Enthusiasm but also doubts about Dell’s strategy change

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Analysts applaud Dell Technologies’ plans to sell its subsidiary VMware. However, the remarkable shift in strategy also creates uncertainty and could have negative long-term effects for both companies.

After weeks of speculation, Dell Technologies confirmed it is exploring a possible spinoff of its 81% stake in VMware. The idea is to transfer the stake in VMware to the Dell shareholders. Michael Dell, who is Dell Technologies’ founder and biggest shareholder would still have control over VMware. Together with his private equity partner Silver Lake. They would together retain a 53 percent majority stake in VMware.

By selling VMware, Dell Technologies thinks it can create more value for its shareholders. Dell Technologies has a valuation shortfall, due to a conglomerate discount. The corporate structure of Dell Technologies is far too complex, it has a lot of different activities and also many investments in listed companies. This affects the share price, leaving it undervalued, compared to when you sum up the value of the Dell Technologies group and stakes in other companies.

Investors attach a negative value of just under $5 billion to Dell’s core activities

The 81 percent stake in VMware is worth approximately $49 billion dollars (€42 billion euros). In addition, Dell owns 86 percent of the share of security firm Secureworks. This stake is worth approximately $860 million. Dell has a market capitalization of ‘just’ $45.5 billion. In other words: investors attach a negative value of just under $5 billion to Dell’s core activities. After the transaction, analysts expect the negative value to disappear.

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Special dividend

The divestment will also help Dell to lower its massive debt, which originates from the $67 billion EMC acquisition. By lowering the debt the credit score should increase and this has a positive impact on the investment grade. Three major credit rating agencies have downgraded Dell to junk status, resulting in a lower valuation on the stock market. So how does the debt reduction take place? Dell wants to achieve this by having VMware pay out a cash dividend before the spin-off.

In 2018, VMware also treated its shareholders with a special dividend of $11 billion. Approximately $9 billion went to Dell. If the dividend will be of the same magnitude VMware will have to go into debt, since VMware is currently not in the position to pay such amounts. VMware currently has a cash reserve of 3 billion. Dell is basically moving part of its debt to it’s cloud subsidiary. But the goal is to maintain VMware’s investment grade rating.

Dell is also exploring other strategic options and the transaction is not scheduled to take place before September 2021 due to tax regulations.

Investors are very excited. Dell’s share price has increased over 15 percent since the announcement. The share price of VMware has only increased by 1.7 percent. The parent mainly gets the benefits of this deal. Morgan Stanley analyst Katy Huberty upgraded Dell from Equalweight to Overweight. The target share price increased from $50 to $68. Although Dell is exploring other strategic options and the transaction is not scheduled to take place before September 2021 due to tax regulations, Huberty believes there is a high likelihood of a spinoff. According to Huberty, VMware’s one-time dividend could be up to $13 billion, of which more than $10 billion will go directly to Dell. Morgan Stanley is optimistic about Dell’s stock because of the decreasing conglomerate discount, increasing market share, expected debt reduction, and simplified corporate structure.

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Lots of debt

JPMorgan also recognises the advantages of the potential transaction. The bank still rates the stock as Overweight and added the stock to it’s Analyst Focus List. Analyst Paul Coster, while holding on to his price target of $68, states that in an optimistic scenario, the price could climb to $80. In that case, the conglomerate discount would have to disappear completely. According to Coster, Dell’s strategic flexibility is still limited by the high level of debt.

Dell has a net debt of $42.7 billion, resulting in a high debt to ebitda ratio of 3.6. The company aims to reduce this debt ratio to 3.0 this year. Fitch says a special dividend from VMware would be positive for the credit rating. However, according to the credit rating agency, a ratio of around 2.5 is necessary for an investment grade rating. Dell’s ability to regain this credit rating, therefore, depends on the extent of the dividend.

A spin-off has the potential to have a significant effect on the credit rating of both companies.

This is why Moody’s did not change Dell’s and VMware’s rating. A spinoff has the potential to have a significant effect on the credit rating of both enterprises. In this scenario, VMware would be liberated from an over-indebted parent company, which would have a positive impact on the credit profile. However, the fact that VMware’s debt is likely to increase significantly could erase this advantage completely. Furthermore, the credit agency points out that acquisitions are a key part of VMware’s growth strategy and that the company also frequently purchases its own stock. It is uncertain whether this strategy can continue at a higher leverage.

Moody’s also has doubts if the successful partnership will go on, if VMware is independent other companies might want to compete with Dell and offer better conditions to VMware. Thanks to the partnership, both Dell and VMware have outperformed their competitors. Dell is the strongest growing distribution channel for VMware. The subsidiary, in turn, benefits from Dell’s financing division. In addition, Dell is successfully cross-selling its hardware to VMware’s extensive customer base, according to Moody’s.

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Decline of revenue and profit

As standalone company, Dell has a huge scale and strong market positions in the IT hardware industry, such as enterprise storage, servers and PCs. These mature markets are associated with infrastructure spending, according to Moody’s. As more companies embrace the cloud, pressure on Dell’s core business is likely to increase. That’s why Moody’s expects a decline in operating profit this year, as well as an increased debt ratio.

Deutsche Bank analysts are fairly pessimistic about the prospects for Dell without VMware.

Deutsche Bank analysts are also fairly pessimistic about the Dell’s future without VMware, as the fast growing company is responsible for a big piece of Dell’s operating profit. After three consecutive years of growth, the core business is expected to decline in revenue in 2020 and 2021. Rising gross margins will also come to an end. Gross margin decreases to a range of 25.3 percent to 25.9 percent, compared to the historical range of 25.7 percent to 27.5 percent. At the end there is not much left for Dell, although the tax burden is difficult to predict in advance. The Deutsche Bank expects, based on historical data, a net margin of only 2 percent to 4 percent.

Dell’s gross margins are estimated by the corporate bank to be approximately a 1.000 basis points higher than the PC activities of competitor HP Inc., but approximately 500 basis points lower than the storage/server activities of Hewlett Packard Enterprise (HPE). Compared to pure players in the storage market, such as NetApp and Pure Storage, Dell’s gross margin is 3.000 basis points lower. The corporate bank argues that the Dell share should be traded against a multiple somewhere in the middle of a PC, server and storage company. Nevertheless, Deutsche Bank upholds the buying recommendation, with a target price of $65.

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