EMC Trading Below Dell's $24.05 Bid

| About: Dell Technologies (DVMT)

Summary

Dell proposed a merger that would pay EMC shareholders $24.05 cash and tracking stock.

Deal has a termination fee.

Arbitrage ideas for income and risk reduction.

EMC EMC (EMC) is expected to release fourth-quarter earnings before the market opens on Wednesday. VMware (NYSE:VMW) is expected to announce earnings after the market closes Tuesday.

Dell made a bid for EMC on October 12, 2015, that was $24.05 in cash plus tracking stock. The total value was estimated to be $33.15. Today EMC closed at $23.98.

Subject to the terms and conditions of the Merger Agreement, at the effective time of the Merger (the "Effective Time"), each share of Company common stock, par value $0.01 per share ("Company Common Stock"), issued and outstanding immediately prior to the Effective Time (other than shares owned by Parent, Merger Sub, the Company or any of its wholly-owned subsidiaries, and other than shares with respect to which appraisal rights may be properly exercised and not withdrawn) will be cancelled and converted into the right to receive {(I)} $24.05 in cash, without interest (the "Cash Consideration"), and (ii) a number of shares of validly issued, fully paid and non-assessable shares of common stock of Parent designated as Class V Common Stock, par value $0.01 per share (the "Class V Common Stock"), equal to the quotient obtained by dividing {(A)} 222,966,450 by {(B)} the aggregate number of shares of Company Common Stock issued and outstanding immediately prior to the Effective Time, plus cash in lieu of any fractional shares (together with the Cash Consideration, the "Merger Consideration"). The aggregate number of shares of Class V Common Stock issued as Merger Consideration in the transaction is intended to represent 65% of the Company's economic interest in the approximately 81% of the outstanding shares of VMware, Inc. ("VMware") currently owned by the Company, reflecting approximately 53% of the total economic interest in the outstanding shares of VMware. Upon completion of the transaction, Parent will retain the remaining 28% of the total economic interest in the outstanding shares of VMware. Because any shares with respect to which appraisal rights may be properly exercised and not withdrawn would not receive Class V Common Stock, any proper exercise of appraisal rights would decrease the aggregate number of shares of Class V Common Stock issued in the Merger and increase Parent's retained interest in the VMware business. Based on the estimated number of shares of Company Common Stock at the closing of the transaction, Company shareholders are expected to receive approximately 0.111 shares of Class V Common Stock for each share of Company Common Stock. Assuming, for illustrative purposes only, a valuation for each share of Class V Common Stock of $81.78, the intraday volume-weighted average price for VMware on Wednesday, October 7, 2015, Company shareholders would receive a total combined consideration of $33.15 per share of Company Common Stock. The value of the Class V Common Stock may vary from the market price of VMware given the different characteristics and rights of the two stocks. The rights of holders of the Class V Common Stock will be governed by the Amended and Restated Certificate of Incorporation of Parent to be filed with the Secretary of State of the State of Delaware and made effective as of immediately prior to the Effective Time (the "Parent Certificate"), (ii) by-laws to be adopted by Parent's Board of Directors concurrently with the filing of the Parent Certificate (the "Parent By-laws") and {(NASDAQ:III)} a Tracking Stock Policy Statement to be adopted by Parent's Board of Directors concurrently with the filing of the Parent Certificate (the "Tracking Stock Policy Statement").

EMC's stock has not performed well since the merger announcement.

The market is either irrational in the pricing of EMC at $23.98 that include a payment of $24.05 plus tracking stock. On the other hand, the market is signaling that the deal will not be completed with a payment of $24.05 in cash plus tracking stock. The deal is expected to close in mid- 2016. Should the merge fail, then a termination fee would be payable.

Under the terms of the Merger Agreement, EMC may solicit alternative acquisition proposals from third parties until 11:59 p.m. on December 11, 2015. The Merger Agreement contains specified termination rights for both Parent and EMC, including that, in general, either party may terminate if the Merger is not consummated on or before December 16, 2016. If EMC terminates the Merger Agreement, we are required to pay Parent a termination fee of $2.5 billion (or, if EMC terminates for a superior proposal prior to December 12, 2015, the termination fee payable by EMC to Parent will be $2 billion). If Parent terminates the Merger Agreement, they are required to pay a termination fee of $4 billion under specified circumstances, and in certain instances, an alternative termination fee of $6 billion.

EMC had 1.938 billion shares outstanding on September 30, 2015. Therefore, should Dell terminate the merger is would appear that EMC would get between $2 and $3 per share in a termination fee.

EMC 52-week low is $22.66, and it currently pays a $0.115 per share quarterly dividend. The current dividend yield is 1.92%. Not much lower than the 10-year US Treasury Note.

Why has EMC's stock price fallen?

A few theories

  1. Investors are selling a liquid stock to raise cash.
  2. Investors have sold VMware as a hedge, placing downward price pressure on the merger deal price. This leads to a lower EMC stock price.
  3. Investors do not believe the deal with Dell will be done, as proposed.
  4. Investors want a higher rate of return for holding EMC stock while the deal is being worked on.

Possible Outcomes

  1. The deal is not done and EMC trades on its fundamental value.
  2. The deal is done with EMC shareholder getting $24.05 in cash and tracking stock.
  3. The deal is revised.

The tracking stock seems to be an issue. For the sake of argument, let us say that the tracking stock is replaced with a preferred stock issue that can be converted into VMware stock. This would provide income and upside potential. It would provide for an arbitrage between the convertible stock and VMware common stock, but unlike the tracking stock, it would require shorts to cover the preferred dividend. Investors might be required to trade income for some upside gain should the deal be revised to include a preferred issue.

What is an investor to do?

An investor wanting to increase holdings in EMC might wish to explore the sale of put options for income and to purchase the stock at a discount. For example, the March 18, 2016, $24 put is bid at $0.71, or a 3% return on the strike price, that is roughly 20% annualized. The effective purchase price would be $23.29 excluding transaction costs.

A more venturesome investor might wish to consider the purchase of 50% of a position and then sell the $24 put at $0.71 and the $25 call at $0.35. The net credit from the options would be $1.06. This would be the equivalent of selling the 50% position at $26.06, or a gain of 8.58%, roughly 57% annualized should the stock be above $25. Alternatively, if the stock were below $24 then adding to the position would be done at an effective price of $22.94. Should the stock at option expiration be between $24 and $25 then the option premium of $1.06 would be earned without having to sell or add to the 50% position.

A more risk adverse investor may buy a 50% position and sell the $24 straddle for $1.45 ($24 call at $0.71 and $24 put at $0.74). The effective sell price would be $25.45, (a 6% gain / 40% annualized) with an effective purchase price of $22.55.

An investor willing to accept a higher risk could purchase the stock and wait for the deal to be completed, revised or collapse. Should the deal generates the $33.15 value then the gain would be 38.2% if it takes 1 year.

One must be comfortable holding EMC as a stand-alone enterprise. For those so inclined some interesting arbitrage opportunities using EMC stock and listed options have been presented and carry the risk of loss.

The release of earnings by EMC and VMware made provide a clearer picture of the status of their business.

Let me know if you found this interesting, or what I might have missed.

Thanks.

Disclosure: I am/we are long EMC.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: also short puts and looking to sell calls.