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Tuesday, July 3, 2018

Some thoughts on getting screwed by Dell $DVMT

Yesterday, Dell announced a reverse merger into their tracking stock (DVMT, disclosure: long). The tracker was already a very popular position among more event value investors; combine that popularity with the new deal’s complicated structure, huge leverage at the Dell stubco, and the potential for an activist to step into the current merger, and I have a feeling the finance internet is about to be flooded with takes on the Dell tracker/ merger (indeed, Clarkstreetvalue published on it last night, and the VIC message boards are already going crazy discussing it).

I was tempted not to add my take on the deal / stock, but given the Dell tracker was one of my three ideas for the New Year and the big risk I discussed in that post was “Dell screws you” risk and Dell has now properly screwed us, I ultimately caved and decided I needed to throw some thoughts into the void.

Editor's note: After some reflection, I realized some of my conclusions in this post were slightly off and published an update here. While the update didn't change any of the takeaways here, I wanted to highlight that update. The rest of this post is unedited from its original form.
Let’s start with the obvious: Dell is screwing us / stealing the tracker. Dell’s press release focuses on the 29% premium to DVMT’s closing share price, but that’s complete bullshit for a host of reasons. The two major ones are 1) that premium values the shares of Dell that DVMT shareholders will receive at $109/share, and, with shares trading in the low $90s, the market is clearly not subscribing that value to the Dell shares and 2) given share repurchases, DVMT today owns ~1.016 shares of VMW (disclosure: short a small bit against the DVMT long) for every share of DVMT, which would be worth ~$165/share at today’s prices (with VMW at ~$163, though some of that is driven by the ~10% rally in VMW shares after news they wouldn’t be taken out).
That brings us to the second most obvious point: I think there’s a huge opportunity for an activist to step in and get a better deal. The deal requires approval from DVMT minority shareholders, and we already know there are two great activists in the tracker (per Bloomberg, Elliot is the third largest holder and owns ~4% of the tracker, and Carl Icahn owns both VMW and DVMT). Remember, Dell had to (modestly) bump his offer to take Dell private, so he has a semi-history of boosting bids, and Icahn has a history of screwing with people who have messed with him in the past; given Icahn’s experience with the prior Dell take private, Icahn may get big in DVMT and push for a bump (in an incredibly lazy piece of journalism, the NYPost is reporting he’s “considering ” a VMW  play) just for the hell of it.
The way I look at it is this: DVMT’s “unaffected” price was ~$85 against an “unaffected” VMW price of ~$145, so there was ~$60/share of value to be captured.  Dell’s $109 offer gives ~$24/share of that value to DVMT shareholders while keeping ~$36/share for themselves. Dell is also going to point out that their offer is a 29% premium to DVMT’s “unaffected” price, and that Dell had the option to IPO and then  force convert DVMT shares into Dell shares at a 10-20% premium (see p. 27, but basically they would need to pay a 20% premium in first year after IPO dropping to 10% premium more than two years after), so shareholders should be happy with their 29% premium.
I think minority shareholders have a lot to push back on there.
The most obvious point of pushback is on the premium paid. As mentioned earlier, DVMT shares are trading in the low $90s (let’s call it $94/share to make the math easy), so DVMT shareholders can push back on Dell and say that they are only getting $9/share of value while Dell is getting ~$51/share. DVMT shareholders can also point out that both DVMT and VMW shares blew up (in a negative way) when it became public that Dell was considering taking them out; DVMT shareholders can (rightly, in my mind) argue that the premium is on an artificially wide spread to VMW’s artificially depressed price (i.e. without Dell, DVMT shares would trade tighter to VMW and VMW would trade higher; VMW shares were up ~10% on the news they’d remain independent so I think there’s a lot working for shareholders here).
So I think shareholders are going to push back that Dell is getting too much in this deal. And I think they’ll have a lot of leverage to force Dell to go higher. Why? Dell always had two big sticks over DVMT shareholders: the first was the forced conversion option, and the second was the “doomsday” option (for DVMT shareholders) of Dell taking VMW private while leaving DVMT out. Now that Michael Dell did not get what he really wanted, that doomsday scenario seems off the table.
With the doomsday scenario gone, it comes down to Dell threatening shareholders “take this deal, or I’ll IPO and force convert you at a lower price.” And given how the market has responded to Dell’s attempts to go public, I think that’s a hallow threat at best.
Consider how the market is currently valuing Dell in the DVMT deal. Getting to “core Dell’s” valuation is a bit complex, given they own a huge stake in VMW (as well as stakes in Pivotal and Secureworks), but Dell was kind enough to provide an illustrated look through valuation in the merger deck.
Core Dell is very levered, with ~$31.7B of “net core debt” (see slide 28 of the DVMT presentation), so a better way to look at it is probably on an EV / EBITDA basis. With $6.9B in “core” adjusted EBITDA (see slide 17), Core Dell’s EV / EBTIDA would be ~7x at Dell’s valuation.
Of course, the market isn’t valuing DVMT at $109/share; it’s valuing DVMT at ~$94/share. Dropping in $94/share into the table Dell provided gives a “Dell Stub” value of ~$3B (assuming the cash consideration maxes out).
