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Is VMWare Stock the Best Choice for VMWare Investors?

By Will Healy – Jun 30, 2020 at 7:44AM

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Stockholders can also own VMWare through Dell's 80.9% stake in the company.

Should it stay, or should it go? That is the question regarding VMWare (VMW 0.46%) that Dell Technologies (DELL 0.06%) will probably have to decide in the near future.

Dell acquired a majority stake in VMWare when it bought out VMWare's previous owner, EMC Corporation, in 2016. Since Dell was private at that time, many came to regard VMWare stock as a proxy for Dell.

However, a tax rule states that Dell and EMC must continuously operate together for five years to execute a tax-free spinoff. For this reason, such a move is unlikely before September 2021.

Moreover, this creates a problem for those who want to buy this one of these technology stocks: Should they buy VMWare, or are they better off owning Dell stock?

Secure data network and digital cloud computing image.

Image source: Getty Images

The case for VMWare stock

VMWare was a high-flyer in the days before the financial crisis. The company was an early innovator in virtual machines and data centers. Over time, the valuation fell as virtual machines became commoditized. Today, it trades at a forward P/E ratio of approximately 24.

Now VMWare has become a leader in private cloud software. Best of all, these clouds can interact with public clouds when needed, allowing customers to enjoy the best of both worlds.

Earnings grew by about 5.7% in the most recent quarter, while revenue increased by 12% year over year. This is an improvement over the previous quarter, which saw falling profits amid double-digit revenue growth.

Optimism over this growth took VMWare stock to an all-time high of $206.80 per share in the spring of 2019. Hence, the falling profits seem to have hurt VMWare stock temporarily. However, with the stock in the $150-per-share range, it could surge to new highs as customers take a greater interest in its private clouds.

VMW Chart

VMW data by YCharts

Why VMWare bulls should consider Dell stock

Despite the appeal of owning VMWare stock directly, investors also have some reasons to consider investing in the company through Dell stock.

Dell returned to the public markets in late 2018. Unfortunately for Dell investors, the stock has gained little net traction in its second stint as a public company. However, Dell is cheap. It trades at a forward P/E ratio of about 9.

DELL Chart

DELL data by YCharts

Admittedly, it is likely cheap because the business has become slow-growth and commoditized. A sudden increase in demand for PCs as more people work from home could help Dell stock in the short term. However, most of the company's growth comes from its VMWare subsidiary. This gives Dell some incentive to either try to buy out VMWare entirely or stay with the status quo.

Moreover, Dell holds billions in unlocked value tied to VMWare. Dell's market cap currently stands at around $38.8 billion. However, the market cap of VMWare stands at around $61.9 billion. This implies that Dell's 80.9% stake in VMWare is worth approximately $50 billion, over $11 billion more than Dell's market cap.

Consequently, Dell stock not only undervalues the VMWare stake, but it also does not assign a clear value to Dell's PC and data storage businesses. Hence, investors could see a bump in Dell if and when it spins off VMWare.

What should investors do?

Dell will probably not make a decision regarding VMWare until 2021. Still, its direction remains unclear. It could wholly absorb VMWare, sell its stake, or it could maintain the status quo.

Nonetheless, despite the potential for unlocked value with Dell, I would recommend that investors own VMWare. As mentioned before, VMWare holds the most potential for increased profits, and it offers that at a reasonable forward multiple.

Additionally, even if Dell wanted to buy out VMWare, it may struggle to find the funding. Dell carries a total debt load of approximately $57.3 billion. This is a crushing burden, considering that after subtracting liabilities from assets, Dell is only worth $3.24 billion.

Hence, Dell will probably devote some or all of the proceeds from a spinoff to paying down its debt. While that would make Dell solvent, investors will have a business with negligible revenue or profit growth. This makes the direct investment in VMWare the far more attractive option.

Will Healy has no position in any of the stocks mentioned. The Motley Fool recommends VMware. The Motley Fool has a disclosure policy.

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Stocks Mentioned

VMware, Inc. Stock Quote
VMware, Inc.
$108.20 (0.46%) $0.49
Dell Technologies Inc. Stock Quote
Dell Technologies Inc.
$34.72 (0.06%) $0.02

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