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I predict Dell (NYSE:DELL) is more likely to obtain full control of VMware (VMW) than to spin off its majority position, scuttling the hopes of activists and sum-of-the-parts bulls looking for a quick catalyst. But Dell still has a path to 100% upside via the “scenic route”—a combination of smaller catalysts in FY22 and beyond. These include returning to free cash flow growth, clearing a large bolus of debt maturities, and capturing greater synergies from VMware.
Excluding its VMware stake, Dell currently has negative equity value, despite having positive earnings and free cash flow. This unusual mispricing is caused by fear of a full VMware consolidation and deteriorating hardware fundamentals against the backdrop of a high debt load. These fears are not without merit (as I will show), but the current margin of safety limits the downside risk. Investors with a patient time horizon should consider buying shares now.
Mispricing Created by Fears of VMware Consolidation, Near-Term Hardware Deterioration, and High Leverage
Leading financial publications, prominent sell-side analysts, and multiple Seeking Alpha writers have pointed out the compelling upside suggested by Dell’s sum-of-the-parts ("SOTP") valuation, yet the stock has barely budged. This article explains the market’s concerns but argues that the current valuation dislocation creates a margin of safety with a massively asymmetric risk/reward profile.
To briefly summarize the situation: Dell owns about 81% of VMware, which translates to about $51 billion of VMware equity value, or about $68 per DELL share. The market cap of DELL is valued at less than this - only about $35 billion ($46.95 per share intraday on 2/26/20), suggesting standalone Dell equity is worth negative $16 billion, even though standalone Dell has positive earnings and free cash flow!
A conglomerate discount can’t explain the current situation. Long-time followers of Dell often attribute this unusual situation to a conglomerate discount. They cite the historical persistence of such a dislocation dating to before Dell's acquisition of EMC (though it's hard to find a time when the dislocation has been as severe as it is now).
But this explanation doesn’t fit the current situation. Conglomerates don't merit discounts by default. In fact, conglomerates can create value by generating scale efficiencies, allowing total cash flows to be greater than the sum of the parts: a 2+2=5 situation. Conversely, conglomerates destroy value (and discounts arise) when total cash flows are lower than what the sum of the parts: a 2+2=3 situation. This latter situation is caused by mismanagement: distracted managers miss growth opportunities, they starve a growing business of capital, they alienate customers, or they fail to achieve synergies.
None of these 2+2=3 traps describes Dell-VMware right now. VMware has a separate management team, separate operations, and separate culture – all of which are well-respected. In fact, VMware’s independence is widely credited for its historic success. Plenty of investors think it is doing well enough to be valued at 20x+ forward earnings even though Dell owns 81%.
The market's three main concerns. I think Dell’s stubbornly low valuation reflects fear about three issues:
- The possibility that Dell could obtain full control of VMware, destroy its independence, impede its cash flows, and thereby justify the conglomerate discount narrative. This is enabled by a governance structure giving full control to Michael Dell, who may be motivated more by long-term legacy than by short-term gains.
- IT hardware fundamentals are deteriorating into FY 2021 due to a combination of temporary factors, cyclical factors, and long-term competitive risks.
- The debt level at legacy Dell (ex-VMware), when viewed from the lens of an equity investor, is about two turns of EBITDA higher than the “core leverage” ratio presented by management – and likely to rise over the coming year.
I’ll examine each of these in detail, but one critical insight is that the last two points don’t matter given where Dell’s valuation currently stands. Most of Dell’s debt is not securitized by VMware assets. In other words, Dell could declare bankruptcy and current shareholders would still come out ahead due to their VMware stake being worth $68 per share! This is a highly unusual situation, and it’s why I’m willing to take a position even though I normally wouldn’t invest in a cyclical hardware company with weak governance.
The only way I see for permanent value impairment is for Dell to gain control of the remaining 19% of VMware (exposing VMware’s assets to Dell’s liabilities) and then to destroy VMware independence and seriously impede its financial performance. While I am predicting Dell will make a bid for the rest of VMware, I think Dell is savvy enough to manage VMware effectively.
A Full Buyout of VMware is More Likely than a Spin-Off
I predict Dell is more likely to obtain full control of VMware than to spin off its minority position. VMware is a key component of Michael Dell’s long-term vision, and Michael Dell will get his way via super-voting shares. This will require Dell to manage VMware carefully, integrating it enough to eke out synergies while trying to give it enough independence to keep partners and employees happy. This will not be easy, but Dell and VMware have worked side-by-side for nearly four years—long enough to learn how to manage the relationship effectively. And with a 7:1 risk/reward asymmetry, investors have a substantial margin of safety against the worst-case scenario in which Dell severely mismanages VMware.