At that valuation, core Dell is valued at ~5x EBITDA.
Even that’s probably not enough adjustment though. A ton of Dell’s value is coming from their publicly traded stakes (particularly VMW), and you need to make two adjustments there. First, VMW’s stock went up ~10% as the market rejoiced that Dell wouldn’t steal the company (plus gave them a little credit for leveraging up). Second, most companies with big stakes in other companies will trade at a discount to the value of those stakes, as the market adjusts for potential tax drag on a sale or simply assigns a conglomerate discount (IAC, for example, has long been a favorite of mine (disclosure: long IAC) and persistently trades at a discount to the value of their cash and publicly traded stakes despite a history of creating value for shareholders (a history Dell lacks)); it’s likely the market would put a heavy discount on Dell’s publicly traded stakes given Dell’s leverage and history of self-dealing.
In the table below, I’ve adjusted Dell’s publicly traded stakes value to take into account VMW’s share price increase and assigned a 25% “equity drag” to the value of their stake. Doing all of this takes their net equity value (after the VMW dividend) from the $44B they presented on slide 24 to $36B.
Putting it all together, if we adjust DVMT’s share price from the $109/share given on slide 24 to the current price of ~$94 while pulling down the equity stake value from $44B to $36B, we can see the market is valuing Dell stub at ~$10B (assuming everyone takes cash)
At $10B equity value, core Dell’s EV is ~$42B, and the company is valued at ~6x EV / EBITDA.
Honestly, that multiple seems in the realm of reasonableness. I’m no expert in the space, but IBM, HPQ, and HPE seem like decent comps (I’m just pulling from slide 13 of the merger deck); those are all valued at 6-8x EBITDA. Given Dell’s way higher leverage, you could make an argument they should trade at the low end of that range (fear of distress) or at the higher end of that range (more equity upside / levered cash flow). I would probably tend towards the higher end of that range given Dell seems to be performing a bit better than peers, but I’d leave the ultimate determination to people who know the sector better than me.
So why bother to walk through that whole valuation exercise? With VMW at ~$160 and DVMT at ~$94 and 200m DVMT shares out, Dell is stealing ~$13B of value from DVMT shareholders ($160 minus $94 times 200m shares). The market is currently valuing the PF Dell equity (i.e. after the DVMT deal) at $10B or less, meaning that without stealing DVMT the market is assigning a negative value to core Dell’s equity.
With Dell’s “stub” value trading negative before any value from DVMT shareholders, DVMT holders can rightly push back on any argument from Dell that he’ll IPO and force a conversion on DVMT. There’s no market for an IPO of something with negative value. (UPDATE- I was a bit off in saying this and published an update here; for the most part my new thoughts don't change anything but I wanted to highlight that. The rest of this post is unchanged).
That’s not to say Dell has no leverage. DVMT is a controlled tracker, so it probably deserves some discount, and Dell has the benefit of time (DVMT isn’t going anywhere without him, and maybe the market won’t give Dell equity value today, but perhaps they would after more debt paydown in a year? Or two years?). At some point DVMT shareholders will have to play ball w/ Dell, and since he’s put DVMT in play it’s likely going to be today.
One other point of leverage for DVMT shareholders- it seems Dell put DVMT in play because the tax code changes messed with the tax deductibility of Dell’s massive debt load. Taking out DVMT gets Dell cleaner access to DVMT’s cash. So, in many ways, while Dell can argue “take this deal or I’ll wait you out”, DVMT shareholders can counter “you need this deal today, not tomorrow.”
Ultimately, I think Dell comes back with a bid bump. Another $10/share is probably enough to get shareholder to begrudgingly accept, though personally I would hold out for $15-20/share (which would be a ~$30/share premium to DVMT’s unaffected stock price and split the ~$60/share discount DVMT traded at evenly between Dell and DVMT). Most people I know who think a bump’s coming think it will be a bump in equity (i.e. hold the cash figure constant but give DVMT more of Dell’s equity). I disagree because there seems to be a valuation mismatch (the market thinks Dell’s equity is worth nothing while Dell thinks it has a lot of value). That type of value mismatch creates a very difficult dynamic for getting everyone on the same page in a negotiation, particularly when you consider the leverage at Dell would involve massive amounts of dilution to bridge a $10-20/share gap. Better to use cash to make up the difference; I know it seems crazy to suggest a company as levered as Dell should send out cash, but Dell has ~$8b in cash and investments on their balance sheet and could lean on VMW to increase their special dividend if they needed more cash to pay off DVMT shareholders.
Anyway, my bottom line is I think this initial Dell bid is just an opening salvo. Dell is taking too much value from DVMT shareholders for them to let this bid stand. I’d expect to see several activists stepping into the process and forcing Dell back to the table, and Dell should happily give them a bump in order to capture ~$10B of value and get a public stock.
PS- the deal is barely 24 hours old and the proxy is several months out. Perhaps both the market and I are undervaluing core Dell and a proxy will show that. Perhaps there's some quirks to the deal I haven't noticed yet. I'm very open to feedback here or the possibility that some of my thinking is off (this was written rather quickly!); feel free to drop me a line if you'd like to discuss further!

