Analysts: Why An HP Acquisition Of EMC Would Work

Crunching The Numbers, Noting The Trends

There is a strong chance that Hewlett-Packard will acquire leading storage and cloud vendor EMC, according to a research report released this week by financial analysts Brian Alexander and Adam Trindle of financial powerhouse Raymond James.

Such a merger is now more likely than when it was first proposed last year, given activist pressure on EMC to sell all or part of itself by year's end at the same time that HP is splitting up into two separate companies, Hewlett-Packard Enterprise and HP Inc., according to the analysts.

The analysts wrote that they expect the deal to be announced before HP's securities analyst meeting, which will be held Sept. 15, with the deal perhaps closing after HP fully separates Nov. 1.

"We believe shareholders of both companies would earn substantial returns if a deal is consummated," the analysts wrote.

Turn the page for the financial and enterprise reasons why the analysts say such an acquisition could work.

So Why Didn't HP Buy EMC Last Year?

HP last fall was in talks with EMC about an acquisition, according to reports at the time. However, talks on the deal fell through.

The Raymond James analysts said the move to merge didn't work because EMC and HP archrival Cisco had a joint venture in VCE, and because an acquisition at the time when HP was considering a separation into two companies would have made that separation even more complex.

Since then, however, EMC acquired all but a 10 percent stake in VCE from Cisco. The analysts wrote that the roughly $700 million in sales from Cisco's portion of the VCE revenue could easily be replaced by HP equipment.

Turn the page for a look at why Raymond James thinks an HP deal to acquire EMC is a very strong possibility.

Hewlett-Packard Enterprise Needs A 'Value-Creating' Merger Or Acquisition

Hewlett-Packard's share prices have fallen about 17 percent since October, the analysts said, when HP announced it would split into two companies, and over the past 12 months, HP share prices have fell about 10 percent, while EMC's have remained flat.

That, the Raymond James analysts wrote, indicates that investors are skeptical about the move.

"We actually believe the split creates value for HP Inc. [HPI] shareholders given steady cash flow generation and the high expected return of cash, but the benefits to HP Enterprise [HPE] shareholders are less obvious absent value-creating M&A," the analysts wrote.

Meg Whitman's Legacy Is At Stake

The $2 billion-plus cost of splitting HP into two parts, HP's dropping of its fiscal year 2015 free cash flow outlook by 50 percent and other factors have caused HP's share prices to fall this year, the Raymond James analysts wrote.

"(HP) CEO Meg Whitman has done an admirable job stabilizing HP, but if the separation does not result in greater shareholder value, her legacy will be questioned. Buying EMC could dramatically change that perception," the analysts wrote.

Hewlett-Packard Enterprise Needs A Big Merger Or Acquisition

Raymond James analysts wrote that HP could pursue a "string of pearls" merger and acquisition approach to solve certain strategic needs. Under that approach, a company makes a number of small acquisitions hoping to add value at a relatively low cost.

However, the analysts wrote, the high price tags for emerging growth companies, which is now typically five times revenue, would make this a costly strategy for HP. HP also has a spotty record for integrating and retaining technology and people from acquired companies with strong intellectual property, they wrote.

"If HP acquired EMC (along with VMware and Pivotal), however, it would enhance its software assets across a number of key strategic priorities, including cloud, analytics, mobility, data center, converged infrastructure and security," they wrote.

Hewlett-Packard Enterprise Needs Software

Should HP acquire EMC, software would account for 32 percent of HP's operating income, as opposed to the current 17 percent, the analysts wrote.

That could have a big impact on HP's bottom line. HP in May reported that, for its second fiscal 2015 quarter, operating margin for its software group was 17.9 percent vs. 14.5 percent for its enterprise group. EMC in April reported overall operating margin of 12.7 percent for its core storage business, including hardware and software, but operating margin of 30.4 percent for its VMware business.

Raymond James' analysts wrote that HP's post-acquisition software revenue would reach $13.5 billion, up from about $4 billion before the acquisition.

