabilised, with net interest income showing an upward trend; the bank made €850m in operating profits for the 9 months to Sep16 and average pre-provision income for the last 4Qtrs has been €256m. I forecast the bank to make just over €1000 in pre-provision income for FY17.

One of the best Cost to income ratios among peers - The bank has done a commendable job in controlling costs, with cost to income ratio having fallen from 85% to 50% between 2013 and 2016. Cost to net operating revenues has average 48.5% over the last 4 Qtrs.

NPLs showing downward trend with robust coverage at 99% - NPE’s have consistently shown a downward trend, having fallen from €12,783m in Dec13 to €9,257 in Sep 16 (a fall of 27.6%). NPE’s currently stand at 18% of gross loans and have a robust coverage ratio of 99% due to the bank having taken some hefty provisions of late. I believe that the bank must be applauded for such robust provisioning and the 99% coverage provides comfort on future earnings bar a disastrous spike in NPEs and provisions. The made a €251m net loss for the 9 months to Sep 2016 of the back of hefty impairments and provisions to bring the coverage ratio to 99% (this in spite of having made €850m in pre-provision income). Commenting on the hefty impairment and provision charge, CEO Nuno Amado said 2016 was "absolutely unusual in terms of impairments", which should not happen again.

The other key metric I look for in a distressed bank is the trend in loans overdue for more than 90 days. For BCP, this shows a downward trend with robust coverage.

Overall trend in NPEs and total coverage in the banks's Portuguese business

Positive trend in other KPIs – Other Key Performance Indicators showing a positive trend with net loans as a percentage of customer funds standing at 97%; ECB funding usage down by a billion to €4.9bln against prior year comparable period; and number of customers showing a solid 6% growth in the 9 month to Sep16 and now standing at 5.4 million.

Portuguese economy showing positive signs – After years of painful structural reforms, the Portuguese economy has been showing positive GDP growth since FY14 (with GDP growth projected at 1.4% for FY16); unemployment is expected to fall to 11.4% in FY16 compared to the height of 16.8% in FY12; and current account balance as a % of GDP has been positive for the past few years.

Valuation

I forecast FY17 pre-provision income of €1,022m. Net income will largely depend on the level of impairment and provisions, but given the robust 99% coverage ratio and significant impairments booked in current and prior years, I believe that net income should be in the range of €206m to €343m, giving a Forecast ROA in the range of 0.28% to 0.47%.

European banks current trade at average Price to Earnings ratio of 10.5x and Price to Book of 0.77x. Even allowing a 20% - 30% knock down in the PE ratio for BCP (for the more risky south European bank), I get a per share value of €2.23 for an 80% return to current share price.

Other matters

Forsun’s investment – The Chinese conglomerate Forsun has offered to buy new equity in the bank amounting to a 16.7% stake at current price (plus a potential premium). This should rise additional ~€189m of equity and add a long-term investor to the share register. Forsun has further expressed interest in increasing its stake to 30% though secondary market purchases (or in the event of capital increases). Although I don’t know much about Forsun – other than the fact that it has been a hyper active acquirer of late – overall, this investment could be taken as a positive sign.

€750m of bonds due for repayment - The bank has expressed its intention to repay the €750m of contingent convertible bonds due to the Portuguese State by June 2017. Given the current trend in operating profits, including the Forsun cash, I believe that this should be easily achievable bar a disastrous happenstance with NPE’s or impairments.

Conclusion

With its positive trend in operating profits, downward trend in NPEs combined with a robust coverage ratio at 99% of NPEs, and with decent uptick in Portuguese macroeconomic indicators, shares in BCP, which currently trade at a cheap 26% of TBV, offer a good upside potential. Bar a disastrous rise in NPEs and impairments, downside appears to be limited.

Bonmarche (BON:LSE)

Bonmarché is a clothing and accessories retailer catering to women over 50 years old in the UK. After a good couple of years since listing in the AIM at 213p a share in Nov 2013, its shares hit a high of 318p a year ago, returning 49% over the two years. The company moved from AIM to the main market (LSE) in October 2015, owing largely to its growth story and performance in AIM. Since then it has lost over 72% of its market cap and the shares now trade at 87.5p. The latest fall of ~24% in the share price came just after the company reported like-for-like sales falling by 8% for the first half of FY17. At a LTM price to earnings ratio of just 5.6, the shares may appear dirt cheap, but the LTM P/E is deceptive. In my opinion Bonmarche is a falling knife.

Enterprise value calculation

Faltering sales

The company’s pitch as a growth story is faltering with like-for-like sales showing a downward trend since.

The extremely intense competition in the sector doesn’t show any signs of abating and it is difficult to see Bonmarche return to its glory year of double digit growth. With thin margins, the declining sales trend spells disaster down the line. 

Operating leases

Bonmarche was bought in 2012 by the private equity house – Sun European Partners – when its parent company Peacocks went bust. Sun used the standard private equity playbook, shutting down 130 worst performing stores and renegotiating the leases on the remaining 265 stores to get rents down by 28%. Spend on operating lease rents fell from £23.3m to £16.9m between FY13 and FY14. Approximately 30 per cent of the leases expire in 2017, this exposes the company to a high risk of substantially higher rents from FY17. The already thin margins will come under severe pressure if the rents go up. The alternative of stores closing doesn’t sound good as the stores where rents increase are likely to be the ones with good sales.

I calculate the off balance sheet operating lease liability to be £118m even without a significant rent increase in FY17. Any material increase will significantly add to the off balance sheet debt.

The falling pound will significantly erode margins

As per the prospectus filed in Sep15 when the group entered the main market, £47.6m of its costs were in USD for FY15; with total COGS of just over £135m for FY15, USD costs represent 35% of COGS. The pound has fallen close to 20% against USD since Brexit and all indications are that the pound could call further. Moreover, Brexit represents a permanent fall in value, representing a permanent increase in Bonmarche’s cost base. Running the numbers, allowing a 20% increase to 35% of its COGS represents a 5% fall in gross profit margins from the current ~24% to ~19%. With EBIT margins at under 6% even before the fall in pound, I estimate EBIT margins to fall to just over 1% in FY17, and continue to remain low. This doesn’t account for any increase in operating lease rentals, which could trip the company to a loss.

Significant capex plan for FY17

The group has been growing stores each year with capex averaging at roughly 3% of sales (averaging £5.7m over last 3 years). For FY17, the group is embarking on a major capex programme with a planned £14m expenditure which includes implementation of an ERP system. Even without any increase in operating lease rentals, I predict this will mean the group burns through ~£5m of cash in FY17.

Liquidity and viability

If sales continue to falter, operating lease rents increase significantly in FY17 and margins fall as expected, the group’s viability will be under threat. My cash flow projections indicate that expected fall in margins, a 28% increase in rents from FY17, and the planned capex spend, could lead to a severe liquidity crisis if sales continue to falter. The group has current cash balance of £13m with a £10m revolving facility. However, the revolving facility expires in Nov17 and may not get renewed if the business deteriorates further, or the terms of renewal may be more onerous.

Valuation

Even a fairly optimistic DCF valuation predicts a 100% downside. The below DCF assumes what I believe to be a fairly optimistic scenario where FY17 sales fall is arrested over the holiday period and sales begin to grow by 2% from FY18, gross margins improve gradually to 21% after the immediate fall in FY17 and no increase in operating lease rents.

Conclusion

As value investors, we love a bargain; and one of my favorite hunting grounds is a stock screen showing the fallen ones. But such a screen tends to be a mix of falling knifes and value buys (more of the former in my opinion). Bonmarche looks like a falling knife.

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.