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Board Takes Serious Look at VMware-Led Takeover of EMC

As EMC shares plummet, the company's board is warming to an unorthodox deal.

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The board of directors of Data storage and IT giant EMC is taking a second and closer look at a proposal under which it would be acquired by VMware, the software company of which it is a majority owner, according to people briefed on the discussions.

The transaction, known as a downstream merger, is gaining favor among board members after the China-induced market meltdown decimated the shares of U.S. tech companies, including EMC. The idea was first proposed by VMware CEO Patrick Gelsinger, sources said, and is actively being considered by EMC’s board. EMC currently owns about 80 percent of VMware. Re/code reported the news of the proposal earlier this month.

EMC’s share price has sunk more than 11 percent since last Friday, and closed Tuesday at $22.79. EMC fell further than the Dow Jones Industrial Average, which fell by 8 percent. During the same period, VMware shares have also declined by 6 percent and are considered to be “holding their own” amid the current turmoil in the market, sources said. Update: As of 7:55 am PT this morning, EMC shares had risen by more than 4 percent while VMware shares fell by 4 percent.

Via Google Finance

Additionally, board members have reached a consensus that CEO Joe Tucci must step down from that role before the end of the year. Tucci, 68, has put off several self-imposed deadlines to announce his retirement and name a successor, and is currently working without a contract.

Tucci is said to be opposed to the downstream merger, and favors a more conventional “spin-in” scenario under which EMC would buy out the remaining shares of VMware it doesn’t already own.

Pressure is building on EMC’s board to act as the Sept. 1 deadline approaches on the expiration of a standstill agreement between the company and Elliott Management, an activist hedge fund controlled by billionaire Paul Singer.

Elliott, which owns about 2 percent of EMC shares, has publicly pressured EMC to divest its stake in VMware, arguing that the investment has left the parent undervalued and has caused the two companies to compete. Tucci has remained steadfastly opposed to selling EMC’s stake in VMware.

The activist firm still favors a divestment of VMware by EMC, sources said, but has indicated to EMC’s board that it would support the proposed downstream merger.

Specific terms of the proposed transaction, including prices and potential premiums, have not been ironed out, and sources stressed that an agreement has not been reached and may not materialize.

However, under the proposal, VMware would issue about $50 billion worth of new shares, a portion of which would be exchanged for EMC shares. The remaining portion of the new VMware shares would be issued to EMC shareholders, who would also get some cash generated from the issuance of about $10 billion in new debt. EMC’s market valuation as of Tuesday’s close was $43.6 billion. VMware’s was $34.3 billion.

One argument in favor of the downstream merger is that VMware’s shares currently trade at a higher valuation relative to earnings than EMC’s shares. EMC shares are trading at about 11 times estimated 2016 earnings, while VMware shares are trading at about 18 times forward earnings.

Whatever kind of transaction the company settles on — whether EMC buys out VMware or vice versa — the process will have to be led by EMC’s board. While VMware enjoys a measure of independence as a publicly traded company in its own right, five of its nine directors, including Tucci, also sit on EMC’s board. As of March 31, regulatory filings show EMC owns more than 80 percent of VMware’s common stock and exercises control over more than 97 percent of its voting proxy.

EMC acquired VMware in 2003, paying $625 million for a startup whose software emerged as one of the driving forces in the revolution in cloud computing. VMware’s virtualization software allows one computer to act like many at once, allowing for greater efficiency and lower operational cost in data centers.

Four years after the acquisition, EMC sold about 15 percent of VMware’s shares in an IPO that valued it at about $19 billion, but retained a majority stake. Cisco Systems owns a little less than 5 percent of VMware.

Since then, cloud computing, along with new technologies like flash memory, have put pressure on EMC’s core business of selling data storage equipment to large companies. Its information infrastructure unit posted $16.5 billion in sales in 2014, up 2 percent from the prior year.

Spokespeople for EMC, VMware and Elliott Management all declined to comment.

Tucci’s successor hasn’t been named, but one of the contenders — David Goulden, the CEO of EMC’s information infrastructure unit — will be speaking at our Code Enterprise Series: New York event on Sept. 29. Registration is open, but tickets are going fast. You can find all the information you need right here.

This article originally appeared on Recode.net.