VMware independence is historically important. When EMC agreed to purchase VMware in 2003 for $635 million, EMC executives made the critical decision to let VMware operate independently—a decision that allowed VMware to grow into a ~$60 billion powerhouse. VMware has retained its independence through the turmoil of Dell’s EMC acquisition and subsequent return to the public markets. Independence has given VMware several advantages:
- It has allowed VMware to partner with other hardware vendors that compete with Dell.
- It has allowed VMware to retain talented and respected leaders, who have been particularly successful steering VMware through competitive challenges.
- It has allowed a distinctive corporate culture to emerge where talent seems to flourish. Part of this seems to be the ability to grant its own stock-based compensation.
Why might Dell risk jeopardizing these advantages by buying the remaining 19% it doesn’t own? I see six reasons.
Reason #1: VMware is a critical and well-integrated part of Dell’s strategy. If you visit a public-facing Dell event such as Dell Technologies World, it’s hard to miss the volume of VMware-centric announcements. It’s obvious that Dell and VMware are working synergistically, and separating them could be challenging at this point.
Dell has identified at least $700 million of revenue synergies already generated in addition to cost synergies. Management’s comments are unambiguous about the importance of VMware to the company’s strategy.
“if you just take all of the salespeople and say go sell more VMware, okay, that's great…But it's the technical integration of these solutions and innovating together that's building a whole new class of capabilities that weren't there before that I think is actually the foundation of all the success that we're going to drive in the future.” Michael Dell, Chairman and CEO, speaking at Dell analyst event on 9/26/19
“We are really spending our leadership time on the strategic revenue synergies [between Dell and VMware]….What we've done is deep levels of integration” Jeff Clarke, Vice Chairman of Products & Operations, speaking at Dell analyst event on 9/26/19
“Our customers are asking us to come to them holistically, not piecemeal. They want solutions that are more integrated rather than less integrated. All of that has…accelerated the synergy dynamic….We think we're in sort of the early to early-mid innings on synergy opportunity over time….We don't have any plans to change the current structure. We're happy with the current structure. We think there's tons of value to be created in the combined innovations that exist” Tom Sweet, Executive VP & CFO, speaking at Dell analyst event on 9/26/19
Reason #2: Michael Dell is in this for long-term legacy, not short-term gains, and VMware is part of the legacy. Dell’s 2013 go-private transaction, the 2016 EMC transaction, and the 2018 return to public markets were all controversial. Activists accused Dell management of acting in ways unfriendly to shareholders. This situation arose because management’s interests were not aligned with shareholders in parts of those deals.
With Michael Dell now owning 53% of common shares, many minority shareholders think their interests are now aligned with Michael Dell. I am unsympathetic to this argument view given the multi-class share structure that allows Michael Dell to maintain voting control indefinitely, even if his economic ownership declines below 50%.
Exhibit 1. DELL’s Multi-Class Share Structure Creates Governance Risk
Michael Dell’s interests may not be aligned because his ultimate vision and time horizon are probably different than other shareholders. Michael Dell could have sold his company and ridden off into the sunset a wealthy man, but he chose not to. This suggests he is most interested in legacy. Legacy can take decades to build, and it can turn out positively (Amazon’s willingness to endure decades of losses in exchange for market power) or negatively (the fall of the GE empire).
I strongly suspect part of his legacy vision is for VMware to be an integral part of Dell, and this vision would be more powerful with complete ownership. This vision is probably a bigger motivator for Michael Dell than a near-term improvement in valuation. And multi-class governance assures Michael Dell will get his way.
Reason #3: Migration to the cloud simultaneously makes VMware more important to Dell and lessens the risk of alienating other hardware vendors. VMware partners with Dell’s competitors in the server market, such as Hewlett Packard (HPE)—something that has been made possible by VMware's independence. Meanwhile, VMware has partnered with major cloud providers, such as Amazon Web Services which effectively competes with all third-party server providers (including Dell) by building its own custom servers. I am not able to quantify VMware’s exposure to direction competitors or to cloud providers, but it has become clear over the past few years that the future is in the cloud (or at least the hybrid cloud), making the cloud competitors the more important factor.
