EMC Corporation (NYSE: EMC) develops, supports and packages information technology into a delivered service. Its clients include large corporations and governments, as well as small businesses and individual consumers. EMC has three main components to its business: Pivotal, a provider of application and infrastructure software that develops applications and platform-as-a-service solutions; EMC Information Infrastructure, which provides information storage options; and VMware Virtual Infrastructure, which manages the infrastructure of information storage as it pertains to cloud-based and remote solutions. In the case of Pivotal and VMware, EMC is actually the majority owner.
On Oct. 12, 2015, Dell announced it would acquire EMC for $67 billion, or $33.15 per share, in a deal that combines cash and stock. On Oct. 9, 2015, EMC closed trading at $27.86 per share, so the deal price represented an almost 19% premium. The day the deal was announced, EMC rose to a day high of $28.77, and then started to decline. By Nov. 18, 2015, the company’s share price went as low as $24.93 before settling in the low $25 range. Investors buying in at $25.50 would make a return of roughly 30% on their investments when the Dell deal goes through, but there are several risks of investing in EMC stock as of December 2015.
Understanding the Effect of M&A on Share Price
When a mergers and acquisitions (M&A) deal is announced, the share price of the target company rarely rises to meet the offer the acquiring company makes, and there is good reason for this. The biggest reason is M&A deals are usually announced several months in advance. This gives the businesses in the deal the chance to talk to shareholders, obtain regulatory approval and raise whatever cash may be necessary for the deal to go through. It is a great deal of work, and M&A deals do not always go through. If that happens, the share price of the target company almost always goes down. It does not matter why the deal failed.
The difference between the target company’s share price and the acquiring company’s offer reflects this risk, which is often called a deal discount. The larger the deal discount, the more the market expects the deal to fail.
Dell’s Acquisition of EMC
Dell’s acquisition of EMC is expected to go through in the middle of 2016, but there is quite a bit that could happen between late 2015 and the middle of 2016. For one, EMC included a 60-day provision to allow it time to solicit higher offers. Even at its current level, this would be the second-largest merger between technology companies in history, second only to the deal AOL and Time Warner struck for $106 billion in 2000.
The deal is not a surprise. EMC and Dell were partners for nearly 10 years. Dell sold EMC storage components as an original equipment manufacturer (OEM). Dell brought in 8 to 9% of EMC’s annual revenue, while EMC contributed around half of Dell’s storage revenue. The deal ended when Dell tried to acquire its own storage vendors, Compellent and EqualLogic.
Dell, EMC and Debt
Dell’s acquisition of EMC is being financed by Silver Lake, the private equity firm that facilitated the purchase of Dell in 2013, as well as Dell CEO Michael Dell’s family office MSD Partners and a sovereign wealth fund out of Singapore called Temasek Holdings. Even still, Dell has to issue a relatively large amount of new debt. Michael Dell justified these costs by saying, “The revenue synergies here are three times larger than the cost synergies.” Elliott Management, a hedge fund company and 2.2% stockholder in EMC, issued a statement giving its support to the deal the day it was announced. However, keep in mind this merger means the combined Dell-EMC company will take on over $45 billion in debt, which is roughly the gross domestic product (GDP) of Lebanon. This could leave it exposed to interest rate risk, especially if the Fed raises its rates.
Price Weakness Is Not Always an Opportunity
While this price gap could be interpreted as an opportunity, as several analyst houses such as A.B. Bernstein are touting it, it could also be a disaster. EMC’s business is based on the movement of information and operations to the cloud, or something more mobile and shareable. The company’s strategy has always been to try and deliver the “best-of-breed” products available and focus on providing efficiency and interconnectivity through those vehicles. EMC distributes these offerings through direct sales and partners ranging from OEM companies to value-added resellers.
EMC has done well in this capacity, but there have been roadblocks. According to EMC’s annual report, the company identifies managing operations as a difficulty and specifies it faces a variety of pricing pressures. Dell might not be the best match. The company is already struggling to remain relevant despite acquisitions of companies such as Boomi, SecureWorks and SonicWALL. Dell is going to have to leverage EMC’s strong sales force and distribution networks to make a go of it, and there are a lot of uncertainties. EMC’s profit margin is less than 10%, and its earnings per share (EPS) have been weak, suggesting there is not much room for maneuvering.
The deal gives Dell control of EMC and VMware, which is a publicly traded company. EMC owns approximately 80% of VMware stock, and its shares give it 97% of the voting power. EMC is an attractive target on its own merit, but VMware is a big part of that. The original plan was for Dell to retain its majority stake in cloud service company Virtustream and combine that in a joint venture with VMware.
The market, however, seems less enthusiastic. On Oct. 9, 2015, the last trading day before the Dell-EMC deal was announced, VMware closed at $78.65. After the deal was announced, VMware sank to $69.75, and the stock has rarely topped $60 per share since the end of October. There are some real fears as to what Dell’s influence will have on VMware going forward. Already, pressures from investors have forced a new plan. According to Reuters on Nov. 24, 2015, instead of VMware absorbing Virtustream's costs, EMC would absorb the costs because of its majority stake. If investors do not get on board, Dell’s acquisition could be dead in the water.