News of mergers and acquisitions almost always shake a company’s share price.
Normally, there is a boost in the share price of the target company because an acquisition is in sight. The target’s share price rarely reaches the offer price, but it might hover a few points below. This is called the “deal discount.” It reflects the risk that the deal won’t go through. This is always a risk for various reasons, from antitrust issues and regulatory concerns to a new buyer coming in with a better price, and the price of the target company usually takes a pretty big hit if the deal falls through.
Sometimes, the effect is especially pronounced, as in the Dell-EMC acquisition.
It all started Oct. 12
On Oct. 12 Dell Inc. (DELL, Financial) made an announcement that it would acquire the EMC Corp. (EMC, Financial) for $67 billion. The deal would mean that EMC investors would get $24.05 per share in cash plus tracking stock proportionate to EMC’s interest in VMware (VMW, Financial).
EMC owns around 80% of VMware but has 97% of the voting power at the company. This would bring the full offer to around $33.15 per share and make Dell-EMC the largest privately controlled technology company in the world. Elliott Management, who owns 2.2% of EMC, was one of the first to give its support to the deal, noting the value of VMware’s tracking stock and touting the synergies between the companies.
It was a Monday. The previous Friday, the last trading day before the acquisition was announced, EMC closed trading at $27.86 per share. After the news had broken on Monday, EMC’s share price went up to $28.77 before beginning its decline. It went to just under $25 per share before leveling off. EMC has been trading at less than $26 per share since.
VMware’s share price followed a similar trend. The company closed at $78.65 on Friday, Oct. 9. By the end of trading on Oct. 12, it was trading at just $72.27 and within a week its share price was trending around $60 per share. That is a 23% decline.
The deal is expected to go through in October 2016. If an investor were to buy EMC now, at $26, and the deal went through at the $33.15 offer, it would mean a return of 27.5% in less than a year. So why isn’t EMC trading higher – or VMware for that matter?
Let’s start with VMware.
VMware and Dell
“As part of the payment from Dell, EMC shareholders would receive $24.05 a share in cash, and another 0.111 shares of a tracking stock tied to EMC’s 80% stake in VMware,” explains the Wall Street Journal. “The tracker would essentially comprise a new class of shares that track the assets held by VMware. The holders won’t actually own a stake in the company, however. The stock will simply reflect the performance of VMware.”
Because shareholders would not own a piece of VMware,  they would get nothing if Dell goes bankrupt. Also, this tracker basically increases VMware’s float. “With EMC holding 80% of VMware’s, only 20% of the stock has been trading. That could increase to almost 75% after the deal, according to one estimate,” notes the Wall Street Journal.
VMware shares were also declining because of Dell’s initial plan to put enterprise Cloud company Virtustream in a joint venture with VMware, leaving VMware to assume a large portion of Virtustream’s costs. That has since changed. On Nov. 24Â Reuters published an exclusive report that said that, instead of VMware taking on Virtustream’s losses, EMC would assume those costs. The news has caused a small increase in VMware’s share price, bringing it from a closing price of $58.11 on Nov. 23 to a higher price of $62.50 after the change in plans came out.
Merger pessimism
The market has been pessimistic about the merger, and there are a few good reasons for that. First, there is the fact that EMC might feel a little undervalued. According to Fortune, the company asked for a 60-day “go shop” provision so that it could solicit larger or more advantageous offers.
There is also the issue of debt. According to David Faber at CNBC, Dell-EMC will require more than $45 billion in additional debt. Dell CEO Michael Dell defended the high cost, saying that “the revenue synergies here are three times larger than the cost synergies,” but that is still a lot of debt for an uncertain venture. There is also the potential tax burden from the sale. The new type of stock share Dell will issue to pay for the EMC acquisition could trigger a tax bill as high as $9 billion, adding to the already significant costs of the deal and costing existing EMC shareholders somewhere between 20% and 40% in taxes on the cash value of the stock – and that is if tax issues do not derail the deal completely. There are also issues relating to the overall strategy Dell-EMC will adopt.
Sales and selling
Remember that EMC has one of the strongest sales forces around. Dell will need to leverage that if it is going to remain relevant. Neither Dell nor EMC have mentioned job cuts in their sales forces, but there is bound to be redundancy, and people often leave in a merger, anyway; Dell-EMC together simply will be massive.
Dell salespeople have said that they are “excited” to have more to offer their customers, but the core businesses for both Dell and EMC are hardware and storage, and these are practically commodities at this point. The technology between devices and storage units or components is virtually the same, and the price consumers are willing to pay reflects that. In turn, profit margins are much lower. Point in fact, EMC’s profit margin is under 10%.
“Just because a market is big and growing, it does not mean it has profit potential,” says Peter Cohan of Forbes. “Its focus on commodity hardware dooms it to make very little profit. They sell to enterprises that are shifting much of their work to the Cloud and thus will purchase less of this hardware at the lowest possible price with no vendor loyalty.”
The digital question
Dell-EMC will focus on helping customers transition to more digital systems, but the world of data storage is changing rapidly. Whereas EMC CEO John Tucci says, “We have the assets between us now and the heft to make sure that we can help customers with digital transformation, help them with their Cloud computing needs both on and off premise,” market conditions are very different now. Companies have less of a need for the type of turnkey storage systems seen 20 years ago.
Today, systems are in the Cloud, and most things are standardized. There are thousands of people being trained in those technologies every day so big enterprise solutions are not needed. Even among competitors like Oracle (ORCL, Financial) and Microsoft (MSFT, Financial), the focus is on managing Big Data and developing more secure Cloud storage than focusing on network storage solutions.
Financing the deal
On top of all this, Dell still has to finance the deal, which is reportedly one of the most leveraged in history. Silver Lake, the private-equity firm that helped take Dell private in 2013, will participate, as well as Michael Dell (Trades, Portfolio)’s family firm MSD Partners and sovereign wealth fund Temasek out of Singapore. According to Fortune, “institutional shareholders have committed to providing $8 billion in funding to the deal.”
Bank loans will account for just $10 billion, plus an additional revolver of $3 billion. Obviously, this is going to expose the company to a variety of risks regarding rising interest rates. Also, Dell is looking at raising around $10 billion in the high-yield market and $17 billion in high-grade bonds associated with the deal.
To reduce the amount of corporate debt it takes on, Dell is reported to be selling some of its assets. “Buyout firms KKR & Co. LP (KKR, Financial), Thoma Bravo LLC and Vista Equity Partners Management LLC are competing for $4 billion worth of Dell Inc.'s assets, people familiar with the matter said,” said Reuters in an exclusive report on Dec. 2. Dell-owned Quest Software and SonicWall could each bring in $2 billion. Goldman Sachs (GS, Financial) is advising on these assets. Also, Dell is reportedly considering the sale of Perot Systems, which has a value of $5 billion to $6 billion. Citigroup (C, Financial) is advising on this asset.
The bottom line
There are so many ways this deal could fail. The financing could fall through or the tax burden could be prohibitive. In addition, there are regulatory issues regarding how much leverage Dell is seeking to finance the deal and tax issues about the structuring. It is a lot to overcome. Then, if the deal does go through, Dell-EMC will have a large bank of debt and a business strategy that seeks to attack a commoditylike market. Investors trying to play the upside are going to face a much higher tax burden only to be left with tracking stock in VMware that may, or may not, flourish under Dell and EMC’s combined leadership.