VMware is essentially Dell’s access point to the high-growth cloud market, and I think controlling this narrative is much more important to the long-term story than maintaining neutrality with Dell’s direct server competition. Fully controlling VMware would make the cloud-centric narrative more powerful for Dell.
Reason #4: VMware is a better business. To measure the quality of a business, I look at return on invested capital ("ROIC") using my own proprietary estimates and adjustments. ROIC without goodwill measures the inherent returns of a business, while ROIC with goodwill measures how well management has allocated capital in deals. Ideally, I want both measures of ROIC to be well-above the weighted average cost of capital ("WACC").
Dell performs modestly on these metrics. The standalone business (ex-VMware) produces a 15% return ex-goodwill and 8% with goodwill, compared to a 6-7% WACC.
VMware, on the other hand, performs phenomenally. In fact, the return ex-goodwill can’t be calculated because the business doesn’t require any capital (largely due to significant deferred revenue in working capital). Returns are, in effect, infinite. And including goodwill, VMware still achieves an enormous 63% ROIC.
Exhibit 2. Standalone Dell’s ROIC is Slightly Above Its WACC, but Nowhere Near VMware’s Level
Viewed in this way, VMware is a higher quality business than Dell and one that Dell would wisely want to keep in its portfolio.
Reason #5: Dell could extract additional cost synergies. If Dell pays a premium for the remaining VMware shares, it will need to extract synergies to justify the premium. Low-hanging fruit includes public company costs, finance, and accounting. Dell could try to cut costs at the upper management level, but this risks alienating employees and harming culture. In a typical buyout, I would assume 20% of operating expenses could be cut, but in VMware’s case, I am assuming a modest 7% (about $500 million of an estimated $6.7 billion in operating expenses in FY21, including $700 million of G&A). I am using this lower number since VMware excludes stock comp from expenses (a big source of synergy), Dell has already gotten some synergy, and Dell will likely need to keep VMware separate operationally.
Reason #6: VMware could ease the debt burden. I am not an expert on complex M&A transactions, and Dell could plausibly find a way to gain control of VMware without adding significant debt. But the most straightforward way would be to make a debt-financed bid for the remaining shares. Assuming a 20% control premium, this would require about $14 billion of capital, most of which would be new debt (although Dell would gain full control of the $2 billion of net cash I am assuming for VMware at the end of FY 22).
Exhibit 3. A 20% Control Premium for VMW Minority Interest Would Require About $14 Billion of Capital
Why assume Dell could take on more debt when it is already highly levered? I calculate Dell’s leverage ratio would actually decline by paying $14 billion for VMware. And interest coverage would improve. This is because VMware is significantly under-levered relative to its substantial free cash flow. Such a transaction would also allow Dell to accelerate the pace of debt reduction by about 2x by having full access to VMware’s $3-4 billion of free cash flow.
Exhibit 4. Acquiring the Remaining VMW Shares Could Actually Ease Dell’s Debt Burden
What clues do we see that Dell might buy the rest of VMware?
I have been watching for clues that my thesis is correct. Beyond public statements by Dell management about the importance of VMware, I see three clues.
Clue #1: Aligned Accounting. Effective January 1, 2017, VMware changed its fiscal year to match that of Dell. This is not a trivial thing to do—it is costly in terms of time and money, and it is generally a difficult and annoying process. A company would not do this unless they expect the change to be permanent. To me, this confirmed that Dell has no intention of ever spinning off VMware.
Clue #2: The Reverse Merger Trial Balloon. In early 2018 as Dell was considering returning to the public markets, VMware confirmed that a reverse merger was on the table. This demonstrated Dell’s desire to fully unite with VMware. That it didn’t materialize suggests it was met with resistance. It's not a surprise that VMware holders wouldn't want to receive Dell stock in a reverse merger based on the difference in business quality (as I highlighted in the ROIC analysis). This is why I suggest a bid for the VMware minority interest would need to be in cash. Dell's leverage in 2018 made this impossible, but by the end of FY 2022, I estimate the balance sheet can handle it and will actually result in declining leverage, as shown in Exhibit 4.
Also, Michael Dell is chairman of VMware's board and has shown a willingness to make unpopular decisions. With data rapidly moving to the cloud, the case for fully owning VMware has gotten stronger over the past two years and will continue to get stronger as time passes. Eventually, the business case for a VMware buyout will overpower any remaining shareholder dissatisfaction.
