Shares of Dell Technologies (NYSE:DELL) and VMWare (NYSE:VMW) rocketed higher last week, after Dell management confirmed it would in fact be spinning off its 80.6% stake in VMWare later this year. This move has been telegraphed since last summer, but the confirmation -- as well as more detail on the terms of the spinoff -- boosted shares of both stocks.
Dell has been faced with a pesky conglomerate discount, so separating the two companies will force investors to assess each separately. Since core Dell and VMWare are likely worth much more separately than they were being valued together, the spin should create substantial value for shareholders.
Yet despite last week's 10% surge over Thursday and Friday, as well as Dell's 38% return year to date, it appears the stock could run even higher.
The spinoff will probably occur after September, pending confirmation from the IRS. September would mark the five-year anniversary of Dell's 2016 acquisition of EMC, so the spinoff would become tax-free at that point. Dell and VMware will still collaborate on certain go-to-market offerings together, as they did when Dell owned a majority of VMware, but that will now be done through a commercial agreement.
An important part of the deal, VMware will pay a gigantic $11.5 billion to $12 billion special dividend to all shareholders, meaning Dell will take in anywhere from $9.3 billion to $9.7 billion based on its ownership stake. VMWare is a relatively stable and profitable software growth stock, so it shouldn't have too much trouble handling the debt load. Last year, VMWare made about $3.6 billion in operating income.
That money will go a long way toward paying down Dell's massive debt load, which has been a concern for investors. Even when stripping out Dell Financial Services debt (which helps underwrite customer financing for Dell's products), Dell still had $29 billion in other debt, which currently trades below investment-grade ratings. However, post-spin, Dell will have just $17 billion to $17.5 billion in debt, which is much more manageable. Ratings agency Fitch has stated it anticipates upgrading Dell to an investment grade rating after the spinoff.
Even after the spin surge, Dell still looks cheap
Even though VMware will be saddled with debt, its stock rose on the news, likely due to the clarity the spinoff presents. As of now, VMware currently has a market capitalization of $68.75 billion. With Dell owning 80.6% of that, its VMware stake would theoretically be worth $55.41 billion. Today, Dell is trading at a total market cap of $77.35 billion, meaning the non-VMware portion of Dell is currently valued at $21.9 billion.
The non-VMware parts of Dell -- consisting mainly of enterprise servers and consumer desktops and laptops -- made over $7 billion in adjusted (non-GAAP) operating earnings each of the past two years.
So, even after the announcement and the stock's increase, "core" Dell is trading just over three times operating earnings. That's pretty cheap, especially since Dell will have a much lower debt burden post-spin. By comparison, rival Hewlett Packard Enterprise (NYSE:HPE) trades for about 10 times its non-GAAP operating earnings. If Dell were to trade closer to HP's multiple of operating earnings, its stock would trade over 50% higher.
I don't see why Dell should trade at that big of a discount, especially since last year's pandmic-inspired boom in laptop sales appears to be sustaining its strength into 2021. As such, I still don't think it's too late to buy into Dell's spinoff story, even at these higher levels.