Look At What Software HP Would Get

Raymond James' analysts wrote that, with the acquisition, HP would get a number of key software offerings from EMC, including:

* vCloud Air -- This is VMware's IaaS offering, and offers dedicated cloud, virtual-private cloud, and disaster recovery as a service.

* Virtustream -- Virtustream provides cloud software and services, and when EMC's $1.2 of Virtustream closes, it will form the base of EMC's managed cloud services business.

* Converged infrastructure and software-defined data center -- HP has its own converged infrastructure offering, but EMC's VCE and VSPEX are industry-leading. For hyper-converged infrastructure, EMC has VSPEX BLUE and VMware has EVO: Rail.

* Pivotal -- EMC's Pivotal would bring HP technology for big data analytics and tools for software development.

* VMware AirWatch -- This would give HP a leading enterprise mobility management and security offering.

Hewlett-Packard Enterprise Would Get A New Management Team

Raymond James expects HP would get EMC's management team, which the analysts wrote "would be integral to the transaction and ultimately lead the combined entity."

The analysts wrote that with Whitman looking for a possible exit strategy and EMC CEO Joe Tucci planning on retiring, the door would be open for Pat Gelsinger, VMware CEO, to take over as HP Enterprise CEO.

In addition, HP CFO Cathie Lesjak's recent decision to switch from becoming CFO of HP Inc. to becoming CFO of HP Enterprise, which might have been in preparation for an acquisition by HP Enterprise of EMC, opens other doors for EMC executives, the analysts wrote.

In particular, EMC CFO Zane Rowe, who led the integration of United Airlines and Continental Airlines, could take the HP Enterprise CFO position, while EMC Chief Operating Officer David Goulden, who previously served as EMC CFO, could take over as HP Enterprise COO.

Hewlett-Packard Enterprise Would See A Fast EPS Accretion

Raymond James estimated that, should HP acquire EMC for a price of $33 per share, or about 25 percent over current valuation, the company would enjoy an EPS accretion of about 50 percent. In other words, after the acquisition, HP's earnings per share would increase by about 50 percent, or $1.04 per share, versus pro forma EPS of $2.10 per share before the acquisition.

Part of this would come from $1 billion in "cost synergies," the analysts wrote.

Raymond James also estimated that pro forma financial leverage, or the ration of total debt to total assets, would be "manageable at 3x net debt/EBITDA" (earnings before interest, taxes, depreciation and amortization). That leverage would drop if HP then divested non-core assets including Documentum, the analysts wrote.

HP Enterprise Could Afford The Acquisition

Raymond James is assuming that, after the HP split, Hewlett-Packard Enterprise would end up with 5 percent of the total debt, or $558 million, while getting 95 percent of the total cash, or $13.65 billion.

While EMC would be valued at $57 billion at $33 per share, according to Raymond James' math, the pro forma net debt vs. EBITDA ratio in such a deal is only 3.0.

The Sale Of EMC Would Make Some Key Stakeholders Happy

Raymond James analysts wrote that EMC's share prices have "lagged the S&P and large-cap peers for the past few years, and our conversations with investors suggest growing frustration."

Elliott Management last year led a push to break EMC into smaller pieces via sales of assets such as VMware to increase shareholder value in the company, and Elliot and EMC declared a truce via a standstill agreement until this September.

"EMC management has made it clear it has no intention of disbanding the federation (e.g. spin off VMW), and we doubt EMC will do nothing come September. Divesting non-core assets like Documentum and RSA is an option, but a better option in our view is to sell the company for at least a 25% premium," the analysts wrote.

High Per-Share Price Might Satisfy EMC

Raymond James' assumed price for EMC of $33 per share would be the highest share price EMC has seen in 14 years, the analysts wrote.

EMC CEO Joe Tucci had been expected to retire in 2012 when he turned 65, but has held on to his position at, as he puts it, the request of EMC's board of directors. An acquisition of EMC by HP would let Tucci retire with "his head held high," the analysts wrote.

"We believe his retirement has been delayed as EMC explores strategic options, and that EMC is unlikely to make major acquisitions, as this would highly irritate shareholders and only further cloud management succession plans," they wrote.