Clue #3: The Pivotal Deal. During VMware’s recent acquisition of Pivotal (which was majority owned by Dell), Dell chose to take 7.2 million VMW shares in exchange for Dell’s 59% ownership stake in Pivotal. This choice could have been motivated by tax consequences, but in an environment where Dell needs to de-lever as rapidly as possible, choosing to receive more equity rather than $1 billion of cash is a curious choice if Dell really does intend to spin VMW.
(Analytical note: As of the end of the most recent quarter (FQ3 2020), Pivotal was majority owned by Dell (~59%), with about 16% owned by VMware and the remainder publicly floating. VMware paid $15 per share for Pivotal’s public float, but Dell’s consideration came in the form of 7.2 million share of VMW stock. This increases Dell’s proportional stake in VMware by about 30 basis points).
Why should investors care about a VMware buyout? If Dell does manage to acquire full control of VMware, VMware’s business would be exposed to Dell’s liabilities. This becomes a problem if Dell’s fundamentals continue to deteriorate. I will next take a look at this deterioration.
IT Hardware Fundamentals are Deteriorating, Setting Up a Difficult FY 2021
Dell has already guided for “caution” on revenue growth in FY 2021, with margins reverting to FY 2019 levels due to component cost inflation.
To put revenue growth in perspective, I estimated normalized revenue growth for Dell’s three main business lines (excluding VMware), including pro forma estimates including EMC before the merger. I include my own estimates for FY 2021 in the time series.
Exhibit 5. Normalized Revenue Growth for Dell’s Three Main Franchises (ex-VMW)
The first takeaway from this work is that all three businesses are cyclical, but down cycles usually come in different years, offering Dell some degree of hedging.
The second takeaway is that the worst year for any one business line has been a low double-digit level of decline.
Rolling these three business lines together, the range of revenue volatility narrows, and downturns have been limited a low-single digit level of declines.
Exhibit 6. Normalized Revenue Growth for Standalone Dell (ex-VMW)
My base-case estimates for Dell reflect these insights, while my bear-case estimates assume these historical trends deteriorate substantially. In my base case, I forecast a ~1% normalized revenue decline in FY 2021 for standalone Dell.
Six factors impacting FY 2021 revenue deterioration
Dell has called out a variety of temporary and cyclical factors impacting revenue growth, including a “digestion period” after rapid server growth in FY19, the competitive landscape in China, the Intel CPU shortage, and the Windows 10 refresh cycle.
“Digestion” period. FY18 and FY19 were extraordinary years of growth for Dell’s server business. The company has attributed the decline in FY20, in part, to a period of digestion for large corporate customers. This explanation is sensible for a cyclical business and, in my opinion, will resolve itself within two years. The key thing to watch is whether Dell can continue taking market share while the market is in a lull.
Competitive deals in China. Dell has pointed to large contracts in China as another headwind for the server business. Specifically, competitors have been pricing these contracts below where Dell was willing to go. This has allowed Dell to retain margin but has cost it market share in China. Competitors appear to have been using a deflationary cost environment as a means to price aggressively. The more inflationary cost environment in FY21 could help Dell competitively, though I will remain cautious on China until the market visibly improves.
Intel CPU shortage. Due to manufacturing problems, Intel has faced supply problems for 14nm and 10nm processor chips since late 2018. Dell has specifically called out this issue as a factor in its cautious revenue growth outlook for FY21. Based on Intel’s recent statements, I expect this problem to drag on through 2020.
Windows 10 Refresh Cycle. Dell expects headwinds in Client Solutions Group ("CSG") revenue due to a slowing of the Windows 10 refresh cycle. This dynamic is not surprising, but it will be happening at the same time as other pressures on the server business.
To this list, I would add two additional items Dell hasn’t specifically referenced as factors in FY 2021.
Coronavirus Uncertainty. The coronavirus epidemic has disrupted supply chains globally. Dell management has not had a chance to comment on this yet, but I think it is likely that quarantines and factory closures will negatively impact FY 2021 growth.