30 comments:

  1. Great update sir.

    Dell themselves are saying that the deal is worth $109. They have every incentive to mark themselves on the high side of "fair", so it's almost certainly not worth more than that. Regarding the multiple, IMO the high leverage is deserving of a lower multiple for the equity stub. Companies are rewarded with a higher multiple for using leverage judiciously. Dell is well beyond that point and the added risk on the equity deserves a discount. They look like smart now, but if there were a recession things could get ugly fast. They also are likely still in the interest deductibility penalty box created by the new tax law.

    A fair discount would be a typical tracker ~15-20% discount to the unaffected VMW price of ~$150, and I think you're right that we'll see some activist pressure for a number in that range very shortly.

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  2. Adding - they ceased DVMT repurchases and I think it was partly to drive the discount up and make this ultimate crappy offer look better.

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  3. Early investors in DVMT are lucky that the technology sector has been such a stellar performer b/c the chart of long DVMT, short VMW tells the tale of the market's eroding confidence in expectations for fair dealing and good faith on the part of Michael Dell and his co-conspirators David Dorman and William Green.

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  4. Shareholders who vote no to the deal reserve their right to sue for fair value under Delaware law. I think everyone fully understands that Dell is not paying anywhere near fair value.

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    1. (ii) In accordance with Section 262 of the DGCL, no appraisal rights shall be available to holders of the shares of Class V Common Stock in connection with the Merger.

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  5. Great summary, as usual, and agree.

    I don't know that VMW has the capacity to significantly increase the dividend beyond the stated $11b. While they are generating lots of cash going forward, that div pmt takes them < $1b in cash until that future cash flow is actually generated, so not sure there's much additional capacity to pay a higher dividend.

    Dell seems intent on limiting the "cash" portion of its offer for tracker shares to the amount of the cash dividend it receives from VMW ($9 of the $11b total), meaning no use of its existing cash and no new debt. The rest HAS to be made up of new Dell common of unknown value.

    I think the driving force, as you pointed out but few others talk about, is the tax law change limiting interest deductibility to 30% of EBITDA. Dell needs either less interest expense or more EBITDA.

