The Long and Short

Buy VMWare, sell Oracle

Meredith Contente | July 23, 2021

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

VMWare took a step closer in the last week to spinning out from Dell, a move set in motion back in April. The company issued $6 billion in new debt to fund part of a dividend to Dell that will set the company free. With VMWare likely to deleverage its balance sheet, the new bonds have good potential to tighten. In fact, selling Oracle debt to buy VMWare debt looks like a good trade.

VMW (Baa2(*-)/BBB-/BBB-(*+)) tapped the market in the last week to help fund its dividend to DELL as it gets ready to be spun out by fiscal the fourth quarter of 2021. The market had been anticipating the deal as the spin was announced back in April 2021. VMW issued $6 billion of debt across five tranches, in a deal that was well oversubscribed and ended up pricing on top of secondary spreads.

Surprisingly, VMW issued a few billion less than Amherst Pierpont anticipated as the company has a very strong cash balance of approximately $5.6 billion. It appears VMW is set to make its $11.5 billion to $12 billion dividend payment for its separation, and leverage is only likely to increase to roughly 3.0x post spin. While above 3.0x-3.5x is the ratings trigger for a downgrade from the ratings agencies, the agencies will give VMW roughly two years after the transaction to further delever. While new VMW bonds are trading approximately 5 bp through new issue level of 100 bp, there is potential for the credit to tighter further as leverage declines with VMW ultimately settling roughly 10 bp to15 bp through Oracle (ORCL – Baa2/BBB+(n)/BBB+(n)). ORCL has increased its debt load by nearly 50% over the past three years to fund shareholder rewards, pushing total and net leverage to 4.7x and 2.2x, respectively.

Exhibit 1. BBB technology 7Y-10Y curve

Source: Bloomberg TRACE; APS

Recurring revenue base supports free cash flow and debt reduction

VMW currently derives 25% of its revenue from the Subscription & SaaS (Software as a Service) business unit, which means that roughly one quarter of VMW’s revenues are recurring. This enabled VMW to post strong growth even through the pandemic as the company posted top line growth of 8.8% for fiscal 2020. This unit accounts for VMW’s different Cloud businesses as well as its Modern Applications Business and Workspace One solutions. The unit continues to post strong growth that has been outpacing other areas, which means the percentage of VMW’s recurring revenue base will continue to grow. In the most recent quarter, VMW witnessed year-over-year revenue growth of 29% in the Subscription & SaaS unit, which outpaced the rest of the business lines by more than 20 percentage points. Additionally, it helped to further expand the operating margin which witnessed a 90 bp increase year-over-year to 30.8% (Exhibit 2).

Exhibit 2. VMW Income Statement Highlights

Source: VMW Fiscal 1Q22 Earnings Presentation

A consistent revenue base and growing margin not only limits swings in free cash flow, but also provides for free cash flow growth, which is important for the company’s debt reduction plans. For fiscal 2021, note that VMW produced free cash flow of approximately $4.1 billion which was up 13.5% year-over-year. Currently the company plans to use the majority of annual free cash flow to repay debt post spin, which means that we can see debt issued to fund the dividend to DELL mostly repaid within 2 years.

Four out of five tranches contain SMR language

All of the tranches, with the exception of the 5-year tranche (maturing 8/15/26), contain Special Mandatory Redemption (SMR) language which requires the company to redeem the bonds at $101. According to the bond terms, If the closing of the spin has not occurred on or before the earlier of (i) (x) 4/28/22 or (y) if the Separation and Distribution Agreement is amended on or prior to 4/28/22 to extend the date by which the spin must be consummated to a date later than 4/28/22, the earlier of such extended date and 7/28/22, and (ii) the date the Separation and Distribution Agreement is terminated, the company will be required to redeem all outstanding 2023, 2024, 2028 and 2031 notes on the Special Mandatory Redemption Date. Given that the 5-year tranche is $1.5 billion in size, if the spin does not get consummated or is amended by the above dates, VMW will be required to redeem $4.5 billion of the $6.0 billion of debt issued.

Agencies chime In

Moody’s has noted that it expects to conclude its rating review once the spin and special dividend transactions are completed. The agency has indicated that it currently expects to downgrade VMW to ‘Baa3’. Moody’s noted that it expects VMW to generate $3.3 billion to $3.5 billion of free cash flow on an annual basis post spin for two years to three years. However, given that annualized cash flow is closer to $4.0 billion, this could mean that debt reduction could happen at a pace faster than expected, which could lead to upwards ratings migration. S&P noted that it expects leverage to reach close to 3.0x, but that subsequent debt reduction should bring leverage down roughly a half a turn by fiscal 2023 and closer to 2.0x by fiscal 2024. Fitch took a slightly different approach and plans to upgrade VMW to’ BBB’ despite credit metrics being more in line with low ‘BBB’ ratings as the agency expects debt reduction to bring leverage to below 2.5x by fiscal 2023.

Meredith Contente
meredith.contente@santander.us
1 (646) 776-7753

This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.

Important Disclaimers

Copyright © 2023 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.

In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.

The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.

In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.

Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.