- EMC missed estimates on both revenue and earnings, however VMware results drove the underlying value of EMC higher.
- The impending deal with Dell is still progressing smoothly, which reasserts a value arbitrage thesis.
- I value EMC at $33.57 when based on a sum of the parts analysis, but remain cautious on storage fundamentals.
EMC (NYSE:EMC) reported results on April 20th 2016, and missed on both the top line and bottom line figures. The headline figures were $5.5 billion revenue and $0.31 EPS, which compared to analyst consensus of $5.63 billion and $0.33 respectively. Despite falling below consensus estimates, the company has a near-term catalyst to its valuation due to a pending deal via Dell and Silver Lake to acquire the company for $67 billion.
It’s not yet clear whether the Dell and EMC merger will create long-term shareholder value, but accretion really isn’t important. Because once the deal is executed, investors in EMC will not get shares in the new combined holding company, as the deal will be paid in full cash. However, EMC shareholders may end up with a separate holding entity for the Vmware (NYSE:VMW) stake.
Based on a report from the Financial Times a reverse IPO is unlikely:
The result: Dell would re-emerge as a public holding company, represented by a single class of shares tied to only a part of its business. Its main operations would still be held in a private subsidiary, says the person familiar with the plan, though it was unclear how much detailed financial information the combined group would have to disclose.
Okay, so there’s a lot to absorb in that last statement, but essentially the EMC acquisition also comes with some strings attached to VMware in which EMC owns 81% stake. That specific stake in of VMware will be spun-off into a separate publicly traded entity similar to the spin-off idea involving Yahoo’s Alibaba stake into a holding company named AbaCo.
However, as you are all well aware, Yahoo had to step-back from the spin off, because the tax savings from the move wasn’t endorsed/ruled on by the IRS. Well, today Dell is trying to take EMC private while also spinning the VMware stake into a separate holding company to defer $8.1 billion in capital gains tax, according to Bloomberg View. The VMware holding needs to be spun off prior to the sale, and furthermore, if Dell can’t execute the merger it will pay a $4 billion break-up fee to EMC.
There’s a chance that the IRS won’t rule on an EMC/VMware specific spin-off either. Since the deal is dependent on an IRS ruling, there’s the chance that Dell may not acquire EMC. However, EMC shareholders will still walk away with a cool $4 billion, so the downside is capped. Furthermore, if in the event EMC can spin the VMware unit, it lowers the total cash acquisition cost for Dell quite significantly. So, the deal becomes a lot more feasible. Furthermore, Jamie Dimon (CEO of JP Morgan) showed up at a recent EMC Board meeting to reassure the feasibility of financing the deal, so financing isn't a real problem.
So, with all of that out of the way let’s review what was mentioned on the conference call:
- Storage is still in secular decline and the industry overbuilt NAND capacity, which translated into weaker selling prices.
- Conventional IT is slowing, and even with the development of software defined storage, other technologies (file compression) are making it difficult to sustain sales growth.
- The company experienced operating de-leverage from lower unit volumes and couldn’t recapture the reduction in flash storage pricing into its cost structure, so gross margin declined.
- EMC is on track to execute a merger with Dell on original deal terms, which was mentioned on both the conference call and news release.
- Furthermore, EMC refreshed its storage line-up with VMAX (flash) and VNX (hybrid), which created some pent-up demand resulting in fewer sales, the management team anticipates that demand will recover due to these new products.
Analyst commentary going into the quarter was weak due to Gartner data. Intel’s weak data center figures confirmed what was already priced into the stock.
The confirmation of deal progress reasserted the premium valuation it now trades at. Those engaging in merger arbitrage are holding onto the company despite the questionable sector-specific trends and whether replacement of storage platters with all-flash storage arrays are margin/revenue neutral or additive. The commentary on file compression and questionable growth outlook reasserts weakness in long-term fundamentals. However, the management team feels fairly confident in their ability to pivot away from pure storage and transition some of its revenue to software.
Sell side commentary from Steven Milunovich from UBS:
Weaker storage numbers came in as expected, but Buy-rated VMware covered by UBS Software Analyst Brent Thill beat on the top and bottom line last night. Since the Dell deal calls for investors to get $24.05/share in cash and 0.111 shares of a new VMware tracking stock, the results from EMC's core storage business are less important to the stock. VMware's announced $1.2bn buyback and 9% after hours’ jump should help EMC's stock (UBS reiterated $30 price target and buy recommendation).
The momentum in EMC was also driven by the rather unexpected beat on VMware results. The combined value of EMC and VMware remains subjective due to the spin-off. The trading shares are estimated to trade at a 10% discount to VMW's actual shares.
After doing a sum-of-the parts analysis, I anticipate that the trading shares are worth roughly $18.079 billion (10% discount to VMware stock), and the cash component of the EMC/Dell transaction is worth roughly $45.69 billion currently. When combining both of these assumptions, I value EMC at roughly $63.79 billion.
The private Dell/EMC could retain some ownership of VMware, but it's not yet clear if that will be the case. I'm operating on the assumption that EMC will spin-off it's entire 81% stake to make the deal more cost effective. Furthermore, given the potential risks of the IRS not signing off on a tax deferment, I’m not assigning a high conviction buy recommendation. My estimate assumes a 10% discount to the VMware tracking stock from the actual stock, but it’s possible that the valuation could trail by more than 10%.
Therefore, I’m assigning a price target of $33.56, which implies 27.27% upside from current levels. I’m initiating my coverage with a buy rating and anticipate the Dell transaction to close 2H’16.