The saga of Dell Technologies Inc.'s strategic alternatives took a new twist Monday, Jan. 29, amid a report that the company might pursue a reverse-merger with VMware Inc. (VMW) - Get VMware, Inc. Class A Report . Last week, Dell was rumored to explore an IPO or an acquisition of the minority stake in VMware.
Shares of VMware dropped 16.5% to $125.05 on Monday following a report that it may acquire its parent through a reverse merger. The stock had gained nearly 9% on Friday amid speculation that the deal would work the other way around, with Dell buying VMware.
A reverse merger with VMware would allow privately held Dell to trade publicly without going through an IPO. The transaction could also help the company manage its large debt load as the tax code limits the amount of interest it can deduct. The companies did not immediately respond to queries about the CNBC report on Monday.
Dell is likely "floating a trial balloon," Patrick Moorhead of Moor Insights & Strategy said Monday.
"What is odd is why the company would be doing this now," Moorhead added. "Does an investor want to pull money out? Is it cheaper financing in the public equity markets?"
Dell owns nearly 82% of VMware, which is up more than 40% in the last 52 weeks despite Monday's drop. "With Dell Technologies owning the vast majority VMWare, I believe the mother ship wants to retire some debt and with the runup of VMWare value, this all makes sense," Moorhead said.
The parent company has a substantial debt load after a pair of large transactions. Michael Dell and Silver Lake took Dell private through a $24.9 billion LBO in 2013, and acquired VMware parent EMC Corp. for $67 billion in 2016. At the close of the third quarter, Dell had $52.5 billion in total debt including the balance sheets of subsidiaries such as VMware.
The Round Rock, Texas, company has sold off assets to reduce its leverage. The company divested Dell Services business to NTT Data Inc. for $3.05 billion in November 2016; Dell Software to private equity firm Francisco Partners Management LLC and activist hedge fund Elliott Management Corp. for $2.4 billion in November 2016; and its Enterprise Content Division to OpenText Corp. (OTEX) - Get Open Text Corporation Report in January 2017.
More than $8 billion of debt matures in the next two years.
Accessing VMWare's balance sheet could help. VMware generates $3.1 billion in free cash flow that Dell could tap, Credit Suisse analyst Brad Zelnick noted in a recent report. VMware has $7.6 billion in cash, net of debt.
Dell may have greater urgency to reduce its debt and interest since passage of the Tax Cuts and Jobs Act, Adam Holt of MoffettNathanson LLC noted in a Monday report. The bill limits deductions of interest expense to 30% of Ebitda. Dell's interest expense came to 55% of Ebitda in fiscal year 2016, and about 40% of Ebitda in the last quarter, Holt wrote.
Dell's board meets next month. Until then the speculation about Dell's deal scenarios will likely continue.
"What I can be certain of is that with Michael Dell involved it will likely make perfect financial sense," Moorhead said.
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