EMC-Dell merger provides arbitrage opportunities

Summary

Trading EMC’s merger with Dell provides arbitrage opportunities – a decent upside potential with limited downside risk.

The opportunity arises because the market is significantly mispricing the VMware Tracking Share portion of the consideration Dell is paying. I believe that the significant discount on the VMW Tracking Shares implied at current price will narrow once the merger closes.

There are a number of strategies one can adopt to trade this opportunity. I have explored 3 in this blog – going long EMC Corp, buying EMC calls, and a combination of buying EMC calls and selling OTM VMW calls. Each strategy offers different risk-reward.

As with any investment, there are downsides. I believe three main downsides to this trade: merger doesn’t close, VMW Tracking Share discount doesn’t narrow, and VMware shares experience significant volatility. The strategies discussed either mitigate the downside, or offer a decent enough reward for risk taken.

The deal

Dell, owned by Michael Dell (founder & CEO), MSD Partners and Silver Lake, is to acquire EMC Corporation, while maintaining VMware as a publicly-traded company. EMC Corp currently owns 81% of VMware, with the remaining 19% being publicly listed.

Under the terms of the deal, EMC shareholders will receive $24.05 per share in cash in addition to tracking stock linked to a portion of EMC’s economic interest in the VMware business. Broadly, the tracking shares will track 65% of EMC’s current 81% interest in VMware (i.e., equating to 53% direct economic interest in VMware). EMC shareholders are expected to receive approximately 0.111 VMW Tracking Shares for each EMC share held by them.

The transaction is expected to close in mid-2016 (expected between May and October 2016). Based on recent updates from EMC and Dell, the merger is on schedule and should close within the anticipated deadline.

Deal Structure

The below diagram shows the commercial deal structure post closing.

The key features of the VMware Tracking shares are:

-        -  they will be listed and freely traded (there will be 223m VMW Tracking shares compared to just 80m VMware shares currently traded; this should offer a liquid market for the VMW Tracking shares);

-        - they will track Denali’s 53% economic interest in VMware (Denali is the parent of Dell which will acquire EMC Corp);

-         - Denali will have the ability attribute other assets of equal value in exchange for the VMware shares tracked (subject to authorization by an independent committee which will take care of the interests of the VMware Tracking shareholders;

-        - VMware Tracking Shares will have no voting rights in VMware;

-        - VMware Tracking Shares will be exposed to credit risk of Denali (i.e., if Dell / Denali goes kaput, the Tracking Shares go kaput); and,

-        - Denali will retain the right to redeem and/or buy-out the VMware Tracking Shares or convert them to Denali or a Denali sub common.

The mispricing

Based on the most recent share price for VMware’s publicly listed shares, the market value for the 0.111 VMW Tracking Shares which will be issued as part consideration equates to $5.75. However, based on EMC Corp’s most recent share price, market’s implied value for the 0.111 VMW Tracking Shares is just $2.72. The market is pricing the VMW Tracking Shares at a ~53% discount when compared to VMware’s publicly listed shares as the following tables show. 

In my opinion the market is significantly undervaluing the VMW Tracking Shares. Once the merger closes and these shares get listed, the discount should narrow to a more meaningful range of 10% - 20%. Although the VMware Tracking shares don’t offer voting rights or a direct right to VMware’s assets and liabilities, they economically track VMware. In addition, the independent committee provides sufficient safeguard’s from Denali’s being able to strip value from the tracking shares. Furthermore, the VMW Tracking Shares should offer a liquid market to trade VMware – currently there are ~80m publicly traded shares of VMware; Denali will issue ~223m VMW Tracking Shares, creating significant liquidity. Taking account of all these factors, I believe that the VMW Tracking Shares will trade at a 10% - 20% discount to VMware’s listed shares.

Trading strategies

Strategy 1 – Go long EMC Corp

An easy way to trade this situation is by buying EMC Corp and holding till the merger closes in 4 – 7 months’ time. The VMW Tracking Shares will be listed at this point, and the discount on them should narrow. Using EMC Corp’s current share price, and assuming that the publicly listed VMware shares trade at current price levels and the VMW Tracking Share discount narrows to 10% of VMware’s listed shares, this strategy should generate a 9.2% return (see table below).

However, the above is a simplistic scenario and doesn’t capture the impact of volatility in VMware’s publicly listed shares (which will impact the value of the VMW Tracking shares) and the extent to which the discount narrow’s on the VMW Tracking Shares. The below table captures the returns under different scenarios and is a more realistic view of possible outcomes.

As can be seen from the above, all scenarios generate a positive return bar where VMware shares fall by 50% from current levels. Fall in VMware shares of less than 50% from current levels should generate positive returns as long as the discount on the VMW Tracking Shares narrows to 20% or less. Furthermore, any increase in VMware shares increases also has a positive impact on returns.

Strategy 1 is a safe and easy way to trade this situation if you believe that the VMW Tracking Share discount should narrow to 10% - 20% level. The returns may not look great, but this is a clearly defined situation with a short holding period of ~ 4 – 7 months (or max 1 year if one wants to give the listed VMW Tracking Shares some time).   

Strategy 2 – Buy EMC Corp Call

The July 16 EMC Corp Call option with $24 strike is available for a premium of $3.2. Buying this call could generate a 64% return assuming VMware shares trade at current levels and the VMW Tracking Share discount narrows to 10%.

