- The largest ever tech buyout, the EMC Dell deal has encountered a few difficulties.
- The VMW Tracking stock taxation and VMW stock price collapse shadowed the deal.
- An extensive buyback program and favorable tax advice could pave the path for resolution.
Earlier this year, computing giant Dell announced that it was taking datacenter giant EMC (NYSE:EMC) private in a $67B deal of cash and stocks. According to the current deal details, EMC shareholders will receive $24.05 per share in cash and a 0.11 of a Vmware (NYSE:VMW) tracking stock for each EMC share which, at the time of the agreement, added another $9 to the deal’s value, bringing it to a total of $33.15. Since the deal was announced, both EMC and VMWare shares dropped sharply, as shown in the chart below, causing EMC to trade significantly below its buyout price.
There are a number of reasons why EMC is trading below the deal price. First, the market received VMWare Q3 results, and 2016 was forecast negatively. The company presented revenues and earnings slightly above expectations, but the 2016 forecast fell short of the market consensus as the company announced a forecast for an operating margin of a 28% YoY drop. VMWare also mentioned the increased competition in core server visualization business from Microsoft (NASDAQ:MSFT), Amazon (NASDAQ:AMZN), and Citrix (NASDAQ:CTXS). VMWare's stock price reacted with a 20% fall the day after the earnings call, pulling down not only VMWare’s price but the entire EMC buyout deal price.
Second, the VMWare tracking stock receives a lot of attention from all parties involved in the deal, VMWare/EMC/Dell shareholders and hedge funds luring the opportunity. From VMWare/EMC shareholders' point of view, the tracking stock is a mechanism to open a secondary market for low-cost VMW shares. Normally, a tracking stock offers investors exposure to the price fluctuations without the voting rights and dividend rights. However, as VMWare is not paying dividend anyway and many investors buy VMW share just to benefit from the price fluctuations with no real intent to vote in shareholders meetings, the tracking stock starts to look very much like a discounted common stock, which pulls the common stock price down. Hedge funds and other speculative investors try to accelerate this process, and short interest rises to 13% of the float.
On the other hand, Dell shareholders are concerned that using the tracking stock mechanism will trigger a taxable event that will end up in $9B to $10B in tax expenses. Usually in M&A deals, the acquiring company pays the acquired company in cash and its own stocks. The mechanism allows the acquired company to receive cash benefit and a stake in the newly merged company. Dell’s proposed mechanism of a tracking stock offers EMC shareholders a stake in EMC’s subsidiary instead of a stake in Dell, and that should trigger a taxable distribution as VMware is an EMC subsidiary. In the end, the merged company will pay that billions-of-dollars bill to the IRS, and Dell will need to increase its deal financing to include the tax payment as well as the cash payment. Increasing the deal financing terms will increase Dell’s debt significantly. Dell’s shareholders demanded the company to change that part of the deal; however, it seems unlikely that this central part of the deal will be changed.
In order to compensate EMC shareholders for the recent fall in VMWare share price, they demand that VMWare buy back $3B worth of shares and unwind the VMWare-EMC proposed cloud JV, Virtustream. As the deal is still pending VMWare and EMC shareholders’ approval, changes to the original terms are likely to happen. While the taxation problems around the VMW tracking stock are acute, I believe they will be solved and do not jeopardize the entire deal. In my opinion, the deal is likely to move forward toward VMW and EMC shareholders’ approval, with some changes made to the original proposal, with a high probability of a new buyback program in VMWare.
Currently, the deal is valuated in $30.91 per share which reflects a 21% premium on the current EMC share price. Starting a $3B buyback program and solving the tracking stock taxation problem will serve as short-term catalysts for VMW share price and the deal price per share. For the short-term I am bullish on EMC and believe the current 21% premium will increase once the catalysts above are triggered.