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EMC Considers a Buyout by Its Own Subsidiary VMware

EMC's board is considering its options, including a stock-swap deal under which VMware would acquire its parent.

possohh / Shutterstock

Data storage and IT giant EMC is contemplating a deal under which it would be acquired by VMware, the software company in which it is a majority owner, according to sources briefed on the discussions.

That is one of several options EMC’s board is exploring as part of a wide-ranging strategic review of its operations and as a partial response to pressure from an activist shareholder. Over the last several months it has explored selling the company to both Hewlett-Packard and Cisco Systems, as well as acquiring other companies and selling off assets. Pressure has also increased for CEO Joe Tucci, 68, to get the company on a solid footing before he names a successor and retires.

The discussion to have VMware buy out its parent company comes after Re/code outlined the possibility that EMC could buy out its remaining stake in VMware as part of a more conventional deal. VMware’s shares jumped nearly 3 percent Tuesday after the story. EMC currently owns 80 percent of VMware.

EMC board directors are now looking at a second scenario in which VMware would effectively buy out its parent EMC in a transaction known as a downstream merger. In this instance, VMware would issue new shares in exchange for EMC shares in combination with cash raised from the issuance of new debt.

EMC shares rose by more than 3 percent to $26.85 in trading on the New York Stock Exchange Wednesday. VMware shares fell by $4.82 or more than 5 percent to $86.12.

 Shares of EMC rose and VMware shares fell in trading on the New York Stock Exchange today.
Shares of EMC rose and VMware shares fell in trading on the New York Stock Exchange today.
Via Google Finance

The move to have VMware buy out EMC is being supported by activist fund Elliott Management, according to sources. Elliott, led by billionaire Paul Singer, had a hand in installing two new EMC board members earlier this year and owns a little more than 2 percent of EMC’s shares. Previously, the firm 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.

Elliott has lately signaled to EMC’s board that it would oppose a move by EMC to buy out the remaining 20 percent of VMware that it doesn’t already own, according to sources. It’s unclear which way EMC’s board is leaning for the moment. A standstill agreement under which Elliott has agreed not to pressure EMC publicly expires next month. Spokespeople for EMC, VMware and Elliott Management all declined to comment.

Specific terms of the downstream merger deal proposed — including prices and potential premiums — could not be learned, and sources stressed that no agreement has been reached and a deal may not ultimately materialize.

However, the rough outline of the deal under consideration by EMC’s board would work like this, according to sources:

VMware would issue somewhere between $50 billion and $55 billion worth of new shares. A portion of those shares — about $30 billion — would be used to cancel EMC’s 80 percent stake in VMware, which currently has a market value of $38.5 billion. The remaining new VMware shares would be issued to current EMC shareholders, who will also get some cash generated from the issuance of about $10 billion in new debt. EMC shares closed Tuesday at $26.01, valuing the company at about $50 billion.

The downstream merger arguably makes better financial sense, because VMware’s shares currently trade at a higher valuation relative to earnings than EMC’s shares. EMC shares are trading at about 12 times estimated 2016 earnings, while VMware shares are trading at more than 20 times forward earnings. It’s unclear what the management structure of the new company would be or who would be its CEO.

 David Goulden, Pat Gelsinger, Paul Maritz and Joe Tucci (left to right) at an EMC event in 2014
David Goulden, Pat Gelsinger, Paul Maritz and Joe Tucci (left to right) at an EMC event in 2014
drserg /Shutterstock

If EMC decides to combine with VMware in some way, the process would be driven by EMC’s board. While VMware has 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 80.6 percent of VMware’s common stock and has more than 97 percent voting control over VMware’s common stock.

Once combined, the companies would likely save on operational 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 as much as $946 million in 2016. EMC pledged last month to cut as much as $850 million in annual operating costs by the end of 2017.

Downstream mergers are rare. In one notable example, hard drive maker Seagate used the technique in a complex three-way transaction with Veritas Software and the private equity firm Silver Lake in the late 1990s. (As part of that deal, Seagate briefly went private, but returned to public markets with an IPO in 2002.)

EMC acquired VMware in 2003, paying $625 million for the startup whose software is used to make one computer act like many, a technique called virtualization. Four years later, EMC sold about 15 percent of VMware’s shares in an IPO that valued it at about $19 billion, and retained most of the rest. (Cisco Systems owns a little less than 5 percent.) Today VMware is worth about $37 billion and accounts for about 75 percent of EMC’s valuation.

The arrangement has led to an unusual corporate structure that EMC calls a “federation.” Tucci has said the structure allows both companies to jointly approach customers and compete fiercely against shared rivals. EMC’s core business is selling data storage systems to large companies. Other companies in the federation include Pivotal, a big data and analytics software startup it launched in 2013 with an investment from GE. It also includes RSA, a computer security company EMC acquired in 2006.

VMware’s software has emerged as one of the fundamental technologies that companies use in their data centers especially as they shift their computing operations to the cloud, and has recently branched into cloud services and storage hardware that arguably competes against some EMC products.

“VMware has become one of the key companies that provide the glue that holds a data center together,” said Pat Moorhead, head of the research firm Moor Insights and Strategy. “If you’re building data centers, VMware has to be part of the conversation.” VMware ended 2014 with more than $6 billion in revenue, up 16 percent from the prior year.

EMC’s core data storage business has been under pressure in recent years, as new storage technologies based on flash memory have emerged and challenged its dominance and sales of conventional hard-disk-based storage systems have leveled off. The business posted $16.5 billion in sales, up 2 percent from the prior year. It has acquired flash storage companies like XtremIO in recent years and has recently become more aggressive in that relatively new portion of the storage business, challenging upstarts like Pure Storage.

Tucci’s successor hasn’t been named, and contenders include both David Goulden, CEO of EMC’s $24 billion (2014 sales) information infrastructure unit and Patrick Gelsinger, a former Intel executive who is VMware’s CEO.

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