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

The Power of Subtraction: When 2-1=3

Difficult economic and industry conditions have depressed operating results for many firms. This has stimulated changes in corporate strategy and structure. Fusion based mergers and acquisitions are a means to implement such changes. They are based on the premise of 1+1=3, largely through synergy based improvements. The other side of the merger coin is the less well know fission-based de-mergers approach where 2-1=3. The focus of this post is on voluntary as opposed to imposed de-mergers due to financial distress or bankruptcy issues.

De-merger activity, like its merger related cousin, runs in waves. Currently, the wave is in an upswing. For example:

1)     Smithfield: the friendly acquisition to a Chinese firm is challenged by an activist shareholder claiming a de-merger of the vertically integrated pork producer would create one-third to two-thirds value increase over the acquisition alternative.

2)     Sony: activist investor Daniel Loeb is seeking a 15-20% equity carve-out (partial public offering) of Sony’s entertainment division to unlock value and fund the turnaround of its lagging electronics unit.

3)     Media Industry: McGraw-Hill split of its publishing and ratings units and the Fox spinoff of its print from electronic media just to name a few.

De-mergers, unlike mergers have a surprisingly positive value impact. Despite this, it is not something that comes naturally to most managers. It is seen more as a mark of failure-shrinking versus growing- than as a natural process in portfolio management reflecting changes in market conditions and the firm’s life cycle. Consequently, most firms engage in de-mergers only after being prodded by activist or frustrated shareholders signaling their displeasure with disappointing performance. Also, de-mergers appear to be more about financial engineering than value creation. This is partly true as de-mergers are about releasing trapped value inherent in multi-divisional diversified firms than creating something new.

Typically, such firms suffer from a conglomerate discount, which reflects the difference between the values of the separate individual business units on a standalone basis in a conglomerate from the market value of the parent. This difference is in effect a negative synergy or management as an off- balance- sheet- liability. The negative synergy can result from increased overhead expenses, capital misallocation, cross subsidies, and suboptimal incentives. These suggest that the current parent is not the best owner of the division.

The major de-merger methods include among others:

1)     Divestment: usually taxable sale to a third party. An example is McGraw-Hill’s sale of Business Week to Bloomberg. Getting an acceptable price depends on finding a natural buyer (best owner). As Warren Buffett notes, divestment is not Gin Rummy where discard your worst cards. As you are unlikely to get much for losers. Rather, it is about selling good businesses to someone who pays more to you than the assets are worth to you as a continuing operation.

2)     Spinoff: frequently a tax free distribution of subsidiary shares to the parent shareholders - similar to a stock dividend. They continue to own the same operations, but in a separate form. It can be faster and more assured than a divestment - especially, when no natural buyer can be identified. Can be both leveraged and un-levered. In a leveraged spin-off, the subsidiary borrows to fund a special dividend to the parent before the spin.

3)     Split-off: related to a spinoff, whereby parent shares are exchanged for direct ownership in a subsidiary.

4)     Equity Carve-out: portion (typically 15-20%) of a subsidiary’s shares are sold to the public as a partial public offering. Carve-outs, like spin-offs, can be either leveraged or un-levered.

5)     Tracking Stock: separate classes of parent stock whose dividends depend on the performance of an individual subsidiary.

The relative merits of each method vary are beyond the scope the scope of this post. Nonetheless, it illustrates some of the many ways to unlock trapped value in underperforming diversified firms. The key is to recognize that subsidiaries come with different “sell-by” dates. Management needs to watch and act on these dates as part of it on-going portfolio management process.

J