    I say don't underestimate the willingness of Michael Dell to delay and obfuscate to get his way. You note that he's "stealing" $13b of value from the tracker holders and can give back $2b for every $10 he raises the offer for the tracker. But any (or all) of any increase in the offer for the tracker will likely have to come in the form of more Dell stock, as opposed to cash, which of course, is the only thing anyone really wants at this point.

    So the dilemma redux, IMO. Take my 1.33 shares in Dell just like I took my 0.11 shares of DVMT and wait for the market to narrow the discount, or sell the shares immediately and move on? It's been almost 3 years since Dell announced it was buying EMC. At that time, I was looking for $32 for my EMC shares. Instead, I got $24 and a DVMT stub worth about $5 when issued. As of today, that stub is now worth $10.43. So it took 3 more years, but I finally got that $32 on my EMC.

    And now it appears that Michael Dell is asking me to take another ride with him, this time on an over-leveraged conglomerate facing tax law limitations on interest expenses just as interest rates are on the rise. Ctrl-Al-Del.

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    1. Pro-forma Dell isn't as bad IMO as people are framing it. The consolidated entity would be doing, what? maybe $10B of EBITDA (30% of which we know for sure is VMWare growing at a rapid clip in line with Enterprise's need for expanded private cloud infrastructure, essentially Long data & data manipulation growth) with $31B of net debt, so 3x Debt/EBITDA at a ~5-6% fixed charge, or 5x EBITDA interest coverage? I don't see how it's over-leveraged, but I see how people worry about the Michael Dell discount...

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    2. core debt is $32bn for Dell/EMC excl. public subs and they have $6.9bn of Adj. EBITDA, so that's quite a bit more leverage than 3x.

      What's the right multiple for the core business? accepting the deal at $109 based on current trading price will you give a stake in the core business at a sub 5x Adj. EBITDA multiple for a company largely focused on hardware.

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    3. $6.9B is Core Dell's EBITDA only.

      A fair picture of pro-forma leverage would have to compare Dell Technologies' look-through EBITDA (Core Dell's $6.9B EBITDA + its 80% slice of VMWare's EBITDA, or ~$2.3B) to Dell Technologies' pro forma net debt.

      My earlier comment provided an admittedly rough look at this, but the "exact" figures (based on management's deck) would be $9.2B of look-through EBITDA against $31.7B of debt (NB: VMWare will be in a ~$3B net debt position after the special dividend, but that'll be a wash after one fiscal year of cash flows).

      So, the implied EBITDA leverage multiple would be 3.44x, and implied EBITDA interest coverage ~4.2x. Again, that's simply not over-leveraged. It IS more leveraged relative to peers, though. But if they're paying down and/or refinancing the shorter-term debt coming due in the next 3 years, it seems manageable barring some catastrophic hit to earnings, no?

      All of this isn't some sort of endorsement of the $109 offer. No, the two assessments -- Dell's economics and offer fairness -- are separate issues. I expect a bump-up in the equity ratio (which would effectively give DVMT holders shares in Dell Technologies at a lower cost-basis and thus more margin of safety to the widely-expected discounted price that Dell will probably trade at).

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    4. Right, but given that DVMT (and Class C) shareholders bear the credit risk of Dell Technologies, I believe it is better to look at the core ratios only.

      As a small, retail shareholder, here is my view on things:

      Assuming shareholders support this deal, last trading price on DVMT (US$93.85) implies a Core Dell EV / LTM EBITDA multiple of ~5x, assuming 15% discounts on Dell’s public stakes in VMWare, Pivotal and Secureworks. Given where last DVMT price is at, this assume the full cash portion of the offer at $109 is exercised.

      I would not vote for this deal given the valuation disconnect to VMW, but if I bought into DVMT at these levels and the deal goes through then I’ll be left holding Core Dell at 5x, which probably gives me some comfort and upside (each turn of multiple expansion gives you $10 more in your pocket or ~10% return).

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    5. I'm not sure I follow the logic that look-through, controlled cashflow that's available to service fixed charges shouldn't be included in ascertaining leverage/ability to pay. I mean they're doing this deal partly for more direct control over VMWare's cashflow and partyly to ensure they can deduct their full interest charges (Dell's EBITDA alone wouldn't provide enough tax deductibility assuming last year's $2.4B of interest expense).