The below table shows the returns for a selected menu of EMC Corp Call options (I have used July 16 and Oct 16 expiring options & strike prices ranging from $24 to $26). As can be noted, longer duration increases the option premium and reduces the return; similarly, higher strike price increases the cost and reduces the return. The best option seems to be the July 16 option with $24 strike price. 

The above table doesn’t fully capture the impact of volatility in VMware shares and VMW Tracking Share discount. The below table shows the available returns under a number of scenarios and offers a more realistic picture. I have used the July 16 call option at $24 strike price as the basis.

As can be seen from the above table, all scenarios generate a positive return bar where VMware shares fall by 50% from current values. Furthermore, the returns generated are significantly higher compared to Strategy 1 – for example the above strategy returns 64% compared to 9.2% returned by Strategy 1 for the base case scenario where VMware shares trade at current levels and the VMW Tracking Share discount narrows to 10%. However, it is also worth noting the higher risk being assumed under this strategy for where VMware shares fall by 50% from current levels.

The gearing offered by the option clearly juices up the returns, but also exposes one to higher downside risks if VMware tanks significantly. But it is worth noting that VMware shares have fallen by 37.09% over the last 12 months, and have just rebounded from 1 year low of $43.25, currently trading at $51.8. The median price target of 26 brokers covering VMware is $60, with a low target of $40. The probability of VMware falling by 50% from current levels in the next 4-7 months appear low.

Strategy 3 – Buy EMC Corp Call & sell VMware Call

This strategy is aimed at reducing the overall cash cost by selling Out Of The Money (OTM) calls over VMware shares. The premium earned by selling calls partially offset the cost of buying calls of EMC Corp, and increase the overall returns. The EMC Corp Call used for this Strategy is the same as the one shown in Strategy 2 above (July 16 expiry with a $24 strike). As for the VMware calls that can be sold, a number are available – depending on how much OTM one would like the call to be. The more OTM the call, the less the premium earned and lower the overall return; but on the other hand, way OTM calls protect the downside if VMware shares were to go up.

Below is a table showing the available returns for a selection of VMware calls sold in combination with buying EMC Corp July 16 call at $24 strike (again assuming VMware shares trade at current levels and the VMware Tracking Share discount narrows to 10%).

The below 3 tables show the available returns for each of the VMware call option listed above taking account of the impact of volatility in VMware shares and VMW Tracking Share discount.

This strategy has the potential to significantly increase returns compared to Strategy 1 and Strategy 2 – for example, under Strategy 3a, the base case where VMware shares trade at current levels and the VMW Tracking Share discount narrows to 10%, the return generated is 1194%. But the potential downside under this strategy is way too high in my opinion. Furthermore, you can see from the above tables that the more OTM the sold VMware call is, the less the return, but better the downside protection VMware shares increase in value.

In conclusion, Strategy 1 is the easiest and most risk averse to implement but I believe that Strategy 2 – Buying EMC Corp call option – provides the best risk-reward outcome.

Other risks

As discussed upfront, there are three major risks to this thesis:

The Merger doesn’t close- I believe that the risk of this merger not closing is low. Based on recent updates from EMC and Dell, the merger is on schedule and should close within the anticipated deadline of between May and October 2016. The regulatory approvals are progressing smoothly, and it looks like the EMC Corp shareholders should vote in favour of this deal. Dell needs to raise $50 billion of finance to close the deal, and given Dell and its promoter’s track record, it doesn’t look like this will be an issue. It is worth noting that significant termination fee is payable by either party in case of termination (EMC will have to pay $2.5 billion if it terminates the deal, and Dell will have to pay anywhere between $4 billion and $6 billion if it terminates the deal).

VMW Tracking Share discount doesn’t narrow –I see no rationale behind the current 53% discount market is applying to VMW Tracking Shares. As noted earlier, there is no doubt that the VMW Tracking Shares should trade at a discount to VMware’s publicly listed shares, but this discount should be in the region of 10% - 20% instead of the current 53%. Once the merger closes and the VMW Tracking shares are listed, they should clawback the discount.

VMware publicly listed shares experience significant volatility – Significant volatility (in particular fall) in VMware shares will lead to a fall in VMW Tracking shares. VMware shares are down 37% over 12 months, and have been clawing up from their 12 month low of $43, currently trading a $51 - $52. Both Strategy 1 and Strategy 2 generate positive returns under all scenarios excepting where VMware shares fall by 50% from current levels. Strategy 3 – being the high risk strategy – is exposed to higher downside risks if VMware shares increase or decrease in value significantly (depending on which VMware call option is sold). But overall the less risky strategies (Strategy 1 and Strategy 1) are naturally hedged against significant volatility in VMware shares. I also see less likelihood of VMware shares falling by more than 50% from current levels.

Afterword

I am sure there are many more creative ways of trading this special situation. For instance, Strategy 1 could be combined with selling VMware OTM calls. This should reduce the cost of that strategy and increase returns – for example, roughly 1 VMware OTM call could be sold for every 9 EMC Corp share purchased (roughly 9 EMC Corp share equate to 1 VMW Tracking Share). Such a strategy provides a natural hedge to the sold OTM VMware call (VMW Tracking Shares will also increase in value if OTM VMware calls turn In The Money).