Information technology giant VMware Inc. (VMW) has been making headlines over talks of a potential spin off from Dell Technologies, Inc. (DELL). Being one of the most profitable companies operating in the cloud computing sector and x86 architecture, VMW’s potential spin off has allowed the stock to gain 5.1% over the past nine months, and 4.8% over the past three months.

DELL had filed 13D/A with the SEC in July last year, disclosing that it was exploring options to spin off VMW in the near future. The company has retracted its statements several times since then, casting a shadow of doubt regarding the possibility of a spin-off. However, on January 14, DELL CEO Michael Dell announced that the company is on track to spin off its 80.6% stake in VMW after September this year.

Here’s what I think will shape VMW’s performance in the upcoming months:

DELL Spin-Off and Third-Party Partnerships

DELL had acquired an 81% stake in VMW through its acquisition of VMW’s parent company EMC in 2016, listing VMW as a tracking stock on NYSE. However, after a decision to go public in 2018, DELL entered into a reverse merger with VMW to buy back VMW’s tracking shares trading in the markets.

VMW’s strong momentum and low debt were some of the primary reasons causing the parent company DELL to evaluate a spin off. VMW enjoys higher investor confidence, as its market capitalization is slightly higher than DELL, despite DELL’s trailing 12-month revenue being 7.98 times VMW’s revenues. Moreover, DELL’s trailing 12-month total debt of $52.11 billion is 761.3% higher than VMW’s debt of $6.05 billion.

Thus, a spin off can help VMW reach its growth potential without having to account for its parent company’s surging debt and lower profitability. Investors have long wanted VMW to become an independent identity, as many institutional shareholders had voted against DELL’s buy back of VMW trading stocks. However, the deal finally went through in 2018 at hefty premiums.

Though DELL hasn’t announced anything concrete yet, the company is currently favoring a spin off. It is expected to take place after September 2021, as the joint entity needs to have existed for at least 5 years to be eligible for a tax-free spin-off deal, under GAAP accounting principles.

On February 3, VMW partnered with Lumen Technologies to expand the application base of edge computing technologies to be implemented in automated factories, telemedicine as well as smart city developments. Under the agreement, both the companies are expected to operate a joint innovation lab to work on developing and streamlining edge computing, remote working and cyber security technologies. This should allow VMW to expand its product and services portfolio with disruptive technology.

Value Investment

As a subsidiary of DELL, VMW’s shares are heavily affected by the former’s complex capital structure and high leverage, causing the stock to trade at a discount to its peers. VMW’s non-GAAP forward PEG of 1.23x is 41.1% lower than the industry average of 2.09x. Its non-GAAP forward P/E of 20.59x is 26.5% lower than the industry average of 28.01.

Also, the company’s forward Price/Cash flow and EV/EBIT ratios of 16.70 and 16.82 compare favorably with the respective industry averages.

The situation is expected to change if VMW is established as a separate entity, as the company’s operations and market valuation would no longer be dependent on the parent organization.

Price Target and Analyst Ratings Indicate Upside

Analysts expect VMW to hit $170.50 soon, indicating a potential upside of 17.5%. The stock has an average broker rating of 1.6, indicating favorable analyst sentiment. Out of 29 Wall Street Analysts that rated the stock, 7 rated it Strong Buy, and 9 rated it Buy.

POWR Ratings Show Promise

VMW has an overall rating of B, which equates to Buy in our proprietary POWR Ratings system. The POWR Ratings are calculated by taking into account 118 different factors with the weighting of each optimized to improve overall performance.

The stock has a grade of B for Value, Momentum and Quality. VMW has a trailing 12-month gross margin of 83.02%, 73.21% higher than the industry average of 47.95%. Its trailing 12-month net income margin and ROE of 13.76% and 22.24% are significantly higher than the respective industry averages.

Moreover, VMW is currently trading above its 50-day and 200-day moving averages of $140.26 and $142.03, indicating solid short-term bullishness. So, the Momentum grade of B is justified here.

In the 60-stock Software – Business industry, VMW is currently ranked #5. In addition to the grades I’ve highlighted, you can check out VMW POWR Ratings for Growth, Stability and Sentiment here.

There are 18 other stocks in the Software – Services industry with an overall rating of A and B. Click here to see them.

Bottom Line

VMW is expected to reach its true potential following its spin-off from DELL. Its leading market position combined with recent partnerships should accelerate its revenues and earnings. VMW has been labelled as a leader in the cloud computing and IT industry by multiple research and advisory companies such as Gartner, Forrester, and IDC MarketScape over the past couple of months. It has also been named in the Dow Jones Sustainability Index on November 30, 2020. Thus, investing VMW ahead of the spin-off should allow investors to realize robust returns.  

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VMW shares were unchanged in after-hours trading Tuesday. Year-to-date, VMW has gained 2.09%, versus a 4.93% rise in the benchmark S&P 500 index during the same period.

About the Author: Aditi Ganguly

Aditi is an experienced content developer and financial writer who is passionate about helping investors understand the do’s and don'ts of investing. She has a keen interest in the stock market and has a fundamental approach when analyzing equities. More...

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