Michael Dell speaking at the 2019 WEF in Davos, Switzerland on Jan. 23rd, 2019.
Adam Galica | CNBC
The two tech companies are, once again, working with financial advisers to determine the future of their unusual entanglement. Dell, which owns 81% of VMware, plans to explore a variety of strategic options, including a tax-free spinoff of those shares to Dell shareholders in late 2021, according to people familiar with the matter. Dell prefers that route to selling its stake so that it can avoid a multibillion-dollar tax hit, said the people, who asked not to be named because the discussions are private.
The messy entanglement has infuriated many investors for years. Dell obtained its large stake in the virtualization software company through its acquisition of EMC for more than $60 billion in 2016. The rest of VMware has been owned by public shareholders since 2007, when EMC floated about 19% of the stock in an IPO.
Dell then returned to the public market in 2018 through a complicated reverse merger with a now defunct tracking stock that mirrored VMware’s performance within Dell. Its shares are since up 15% (thanks largely to Wednesday’s rally), trailing the S&P 500’s 25% gain.
VMware, meanwhile, is down over that stretch, even though it has stronger margins and higher growth than the Dell and EMC businesses. Dell’s computer and server products, along with the EMC storage unit, have been hurt by a broad shift in computing to the cloud and the ongoing U.S.-China trade war, which has increased the costs for hardware components.
“The Dell ownership structure has been an albatross around the VMware story and ultimately causes the stock to trade at a discount, a dynamic that would be removed if Dell (and its Board) ultimately decided to head down this (spin-off) path,” wrote Daniel Ives, an analyst at Wedbush Securities, in a note to clients.
A spinoff in September 2021 is the most logical move by Dell, said three people familiar with the matter. Talks are in their early stages and it’s possible that the parties decide not to pursue a transaction, the people said.
Large shareholder approval
Several of Dell’s largest shareholders, including private-equity firm Silver Lake and hedge fund Elliott Management (whose 5.9% ownership in Dell is passive) favor spinning out VMware in September 2021, given the tax efficiencies and simplification to the capital structure, the people said.
Spokespeople at Silver Lake, Elliott, Dell and VMware declined to comment.
One possibility if a spinoff takes place is that VMware could pay Dell a large special dividend by taking on added debt and helping Dell reduce its heavy debt load, two of the people said. A similar transaction occurred in 2018, when VMware agreed to pay Dell a special one-time dividend of $11 billion in conjunction with taking Dell public.
Dell currently has about $45 billion in net debt, while VMware’s debt sits at only $3 billion. S&P Global, Moody’s and Fitch all rate Dell’s corporate credit quality as below investment grade. Dell could achieve investment grade status if it moves forward with the spinoff and associated dividend, two of the people said.
For VMware investors, the appeal of a breakup lies in the opportunity to finally operate entirely outside of the Dell-EMC empire, where the business has been stuck for 17 years.
VMware has a market value of more than $62 billion, valuing Dell’s 81% stake at about $50 billion. Yet Dell’s market value is only about $38 billion, for a company that generates more than $92 billion in annual revenue. That means all of Dell, excluding VMware, is valued at negative $12 billion.
Given the strained relationship with China, Dell’s financial picture isn’t likely to improve anytime soon.
“From a margin perspective, I would tell you that, look, part of this is going to depend upon what happens with the component costs as we go through the year and what the pricing environment and demand environment looks like,” Dell CFO Tom Sweet said on the company’s first-quarter earnings conference call last month. “Right now, we see the component cost environment as inflationary as we step through the rest of the year.”
Dell CEO Michael Dell, left and VMware CEO Pat Gelsinger participate in a CEO roundtable discussion at the VMworld conference in San Francisco in 2012.
Kim Kulish | Corbis | Getty Images
While Dell has long coveted owning all of VMware, buying the remainder of the company is unlikely, four people said. The premium required to purchase the shares would most likely require Dell to take on even more debt. And keeping VMware’s stock independent is important to VMware employees, who want their equity incentives to be tied to a growth story.
Working in favor of an amicable outcome is the positive relationship between Michael Dell and VMware management, including CEO Pat Gelsinger, and their shared incentives — the Dell founder is the VMware’s chairman and top shareholder. While there were tensions between EMC and VMware regarding strategic direction, Dell has supported certain VMware decisions even if they present a challenge for his company. For example, he favored VMware’s partnership with Amazon Web Services, according to a person familiar with the matter.
In 2018, after CNBC’s Jon Fortt suggested on Twitter that Gelsinger would be a good replacement for Intel CEO Brian Krzanich, Gelsinger responded that he was happy running VMware. Michael Dell chimed in a half-hour later, expressing support for Gelsinger, with an animated plaque reading, “You’re the best.”
Still, there are significant cultural differences between the companies. VMware, headquartered in Palo Alto, California, has needed to pay top dollar for talent to compete with other cloud-computing companies, while Dell, based in Texas, has a reputation for paying low salaries, three people said.
Another person said that when Michael Dell toured VMware’s Silicon Valley for the first time after the EMC acquisition, he compared the facility to Disneyland for adults. Dell noted that was eventually going to change.
A clean separation of the companies could clean up cultural differences while keeping Michael Dell as its largest individual shareholder.
— CNBC’s Jordan Novet contributed to this report.