Shift to the cloud. My biggest long-term concern for Dell’s growth outlook is the shifting preference for the public cloud over on-premise servers. We can see this in the rapid growth of Amazon Web Services, Google Cloud, and Microsoft Azure. I confess I have been far too bearish about public cloud adoption – I thought companies would be reluctant to cede control to third parties. The consensus seems to be coalescing around a vision for a hybrid cloud model. However, even if we assume public cloud adoption maxes out at 50%, consensus suggests we have not yet reached the half way point of public cloud penetration. Public cloud providers often use their own custom servers and memory, which could put continue pressure on Dell’s Infrastructure Solutions Group ("ISG"). To account for this concern, my post-FY21 growth for ISG is only 1%, and my bear case risk assessment assumes a 40% decline in revenue (cumulatively) through FY 2025.
Margin and cash flow deterioration
Dell has called for margins to revert to FY19 levels in FY21 after a very strong FY20. The margin volatility is mostly a function of component costs, and I have high conviction that Dell can stabilize margins at or above FY21 levels. I am not particularly concerned about margins.
I am, however, concerned about free cash flow ("FCF"). Dell’s FCF has deteriorated much faster than revenue or operating income. In FY19, when revenue and operating income grew, FCF declined, and I expect the same in FY20.
Exhibit 7. Free Cash Flow Growth for Standalone Dell (Ex-VMware) Has Deteriorated Faster Than Revenue or Operating Income
FCF deterioration is the most difficult metric to explain. We can see working capital investments plus capital expenditures have increased substantially (I add these together because a change in lease accounting resulted in a shift of some cash flows from working capital to capex in FY20), but it is hard to know why. Capex and working capital haven't gotten attention on recent conference calls, partially because it is obscured by the financial consolidation of VMware.
Without a good explanation for the drivers of capex and working capital drag, I forecast these items very conservatively in my models.
Exhibit 8. Investments in Working Capital and Capex Have Increased from <1% of Revenue to Nearly 3% of Revenue
Looking beyond FY 2021, things get better. Contemplating all the factors discussed in this article, my estimates for FY 2022 improve considerably. Having visibility to this improvement via management guidance will most likely be the first catalyst for the stock, but it may take 9-12 months to get there.
Exhibit 9. Estimates For Standalone Dell (Ex-VMware) Improve in FY 2022
Leverage on Standalone Dell is About Two Turns Higher Than Bulls Seem to Think (and Likely to Increase)
Dell's valuation dislocation suggests the market is worried about Dell's leverage, despite management's use of a "core debt" metric that shows leverage is a manageable 3.4x. I estimate this calculation understates the leverage ratio equity investors should care about by about two turns, but I think it is still manageable.
Why the confusion? Leverage ratios can be viewed from the perspective of the credit investor (concerned about loan collateral and priority of repayment), the perspective of ratings agencies (concerned about the holistic ability to service debt), or the perspective of an equity investor concerned about residual cash flows after interest is paid. Dell’s “core debt” calculation suggests leverage is about 3.4x, but this is relevant only to credit investors and ratings agencies. For equity investors, it dramatically understates leverage.
Applying my own adjustments (shown in Exhibit 10), I contend that the net leverage on a basis that equity investors should care about is actually 5.5x – and likely to increase over the coming year, even if Dell pays off $4 billion of core debt (per guidance).
Exhibit 10. A Better Representation of Net Debt to EBITDA Suggests Leverage is 5.5x and Rising
Dell management’s “core debt,” excludes debt related to Dell Financial Services ("DFS"), a margin loan used to purchase VMware stock, and VMware debt that Dell consolidates due to Dell’s majority ownership of VMware. Core debt is presented over an EBITDA metric with unusual adjustments (specially, consolidated adjusted EBITDA less 19% of VMware EBITDA less DFS estimated EBITDA, calculated as a 4% return on financing receivables and DFS operating leases).
In a proper analysis, each part of Dell’s debt needs to be supported by a source of cash flow. I fully deconsolidate VMware from standalone Dell, creating two separate cash flow streams. The only debt that truly belongs to the VMware cash flow stream is ~$4.6 billion of debt that sits on VMware’s own balance sheet. The rest of the debt must be paid via the standalone Dell cash flow stream.
To see this intuitively, look at the $4 billion margin loan (which "core debt" excludes) and ask: Where does the cash come from to pay the interest? It comes from standalone Dell’s cash flow (regardless of the fact that it is securitized by VMware stock).
A case for not separating DFS. Dell’s “core debt” calculation makes the implicit argument that DFS should be treated as a separate business with separate EBITDA and cash flow. If this is the case, analysts should be valuing DFS as a separate cash flow stream and source of value, but I argue this wouldn't make economic sense.
