Financial market greed putting EMC and Dell deal at risk?
- Summary:
- If Dell is faced with a high premium for the level of debt it needs to acquire EMC then the deal could end up being scuttled. Much now depends on Dell's response.
The Wall Street Journal is reporting an alarming development in Dell's proposed acquisition of EMC. This from Kurt Marko on Twitter:
Financial engineering for the $EMC deal is getting ugly. Ouch. #DellEMC https://t.co/iL02u9DpX4 pic.twitter.com/RmlZt817Rp
— Kurt Marko (@krmarko) April 22, 2016
For those unfamiliar with the deal, Dell is in the process of reinventing itself behind the curtain of its private status. Part of that strategy includes the acquisition of EMC. Back in October 2015 when the deal was first mooted, we were not overly concerned although we saw plenty of risk. Others were more forthright. Peter Cohan at Forbes said:
Sadly the $67 billion acquisition of EMC EMC +0.78% that Dell proposed on October 12 fails both the profit potential and competitive advantage tests. Its focus on commodity hardware dooms it to make very little profit. They sell to enterprises that are shifting much of their work to the cloud and thus will purchase less of this hardware at the lowest possible price with no vendor loyalty.
The storage hardware industry in which EMC plays is huge — IDC predicted that enterprises would spend over $40 billion on storage hardware in 2015.
The problem is that the profits from that business are falling because the high price and high cost of owning disk drives — the way EMC makes most of its money — create a price umbrella under which aggressive new entrants can cut price to gain market share.
The new entrants offer a variety of technical solutions including companies like Pure Storage with its all-flash arrays — a market in which EMC’s XtremIO holds the lead, according to Gartner – and Nimble Storage — which offers hybrids of flash and traditional disk storage.
While Cohan's view is rather narrow, it isn't outrageous. But it gets worse. EMC recently announced its Q1 results (webcast transcript) and reported a Y-oY decline in revenue of 2.5% although it managed to improve operating income by 8%. That would run counter to Cohan's argument although you have to remember that EMC's results were buoyed by good performances from what it can account for from its Pivotal and VMWare holdings.
Trefis currently estimates EMCs equity worth at $51.7 billion based upon estimated annual EBITDA of $7.7 billion. Dell has said that it anticipates significant synergies - for which read cost savings - coming from the combined group but those would have to be VERY substantial to justify what is now a 29.5% premium on Trefis valuation. You can argue that the level of EBITDA is OK, even if Dell ends up paying the equivalent of $900 million in interest on those junk bonds.
But then the claimed rate is what Eric Wright described as in 'pay day loan' territory. It is hard to disagree with that assessment. As we know, those kinds of rate are only applied where the bond/loan issuer sees significant risk in the deal. One has to assume that the bond holders have access to much more information than is in the public domain. If bond folks see it that way then what does Dell do next?
It is too early to tell but make no mistake, this latest twist puts an already complex deal at risk. It also provides competitors with the perfect gift of creating uncertainty for what must be a due diligence nightmare for anyone wishing to specify EMC. If that sounds harsh then you only have to look at how quickly technology markets are changing and then set that against the drumbeat of recent reported misses by SAP, IBM and Microsoft, three companies that all face challenges but nothing on the scale of EMC/Dell.
I normally reserve due diligence questions for young upstarts and those without a proven market track record. EMC has just been added to that list. But before closing let's also be clear. The WSJ article is speculative. There has been no direct confirmation by Dell that it faces the kinds of rate that give cause for current concern.