A passage from Burton Malkiel's classic A Random Walk Down Wall Street, in a chapter dealing with the tech bubble, appears to be an instructive analogy for the current EMC Corporation (EMC)/VMware (VMW) situation:
An example of the complete insanity that gripped the market - an insanity that went well beyond irrational exuberance - is the case of PalmPilot, the maker of Personal Digital Assistants (PDAs). Palm (PALM) was owned by a company called 3Com (OTC:COMS), which decided to spin it off to its shareholders. Since PDAs were touted as a sine qua non of the digital revolution, it was assumed that PalmPilot would be a particularly exciting stock. Little did 3Com know how strongly the market would react.
In early 2000, 3Com sold 5 percent of its shares in Palm in an initial public offering and announced its intention to spin off all the remaining shares to the 3Com shareholders. Palm took off so fast that its market capitalization became twice as large as that of 3Com. But remember that 3Com still owned 95 percent of Palm. It turned out that the value of 95 percent of Palm was almost $25 billion greater than the total market capitalization of 3Com. It was as if all of 3Com's other assets were worth a negative $25 billion. If you wanted to buy PalmPilot you could have bought 3Com and owned the rest of 3Com's business for minus $61 per share. In its mindless search for riches, the market created anomalies that were even stronger than the fraudulent accounting practices that were soon to be revealed.
(FYI: From its post-IPO high of $802.5/share, Palm fell to $60 a little over a year later, and is now valued at $17)
Much of the same analysis applies, in my opinion, to EMC's spinoff of VMW. The market cap of VMW is now $37.43 billion. However, EMC owns around 86% of VMW. The implied valuation of EMC's stake in VMW is, therefore: 0.86 * 37.43 = $32.2 billion
EMC's current market cap stands at $46.94 billion. In effect, the value of EMC's stake in VMW is 70% of the total market capitalization of EMC. It is as if all of EMC's other businesses are worth only $14 billion. VMW last quarter generated only a fraction (under 10%) of the revenues, earnings, and cash flow created by EMC as a whole. Yet, given the explosive growth in VMW's P/E valuation, we're not far from a point where VMW will be worth more than EMC.
The market does not allow such anomalies to exist for long. There are two things that will happen as we move towards eliminating this discrepancy - EMC will go up, and/or VMW will go down. The question is, which move seems more likely?
VMW now trades at more than 140 times estimated earnings for the next four quarters. Historically, a P/E ratio in the triple digits is impossible to sustain - even if the company is growing at a breakneck pace. While it is possible that we will see some increase in EMC's valuation, a brief look at the history of tech spinoffs and IPOs suggests that it is much easier for a stock with triple-digit multiples (VMW) to disappoint expectations than it is for a large and established business (EMC) to suddenly shoot up to insanely high valuations.
Reading the Malkiel passage I quoted above, it's hard to avoid a sense of deja vu - once again, we have exuberant pricing after a spinoff, based primarily on irrational expectations of permanently high growth. While I believe that VMW is a great company with good business prospects, the bottom line is that it appears to be overvalued no matter how great the underlying business is. In my opinion, we are likely to see a massive correction downward in VMW's valuation.
Disclosure: none