(Analytical note: If others want to pursue this route, I estimate DFS-related interest income (included in revenue) of ~$120 million per quarter as the current run-rate, offset by DFS interest expense of ~$70-75 million per quarter).
Why doesn't it make economic sense to value DFS separately? If we separate DFS, we should view it as a loan-making financial institution (e.g., a bank). A typical bank makes loans across a wide variety of term structures and industries. It is diversified and could withstand a downturn in any one industry or the bankruptcy of any one customer. Not so with DFS. Dell’s financial assets are tied to a limited set of products sold to a limited set of customers, almost all with 2-5 year terms. Putting a bank-type multiple on DFS income streams or equity book-value would dramatically understate the risk to DFS cash flows. If Dell’s new business pipeline dries up, so will DFS. DFS is intimately tied to Dell’s business and can’t be separated in an economic sense, even though assets and liabilities can be isolated in a legal sense.
I propose we view DFS as a sophisticated, in-house way of conducting receivables financing. Most of the leases under DFS are sales-type leases with economics similar to standard receivables (a majority of revenue is recognized on sale, the right to the asset is transferred, and cash is collected over time). In my opinion, treating financing receivables as typical accounts receivable, treating DFS debt as typical debt, and attributing the interest income and expense to standalone Dell gets us much closer to economic reality.
Why I recalculate EBITDA to use for standalone Dell. In Dell’s “core debt” leverage ratio, I object to only subtracting 19% of VMware EBITDA from the calculation. None of the VMware cash flows can be used to service core debt (not without VMware paying a dividend to Dell), thus if I care about identifying the EBITDA from which interest expense can be paid, none of VMware’s EBITDA should be included. I also object to the exclusion of stock compensation as an expense when viewed through the lens of an equity investment, and to be consistent across the companies I analyze, I subtract below-the-line expenses (other than interest-related items), since recent accounting changes have shown that the distinction between above and below-the-line expenses is somewhat arbitrary. Making these adjustments (as shown in Exhibit 10) puts standalone Dell on more of a best-practices basis with leveraged companies in other sectors such as Healthcare and Industrials.
5.5-6.0x EBITDA is still manageable. If we look strictly at unlevered, pretax cash flow versus cash interest expense, Dell will have its interest covered by nearly 2x in FY 2021, based on my estimates. That is manageable if cash flow stabilizes or improves.
Exhibit 11. Standalone Dell’s Cash Interest Will Be Covered About 2x in FY21
My bigger concern is that from FY22 – FY24, between $4-6 billion of debt will mature each year, and Dell has excess free cash flow of only $2-3 billion (unless things improve).
Exhibit 12. Near-Term Debt Maturities Will Require $4-6 Billion of Capital Per Year
How will Dell manage this? It could use cash from the sale of assets (such as the recently announced RSA deal), it could convince VMware to pay another dividend, it could issue new debt (though rates may not be favorable and it’s rarely good to do so under duress), or it could try to obtain full control of VMware. Based on the thesis presented in this article, I predict Dell will choose the latter option and maturities will become much more manageable.
Valuation - 100% Upside In Base Case
I think the right way to value a stock (always) is to use free cash flows. I prefer to use residual cash flows to equity holders, which I call normalized free cash flow and which is essentially free cash flow less stock comp. I "sanity check" my discounted cash flow ("DCF") analysis with multiples but do not rely on multiples exclusively. I explain the rationale on my blog.
I built a base-case DCF using key assumptions in this article including:
- Dell pays $14 billion for the remainder of VMware in F1Q 2023
- Dell is able to achieve $500 million of incremental cost synergies from VMware
- Post FY21 growth for ISG and CSG of 1%
- FY25 is a recession year with negative growth, rebounding the year after.
- Flat margins for ISG or CSG after FY 2022
- VMware normalized growth of 7% in FY22 and gradually declining to 3% by FY33
- Flat margins for VMware after FY24 (margin expansion for the total company comes from VMware growing in the mix)
- Perpetuity growth for the entire company of 0%
- A 10% discount rate
This DCF yields a current valuation of $97 per share – approximately 100% upside.
Exhibit 13. Base Case DCF Assumptions Yielding $97 / Share at 10% Discount Rate
If we then cross check the DCF by seeing what multiples are implied by a sum-of-the-parts analysis, we find a $97 valuation implies 8.0x standalone Dell FY22 EPS and 14.5x normalized free cash flow ("NFCF" - a much more conservative measure than Dell's EPS). These are very reasonable multiples, in my opinion.
