Though there are some differences between the situations as well, Dell's (DELL) reported mulling of a spinoff of its 81% VMware (VMW) stake reminds me a little of eBay's (EBAY) situation in 2015 before it spun off PayPal (PYPL) .
Just as the PayPal spinoff wound up benefiting eBay shareholders -- particularly the ones who held onto their PayPal shares, which are up over 300% since the spinoff -- there's a good chance that Dell shareholders will end up better off if they're given direct ownership of Dell's VMware stake. And just as the eBay spinoff helped open up new opportunities for PayPal, being spun off from Dell might do the same for VMware.
Dell's Hardware Businesses Currently Look Undervalued
Some basic math shows how a VMware spinoff is likely to be a positive for Dell shareholders, even if one assumes VMware's stock sees some post-spinoff selling pressure from Dell investors looking to unload their shares.
VMware currently sports a $62.6 billion market cap, a figure that implies Dell's stake is worth about $50.7 billion on paper. Meanwhile, after backing out the $1.2 billion in net cash VMware has on its balance sheet (and is also recorded on Dell's balance sheet, since it has a majority stake), Dell sports an enterprise value (EV - market cap plus net debt) of $83.9 billion.
As a result, on paper at least, the rest of Dell, including its giant PC, server and storage businesses, is only valued at around $33 billion. With Dell having generated $6.7 billion in free cash flow (FCF) in fiscal 2020 (it ended in January) and VMware responsible for $3.6 billion of this total, the rest of Dell is being valued at less than 11 times its trailing FCF. And before The Wall Street Journal reported that Dell was exploring a VMware spinoff, the multiple was closer to 10.
To be fair here, the rest of Dell probably doesn't deserve an especially high valuation, given the secular growth pressures faced by the PC and enterprise server/storage markets (i.e., slow PC upgrade rates, growing adoption of cloud infrastructure services). But the implied valuation for the rest of Dell on an EV/FCF is still below that of growth-challenged enterprise IT peers such as Hewlett-Packard Enterprise (HPE) and IBM (IBM) , even though Dell has been taking IT hardware share lately more than it has been losing it.
VMware Might Be a Little Undervalued Too
Should Dell pursue a VMware spinoff, the valuation given to the rest of Dell might rise to a more appropriate level by the time that the spinoff is complete. Also, it's possible that Wall Street will grant a higher valuation to a fully independent VMware than what it's granting to VMware as a Dell subsidiary.
VMware currently has an EV equal to 17 times its fiscal 2020 FCF, and 16 times its fiscal 2021 FCF consensus. While that's a richer valuation than what the rest of Dell effectively has right now, it's also comfortably below that of many enterprise software peers, even if one excludes the ones that have been bid up to sky-high valuations.
The secular pressures faced by VMware's core vSphere server virtualization business -- specifically, the adoption of cloud computing instances relying on non-VMware virtualization software, and the adoption of app containers in both cloud and on-premise environments -- undoubtedly has something to do with that valuation. But this is still a company that's delivering healthy (though not massive) sales and billings growth, aided by strong demand for offerings in fields such as remote desktop solutions, network and storage virtualization software, and solutions for deploying vSphere and other software on major public clouds.
So why else might VMware be trading at a discount to many of its peers? It might have something to do with concerns about how being owned by Dell can lead VMware to take actions that might not be in the interests of VMware shareholders, such as VMware's $2.7 billion 2019 deal to buy another Dell subsidiary (struggling Pivotal Software).
And there might also be concerns about how -- just as eBay's ownership of PayPal had made some of eBay's rivals wary of working with PayPal -- Dell's ownership of VMware might be limiting VMware's ability to form deeper partnerships with some of Dell's hardware rivals. VMware does have partnerships with the likes of HPE and IBM -- vSphere's immense popularity makes it hard for them not to partner with VMware -- but they also compete against it in multiple areas.
Should such concerns go away, markets might choose to give VMware a higher valuation.
There is one important difference between eBay/PayPal in 2015 and Dell/VMware today: Dell, unlike eBay, has a giant debt load that it's looking to reduce. As a result, it could try to raise cash by selling off a portion of its VMware stake, or by pursuing some other kind of financial transaction involving VMware, instead of merely carrying out a spinoff.
One other difference: eBay had a high-profile activist investor (Carl Icahn) pushing it to spin off PayPal. While Icahn does have a history with Dell as well, thus far there haven't been any reports of activists pushing for a Dell/VMware split.
But with that said, from the perspective of Dell shareholders, there do appear to be some strong arguments in favor of a VMware spinoff. And it's quite likely that both Dell's management and many Dell shareholders are well-aware of them.