      I have the EV/EBITDA at more like 6.7x if you haircut the public stakes that much, but that's probably still somewhat cheap enough. Though, I prefer looking at the equity values relative to earning power, since I don't consider Dell's debt a problem (Silver Lake LLP isn't putting up that much equity to risk being wiped out).

      Using your same 15% discount to the publicly traded stakes, if Core Dell can muster a merely 10x P/E multiple, the pro forma Dell Tech entity would be worth $90 assuming maximum cash election and assuming the $68.68 opening price per Class C share that a $94 DVMT is implying today. At a 15x P/E for Core Dell, $110. So I think we're all saying the same thing: there's a lot of leverage in that stub Core Dell portion and how that business is appraised by the market will have material effects on DVMT (or Class C Dell) upside.

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    6. All great commments -- thanks. I think the appraisal process will unfold in 2 discrete but related steps. FIrst, Dell's offer for the tracker is absolutely dependent on it getting itself comfortably below the 30% of EBITDA limitation on interest expense. I don't see how that can involve much more cash than the current $9b, and so Dell has to figure out how much more stock (beyond the 1.33 shrs currently offered) it is willing to surrender. I think only until that is decided can we safely settle on what the as-issued market price on the new stock might be. Until then, I'm satisfied with using Dell's own implied estimate which is 1.33 in shrs = $109 in cash, so shrs = $82.

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    7. Sorry on last part - 1.3665 shrs = $109 in cash = $80.

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    8. Popo -- agreed on them needing to get safely under the deductibility threshold and, as such, they would be unwilling to offer more cash in the mix. That said, I think it is necessary to look at a range of values for Dell Technologies per pro forma shares cumulative (A, B, C & D shares) outstanding. Otherwise, we wouldn't be value investing...

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    9. Also agreed. I'm just saying that my hypothesis going into the value analysis is that no more cash will be offered and that Michael Dell knows that an even a $125 offer for the tracker would be deemed too low and that he would prob have to sweeten.
      Consequently, I think the 1.3665 shares was most likely arrived at as Dell's MINIMUM possible equivalent offer to $109 cash using its common shares. So, $109/1.3665 = $80, and that number must have some significance as a starting point in the valuation of the new stock.

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    10. Popo - why do you believe $80 is Dell's Class C share value?

      Market is implying $60 assuming cash portion is maxed out (and with DVMT trading at ~$94, you can surely assume everybody will be hitting that cash option!).

      Agreed with all on the equity component. To make this deal more fair for DVMT shareholders he needs to up that exchange ratio some more.

      By my math... for him to offer $125, using the implied $60 for Class C shares, and assuming the cash component stays fixed, he needs to offer up ~35-36% of pro forma dell. Quite the step up from the 20ish he's currently willing to offer.

      Happy to share my excel math.

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    11. The $80 share value for Dell C is a simple estimate derived from $109/share cash offer vs 1.3665 shares of Dell C. $109 / 1.3665 = $80.

      With DVMT trading at $93 and change, the "market" seems to be (currently) pricing Dell C at $68 (i.e., $93 / 1.3665 - $68).

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    12. Market pricing dell equity at 68 - shouldnts we be using that to calculate implied multiple?

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    13. why are you guys assuming an all stock deal to come up with PF Dell C per share value?

      With where the DVMT shares are trading, isn't it obvious that the maximum cash allocation will be fully tendered into? Not factoring this in skews the valuation for the PF entity.

      In that case, that leaves (~199.4 s/o * ~$94 - $9bn) / (~199.4 s/o - $9bn/109) / 1.3665 = ~$60 per implied Class C dell share.

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    14. I can't (won't) quibble with the deconstruction and bottom-up math. I am just saying that unless the expected market price (at least nominally, in Michael Dell's and Silverlake's heads) is $80, then they don't have a basis to offer 1.3665 shares of Dell C as equivalent to $109 in cash. And I agree that the cash portion will be maxed out.

      BTW, an implied value of $60 for Dell C means the equity portion of the offer values DVMT at $82.00

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  6. Thanks for the clear thoughts as always Drew.

