A Dell spinoff of VMware could benefit both companies

Michael Dell speaking at the WEF 2019 in Davos, Switzerland, on January 23, 2019.

Adam Galica | CNBC

Dell and VMware have never been a perfect match. Now some of Dell’s largest shareholders hope to part ways.

The two tech companies are, once again, working with financial advisors to determine the future of their unusual mess. Dell, which owns 81% of VMware, plans to explore a variety of strategic options, including a tax-free spin-off of those shares to Dell shareholders in late 2021, according to people familiar with the matter. Dell prefers that route to selling its stake so it can avoid a multi-million dollar tax blow, the people said, who asked not to be identified because the discussions are private.

Dell shares, which have lagged behind the overall market, rose more than 8% on Wednesday after the Wall Street Journal first reported on the renewed discussions. VMware was up 2.4%.

The complicated tangle has angered many investors for years. Dell earned its large stake in the virtualization software company through the EMC acquisition of more than $ 60 billion in 2016. The rest of VMware has been owned by public shareholders since 2007, when EMC launched approximately 19 % of shares in a public offering.

Dell then returned to the public market in 2018 via a complicated reverse merger with a now-defunct tracking stock reflecting the performance of VMware within Dell. Its shares are up 15% (thanks largely to Wednesday’s recovery), behind the S&P 500’s 25% gain.

VMware, meanwhile, has fallen during that period, despite having stronger margins and higher growth than Dell and EMC companies. Dell’s computer and server products, along with the EMC storage unit, have been affected by a wide shift in cloud computing and the current US-China trade war, which has increased component costs. hardware.

“Dell’s ownership structure has been an albatross around VMware’s history and ultimately causes stocks to trade at a discount, a dynamic that would be removed if Dell (and its Board) finally decided to follow this. way (derivative), “wrote Daniel Ives, an analyst at Wedbush Securities, in a note to clients.

A spinoff in September 2021 is Dell’s most logical move, three people familiar with the matter said. The talks are in their early stages and the parties may decide not to enter into a transaction, the people said.

Great shareholder approval

Several of Dell’s largest shareholders, including private equity firm Silver Lake and hedge fund Elliott Management (whose 5.9% ownership in Dell is passive) are in favor of handing over VMware in September 2021, given the fiscal efficiency and simplifying the capital structure, the people said. .

Spokespersons for Silver Lake, Elliott, Dell and VMware declined to comment.

One possibility if a spinoff occurs is that VMware could pay Dell a large special dividend by taking on additional debt and helping Dell reduce its heavy debt burden, two of the people said. A similar transaction occurred in 2018, when VMware agreed to pay Dell a one-time special dividend of $ 11 billion along with going public with Dell.

Dell currently has around $ 45 billion in net debt, while VMware’s debt stands at just $ 3 billion. S&P Global, Moody’s and Fitch rate Dell’s corporate credit quality below investment grade. Dell could reach investment grade status if it moves forward with the spinoff and the associated dividend, two of the people said.

For VMware investors, the lure of a breakout lies in the opportunity to finally operate entirely outside of the Dell-EMC empire, where business has been stagnant for 17 years.

VMware has a market value of more than $ 62 billion, valuing Dell’s 81% share at approximately $ 50 billion. However, Dell’s market value is only $ 38 billion, for a company that generates more than $ 92 billion in annual revenue. That means that all Dell except VMware is valued at $ 12 billion negative.

Given the strained relationship with China, Dell’s financial image is unlikely to improve anytime soon.

“From a margin perspective, I would tell you, look, part of this will depend on what happens to component costs as we go through the year and what the pricing environment and demand environment looks like,” Tom Dell CFO Tom Sweet said on the company’s first-quarter earnings conference call last month. “Right now, we consider the component cost environment to be as inflationary as the rest of the year.”

Dell CEO Michael Dell, left, and VMware CEO Pat Gelsinger participate in a CEO roundtable at the VMworld conference in San Francisco in 2012.

Kim Kulish | Corbis | fake pictures

While Dell has coveted owning VMware for a long time, they are unlikely to buy the rest of the company, four people said. The premium required to buy the shares will likely require Dell to borrow further. And keeping VMware shares independent is important to VMware employees, who want their capital incentives tied to a growth story.

Working towards a friendly outcome is the positive relationship between Michael Dell and VMware management, including CEO Pat Gelsinger, and their shared incentives. The founder of Dell is the president and main shareholder of VMware. While there were tensions between EMC and VMware regarding strategic direction, Dell has backed certain VMware decisions even if they present a challenge to your business. For example, he favored VMware’s association with Amazon Web Services, according to a person familiar with the matter.

In 2018, after CNBC’s Jon Fortt suggested on Twitter that Gelsinger would be a good replacement for Intel CEO Brian Krzanich, Gelsinger replied that he was happy with VMware. Michael Dell stepped in half an hour later, expressing his support for Gelsinger, with an animated plaque saying “You are the best.”

Still, there are significant cultural differences between companies. Palo Alto, California-based VMware has had to pay the best price for talent to compete with other cloud computing companies, while Texas-based Dell has a reputation for paying low wages, three said. persons.

Another person said that when Michael Dell visited VMware’s Silicon Valley for the first time after the EMC acquisition, he compared the facility to Disneyland for adults. Dell noted that it would eventually change.

A clean separation of companies could clean up cultural differences while keeping Michael Dell as its largest individual shareholder.

– CNBC’s Jordan Novet contributed to this report.

CLOCK: Dell’s possible spin-off of VMware will benefit both sides: analyst