The Long and Short

Buy VMWare, sell Oracle

| 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

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