    I would think the bump-up would be cash if most of the DVMT shareholder base is in it for special situations reasons. But would be in Dell stock is a sufficient portion of the DVMT shareholder base was long DVMT because it effectively recreated VMWare stock at 8x EV/EBIT and they buy into Dell's idea of a one-stop shop Enterprise IT stack play (it's not the worst idea but it will take time rather for Dell to prove otherwise rather than the market buying into the idea that future Dell isn't simply another HPE/Cisco clone).

    Perhaps the fairest bump up would be a combination of cash/stock for both sections of the DVMT shareholder base.

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  7. Apologies for my lack of understanding of the mechanics of tracking stocks.

    But how can one extract cash from the underlying business (in this case, VMW) without providing this cash to interests that are supposed to represent a stake in the economic value of the underlying business? In other words, how can VMW dividend cash to its shareholders (so Dell + VMW public shareholders) without paying a dime to tracking stock holders?

    Wouldn't you always be at a disadvantage holding a tracking stock if the owner can always erode your equity value through dividends / recaps / etc.

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  8. Still just noodling around on this -- Dell's offer for the tracker is up to 41% cash ($9b max) and the rest in Dell C shares. If everyone takes shares, we end up with 31.0% of Dell C and if we take all the possible cash, we end up with 20.8% of Dell C.

    So just breaking that down, given a fixed (for now) $21.7b total offer. If we take as much cash as possible ($9b), the remaining $12.7B comes in the form of Dell C shares. That $12.7b represents 20.8% of Dell C, so Dell C = $61b.

    If, instead, we take all shares and no cash, then the ENTIRE $21.7b comes in the form of Dell C shares. That $21.7b represents 31.0% of Dell C, so Dell C = $70b.

    The difference between these two valuations of Dell C is $9b, or the amount of the maximum cash involved. My back of the envelope guess is Dell C's valuation is 750m shares @ $80 and it remains to be seen how many shares they will actually have to sell. On a percent basis (20.8%), that means we're likely getting 157.5m shares of Dell C for our 199m shares of DVMT.

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    1. Yes - if all stock, then the $9bn dividend from VMW goes to Dell's cash.

      I haven't seen the documentation, but as part of agreeing to this deal, is the concept that DVMT shareholders are giving up their right to access their share of the VMW dividend? I believe under normal circumstances, if VMW was to declare a dividend, DVMT should get its share of it. At least that's my understanding of the article of incorporation of dell.

      Or perhaps the first step of the transaction is for all DVMT shareholders to be converted into Dell Class C, tracker is collapsed so Dell has 100% of the equity interest in VMW, VMW pays divi, Dell receives $9bn of cash and then exercises a buyback of shareholders electing cash option?

      Separate thought - but has anyone given thoughts to a dividend recap at VMW to allow for a bigger cash component? I guess one would have to keep in mind the group's interest tax deductibility so having more debt at VMW or more debt at Dell is equivalent?

      Apologies for my rambling... just trying to get smart on the situation.

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    2. Still sorting this all out. I am not familiar with any specific stipulations re DVMT's right to any dividends paid by VMW, but Dell's offer absolutely hinges on Dell getting ALL the dividends and DVMT holders getting NONE, at least not directly, since Dell will be using that dividend for the cash portion of its offer for DVMT (capped at $9b).

      Having said that, the irony is that it would not be a ridiculous offer, and certainly much fairer, if DMVT got the VMW dividend on top of Dell's buyout offer, but that is not happening.

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  10. Interesting...https://www.bloomberg.com/view/articles/2018-07-17/dell-dvmt-vmw-buyout-math-doesn-t-compute

    Don't think the math is quite right in the "Big Leap" portion of the article. Can't compare pre-transaction Class C share price with post-transaction because you repatriate the VMW value.

    Just goes to show that market participants really need to do the work to play this deal.

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    1. Thanks for posting this -- very helpful to have some third-party confirmation when you're in the weeds.

      I've noted elsewhere that I believe Dell will not budge on the $9b in cash and, frankly, am surprised they even offered that much. I consider it the spoonful of sugar that helps the Dell C stock go down as Mary Poppins might say.

      If this offer is to be improved, it will solely be in the form of more Dell stock and the question is how much more. My guess is it will be raised to 1.55 shares and after that it is take it or leave it.

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