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Why EMC May Soon Buy Out -- Not Spin Out -- VMware

With the clock ticking on a standstill agreement with an activist hedge fund, the storage giant seems determined to keep the software part of its federation.

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With about a month remaining in an agreement between it and an activist hedge fund, the storage and IT giant EMC may be getting close to shaking up its unusual corporate structure, including potentially buying the portion of software company VMware it doesn’t already own.

EMC has been pressured by Elliott Management, a hedge fund controlled by the billionaire Paul Singer that has a history of using its ownership positions to push companies for changes, to break up. Last fall it argued in an open letter to shareholders that EMC should spin out VMware — of which it owns a stake amounting to about 80 percent — as a way of boosting the overall value of the two companies. It’s an idea that EMC has resisted.

Instead it may prefer another option: A “spin-in” of VMware. CEO Joe Tucci has not only resisted Elliott’s suggestions but argued that EMC and VMware are better together than apart.

Last month on an earnings call, Tucci said EMC plans to cut about $850 million in annual operating costs by the end of 2017, starting with $50 million later this year and as much as $175 million by the end of fiscal 2016.

And in response to a question from an analyst on a conference call last month, Tucci speculated that EMC might save as much as $1 billion a year depending on how “tightly aligned” it gets with VMware. Many took that as a hint that EMC’s board is studying a spin-in.

It makes sense for a variety of reasons. As Elliott Management has pointed out as VMware has grown, its business in some places overlaps and even competes with that of its parent. Tucci has defended this “no seams” approach, saying it prevents would-be competitors from squeezing through openings.

But it also means that both companies have to bear the burden of their own operating costs. Amit Daryanani, an analyst with RBC Capital Markets, estimated in a research note to clients last week that combining EMC and VMware into one company would reduce their combined operating costs by nearly $950 million next year — which, when combined with the $175 million in savings on the table for next year, would exceed the billion dollars Tucci hopes to eventually save.

The combination would also give EMC the full benefit of VMware’s earnings, meaning it would no longer have to reduce the amount it reports every quarter to account for the stake. Daryanani pegged the benefit to EMC’s earnings at between 40 cents and 50 cents per share.

A spin-in would also bring to an end one of the more unusual operational structures among large tech companies. CEO since 2001, Tucci has assembled his “federation” of companies mostly through a series of acquisitions. Other parts of the federation include the security company RSA and Pivotal, a big data software company in which GE is an investor.

EMC acquired VMware, which specializes in software that allows one computer to act like many — a technique known as virtualization — in 2003 for about $625 million. In 2007 EMC sold about 15 percent of VMware’s shares in an IPO that valued it at about $19 billion. (Cisco Systems owns a little less than 5 percent.)

As companies began to move their computing systems to the cloud, VMware’s virtualization technology emerged as an important tool for squeezing a lot of computing work from a single machine. VMware competes heavily with Microsoft in the virtualization software business, but still has a share amounting to about 50 percent. Today VMware is worth about $37 billion and accounts for about 75 percent of EMC’s $51 billion valuation.

Daryanani estimates that it will cost EMC about $9 billion to assume complete control of VMware. EMC has about $7.8 billion in cash and short-term investments on its balance sheet, including about $2.5 billion that is held in U.S.-domiciled accounts. He reckons EMC would combine about $1.9 billion of that U.S. cash with about $7 billion and change in new debt to get a buyout done. VMware has about $7 billion in cash on its own balance sheet, which EMC would absorb, limiting the damage to its own balance sheet.

Meanwhile Tucci is expected to retire soon, having blown past more than a few soft deadlines, and may be looking for some kind of transaction as a “grand exit.” His successor hasn’t been named, but the odds-on favorite is former CFO David Goulden, who was named CEO of EMC’s $24 billion (2014 sales) information infrastructure unit last year.

The company has already explored selling itself first to Hewlett-Packard and then to Cisco Systems. Oracle, another plausible suitor, has signaled that it’s not interested either.

He has also hinted that EMC might buy a company. Networking equipment company Brocade saw its share price rise earlier this year on speculation that EMC might make a bid, but a deal has not materialized. Other potential targets include Arista Networks, Juniper Networks and storage rival NetApp.

And what of the option that Elliott first suggested, that of spinning VMware out? That seems less likely, because EMC would emerge weaker than before. Daryanani says an EMC-minus-VMware scenario leaves the parent with a value of about $11 a share, or less than half what it’s trading for now. Tucci has said repeatedly that he thinks EMC and VMware are “better together.” He may be getting ready to prove just how strongly be believes it.

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