Dell EMC Merger: Return of the Master

Michael Dell’s deal skills are second to none-including the Great Donald (Trump that is-the current presidential contender and author of “The Art of the Deal”). Michael took Dell PC (Dell) private at a very attractive price in 2013 utilizing clever vendor financing and high yield bonds. Now he is capitalizing on an activist motivated seller to make a beautifully structured acquisition of EMC, which will be the subject of numerous cases studies.

Both EMC and Dell are suffering serious business risk issues reflected in their declining revenues. EMC’s data storage business is moving towards the cloud, while PCs face a shift to alternative devices. Also, putting together the firms to create a technology conglomerate runs counter to others in the industry like Hewlett Packard that are spinning off divisions to achieve more focus.

Let’s consider the following:

1)     Deal Type: the deal is structured more like a LBO than a corporate acquisition with its high leverage, break-up fees and go shop clauses especially given the rumored shopping of the PC business for sale post close. The possible sale would also lower integration risk.

2)     Purchase Price: the purchase price multiple is around 11X EMC’s EBITDA-more in line with LBO multiples than higher priced corporate deals. The premium over the pre bid stock price is 20%. This is probably inflated given the use question value of the tracking stock being offer as partial payment. Adjusting for the post announcement fall in EMC’s price means the actual premium is closer to 13%. Dell appears to be getting a fair firm at a great price. EMC’s management is under attack by activist Elliott Management, and appears to be a very willing seller not necessarily acting in the best interests of EMC shareholders. Interestingly, Elliot sought the partial break-up of EMC by spinning off a majority owned subsidiary (VMware). Lawsuits will surely follow. The $2.5B break-up fee due Dell if EMC walks may mean EMC’s shareholders are stuck. Dell receives a substantial break-up fee should a competing bid arise during the go-shop period.

3)     Funding: this is where it gets really interesting. Dell, Silver Lake (partner in the original Dell LBO), et al are contributing around $4B in equity (not all cash?). The hard to value tracking stock representing a currently majority owned EMC subsidiary (VMware) supposedly represents $13B of the “equity” consideration. My take is the tracking stock is actually seller financing to close the funding gap facing Dell. The balance is $10B committed bank debt (plus a $3B revolver) and $40B in bonds. $5.5B of EMC’s existing formerly investment grade bonds do not need to be re-financed because they lacked covenant protection. Based on the combined EBITDA the funded debt multiple is around 5.5X EBITDA-modest by LBO standards and within banking regulator guidelines; hence the ability to secure the up-front bank group commitment. The bond financing portion is huge and market conditions remain unsettled. Nonetheless, Dell must feel comfortable based on the advice of his advisors because he is offering EMC $4B if he fails to obtain the financing.

Bottom line, Dell gets a modestly priced $67B firm with only $4B in equity and regains public market access. Hats off to Michael Dell if he can pull this off. It becomes even better if he can quickly reduce the debt thru the unloading of the PC business. The deal is not without risks, but my money is on Michael Dell.

J

Dell LBO: The Beat Goes On

Part 2 of our discussion of using multiples in valuation will appear Wednesday.  We wanted to get this timely post on Dell out today.

R

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The potential Dell LBO continues to develop. Microsoft is considering a $3B convertible preferred stock investment. This would greatly strengthen the outlook for the transaction. Besides improving the capital structure, it provides a deep-pocket strategic partner. This is crucial to provide comfort to debt providers as a secondary repayment source should Dell experience financial problems.

Microsoft has a strong interest in seeing Dell, a major customer, survive. An out-right Dell purchase might pose concerns with some of Microsoft's existing suppliers and Window's allies. The joint venture with Silver Lake, the lead PE firm, provides a toehold investment with the implicit option for an additional follow-on acquisition. Should Dell falter, then Microsoft could elect to support Dell by increasing its ownership under the cover of protecting its investment. If Dell prospers, then Microsoft could serve as a strategic exit partner. Bottom line, they obtain an inexpensive option for a subsequent acquisition, reduce initial supplier and allies concerns and avoid having to consolidate Dell on its balance sheet.

Next to consider is the value transfer from Dell's bondholders to the transaction.  Like most investment grade bondholders, Dell is currently rated A2/A- by Moody’s and S&P respectively.  Dell's bondholders have minimal covenant protection and cannot force Dell to repay them once Dell goes private. Thus, Dell avoids having to refund the low rate bonds with more expensive buyout debt.  The existing bondholders continue to receive an investment grade coupon on their investment, which is now non-investment grade-most likely BB post close. Worse yet, the bonds will become effectively subordinate to the buyout debt. Consequently it comes as no surprise that Dell's bonds have plunged in price since the LBO discussions began.

I still question the wisdom of a highly leveraged Dell trying to adjust to its strategic challenges in a maturing and highly competitive industry facing substantial competitors who are unburdened by high leverage. Nonetheless, the potential for financial engineering related magic may just make the transaction possible even if it remains unwise. The Dell Silver Lake guys are good.

More to follow I am sure.

J