Sell-side sum-of-the-parts models often include a conglomerate discount, but as I argued at the beginning of this article, I don’t think Dell will impede VMware’s free cash flow, thus I don’t think a conglomerate discount is appropriate.
Exhibit 14. Multiples Implied By Sum-Of-The-Parts Are Reasonable
Some analysts like to use EV/EBITDA multiples for a comparables analysis. I am generally opposed to using EBITDA (it’s not a good reflection of free cash flow), and I am also opposed to comparables-based valuation on principle. But for those who appreciate EV/EBITDA multiples, standalone Dell (ex-VMware) is currently valued at 4.5x my conservatively-adjusted FY 2021 EBITDA.
We can find other companies in the IT hardware space with similar multiples (JBL, HPE), but those companies have far less debt than Dell. Essentially, Dell’s entire enterprise value is consumed by its debt – the equity is price at zero (actually below zero)!
Exhibit 15. Standalone Dell (ex-VMware) is Currently Valued at 4.5x My FY 2021 EBITDA Estimate
Risks - Downside Requires Draconian Assumptions
I am invested in Dell because the margin of safety is so high and risk/return so asymmetric. I am essentially buying the high-quality VMware business at a 25%+ discount while also getting the lower-quality standalone Dell IT hardware business for free.
And yet, as we covered in this article, there is a way things can go wrong. It requires Dell to fully consolidate the remainder of VMware and then seriously impede the business. A true bear case requires the following assumptions:
- Dell pays $14 billion for the remainder of VMware in F1Q 2023
- Dell is unable to achieve any incremental cost synergies from VMware
- ISG revenues decline by over 40% cumulatively through FY 2025 as cloud pressures mount.Revenues never recover and are permanently flat thereafter.
- CSG revenues decline by over 20% cumulatively through FY2025 with no new product cycle. They never recover and are permanently flat thereafter.
- Persistent margin erosion for both ISG and CSG through FY 2033
- VMware normalized growth of 7% in FY22 falls to 3% immediately after the acquisition and eventually goes to zero.
- VMware margins experience massive erosion, eventually losing 800 bps cumulatively through FY 2033.
- Continued FCF deterioration of 4% per year before through FY 2040 before stabilizing at the perpetuity growth rate.
- Perpetuity growth of 0%.
- A 10% discount rate.
Remarkably, even in these extremely dire circumstances, Dell could still meet its debt maturities due to the VMware cash flows. And the value of the DCF is $40 per share, suggesting an unusually favorable asymmetric risk/reward profile of 7:1.
Exhibit 16. Bear Case DCF Assumptions Yielding $40/ Share at 10% Discount Rate
Part of my investment philosophy is to make verifiable predictions about the future and to specify a confidence level in those predictions. These predictions can be updated as new evidence becomes available via a process known as Bayesian inference.
This discipline reduces cognitive bias lets me know when evidence warrants changing my investment thesis. In that spirit, I share the following specific predictions related to my investment in Dell.
- Dell will not spin-off VMware on or before 12/31/2022. Confidence level: 95%
- Dell will announce an attempt to fully consolidate the remaining 19% of VMware on or before 12/31/2022. Confidence level: 70%
- The combined revenue of the ISG and CSG segments will decline on a reported basis in FY 2021. Confidence level: 85%
- The combined revenue of the ISG and CSG segments will increase on a reported basis in FY 2022. Confidence level: 75%
Despite the unusual and compelling dislocation in Dell stock, the market is telling us there is a way things can go wrong. That way is for Dell to acquire the rest of VMware, destroy its independence, and impede its cash flow, all while the Dell's IT hardware business deteriorates substantially. My models suggests this is a highly unlikely bear case.
I do think Dell will acquire the rest of VMware, but I think management can do so prudently, without ruining the company. Even in the case where things don't go perfectly, the risk/reward is so skewed that investors at current levels would likely still come out ahead.
If I am right, activists and sum-of-the-parts bulls will not get the quick catalyst they are hoping for. It will become a slowly unfolding “show-me” story. It will take years of a fully-combined Dell-VMware putting up better growth, solid free cash flow, and consistent de-levering to fully realize the substantial value currently locked up in Dell shares. For me, the value is worth taking this scenic route.