Dell and VMware Debt: Should Dell Have Been More Aggressive?

Dell's VMware Spin-off: A Detailed Examination

Yesterday’s announcement regarding Dell’s decision to spin off VMware wasn’t unexpected, as industry discussions had been ongoing for a while. However, despite the anticipation, Dell had several potential strategies for this separation, ultimately choosing to establish VMware as an independent entity with a constituent dividend rather than a complete sale.

The Financial Implications of the Dividend

This dividend approach, valued between $11.5 billion and $12 billion, offers a significant benefit: potential tax exemption, pending approval from the IRS. For Dell, holding an 81% stake in VMware, this translates to approximately $9.3 billion to $9.7 billion in cash.

The generated capital is earmarked for debt reduction, specifically addressing the substantial financial obligations incurred from the $58 billion acquisition of EMC in 2016. This move is intended to strengthen Dell’s financial position.

VMware's Strategic Importance

VMware represented a key asset within the EMC acquisition, providing Dell with essential access to the cloud computing market. Prior to this deal, Dell lacked a strong presence in this rapidly growing sector.

VMware pioneered the concept of the virtual machine, a foundational technology that directly enabled the evolution of modern cloud computing. The company’s scope has since broadened considerably, establishing a firm position for Dell within the realm of cloud-native computing.

Maintaining Alignment Post-Spin-off

Dell aims to achieve a dual benefit through this transaction: substantial cash infusion for debt repayment and a continuing collaborative relationship with VMware. A five-year commercial agreement is in place to ensure ongoing alignment between the two companies.

Furthermore, Michael Dell will continue as chairman of the VMware board, a factor expected to facilitate a smooth transition and maintain a strong working relationship following the spin-off.

Potential for Increased Value?

A key question remains: could Dell have secured a higher financial return from this separation? The chosen path prioritizes long-term strategic alignment alongside immediate financial relief.

Here's a summary of the key benefits:

• Significant cash generation for debt reduction.
• Tax-advantaged dividend distribution.
• Continued strategic partnership with VMware.
• Ongoing leadership from Michael Dell.

A Mutually Beneficial Outcome

According to Patrick Moorhead, principal analyst at Moor Insights and Strategies, the transaction extends beyond mere financial gain, offering a pathway for continued collaboration between the two organizations with minimal operational disturbance.

Moorhead explained that the separation is primarily intended to enhance the stock valuation of both Dell and VMware, without negatively affecting customers, Independent Software Vendors (ISVs), or channel partners.

He asserted that the market had not been adequately recognizing the combined value of the two companies, a situation he anticipates will improve with their independent operation.

The arrangement also facilitates a sustained close business alignment between Dell and VMware. A five-year strategic agreement ensures operational continuity, suggesting limited immediate changes.

Furthermore, Moorhead suggests the altered optics may permit Dell Technologies to forge stronger partnerships with VMware’s competitors, and conversely, allow VMware to collaborate more freely with Dell’s rivals, though such collaborations were already occurring.

While VMware’s integration within Dell proved advantageous for Dell, Moorhead highlighted a reciprocal benefit often overlooked. “Dell was instrumental in driving a significant portion of VMware’s recent expansion, and VMware, naturally, provided benefits to Dell as its primary partner for new ventures,” he conveyed to TechCrunch.

Debt Transfer to VMware

Dell opted for a strategic approach to debt reduction, choosing a spin-off rather than a direct stock sale, likely to minimize tax implications. This planned maneuver is projected to lower the company’s net debt to adjusted EBITDA ratio from approximately 2.0x to 1.6x. While this signifies progress, it highlights the substantial financial commitments Dell will continue to manage.

The company intends to utilize dividends received from VMware to address its core and margin debts. Notably, debts associated with Dell Financial Services (DFS) will remain unaffected. From a broader perspective, this arrangement can be characterized as a transfer of debt; Dell’s overall debt will decrease through the spin-off, while VMware will assume additional financial obligations.

The necessity for VMware to incur debt stems from a lack of sufficient cash reserves to cover the special dividend payout without external financing. According to transaction details, the $11.5 billion to $12 billion distribution will be funded through a combination of $2.5-$3.5 billion in cash and newly acquired debt. Assuming the higher end of the payout range, VMware may need to secure approximately $8.5 billion in debt to finalize the transaction.

Is this a significant amount of debt for the company? The answer is nuanced. It represents a substantial expenditure, expected to consume two years of VMware’s free cash flow for debt reduction, as reported by the company. However, current economic conditions offer favorable borrowing rates, and VMware previously generated $4.4 billion in operating cash flow during its last fiscal year.

Considering alternative scenarios, a more substantial sale of Dell’s VMware stake could have yielded further debt reduction. However, this would have incurred a considerable tax penalty. Furthermore, large-scale stock sales could have negatively impacted VMware’s share price, making it an undesirable option.

The current plan allows Dell to reduce its debt, enhance its creditworthiness, avoid tax liabilities, and distribute 0.44 VMware shares to its shareholders for each share of Dell stock held. This outcome may represent a compromise that satisfies all parties involved, even if Dell’s balance sheet will still carry a significant debt load.

For Dell, the VMware deal potentially concludes a prolonged period of deliberation. It allows the company to retain control over the majority of its EMC acquisition while achieving a more streamlined balance sheet. With this phase completed and improved borrowing terms resulting from reduced leverage, Dell can potentially shift its focus from debt management to pursuing growth opportunities.