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Jericho Capital Sends Letter to Independent Directors of VMware
[March 12, 2018]

Jericho Capital Sends Letter to Independent Directors of VMware


Jericho Capital Asset Management L.P., together with its affiliates ("Jericho"), a significant shareholder of VMware, Inc. ("VMW" or the "Company") (NYSE: VMW), beneficially owning approximately 1.8% of the Company's outstanding Class A common stock, today sent a public letter to the independent members of the VMware Board of Directors (the "Board").

The full text of the letter follows:

March 12, 2018

Independent Members of the Board of Directors
VMware, Inc.
3401 Hillview Avenue
Palo Alto (News - Alert), California 94304

Ladies and Gentlemen:

Jericho Capital Asset Management L.P., together with its affiliates ("Jericho"), is a significant shareholder of VMware, Inc. ("VMW" or the "Company"), beneficially owning approximately 1.8% of the outstanding Class A common stock. Jericho is a firm dedicated to fundamental research with a long-term investment horizon. We are sector specialists with a long and successful history of investing in companies in the technology, media and telecommunications sectors globally.

It is our general practice to refrain from commenting publicly on corporate proposals and actions. However, in view of the recent public announcement by Dell (News - Alert) Technologies, Inc. ("Dell") that it is evaluating a potential reverse merger with the Company, we feel compelled to voice our concerns in a public manner as any such transaction will likely lead to a significant destruction of shareholder value.

There is no doubt in our mind that a reverse merger of Dell into VMW would be a terrible deal for VMW shareholders. Even the most casual observer can see that VMW gains nothing by saddling the Company's faster growth, net cash, highly strategic software business with the dead weight of Dell's slower growth, heavily debt-laden, legacy hardware-dependent entity. Any such transaction would significantly damage VMW. But assuming the Company is of the view that a strategic acquisition is necessary, we believe there are any number of other compelling opportunities for VMW to pursue that are far more accretive and value-enhancing for all shareholders, as opposed to a transaction that would burden the Company with a massive debt load and benefit solely its majority shareholder.

Over the last two months, VMW's stock has been battered by reports in the press that Dell, VMW's ~82% controlling shareholder, is exploring a potential reverse merger with VMW. As you know, Dell filed a Form 8-K on February 2, 2018 stating that as part of its "ongoing multi-year strategic planning", Dell was examining a number of potential business opportunities, including (i) business as usual - continue with the existing ownership structure, (ii) public offering (IPO) of Dell Technologies Common Stock and (iii) business combination with VMware. On the day of VMW's most recent quarterly earnings report on March 1, 2018, another round of press reports circulated that Dell and its advisors were focused on the details of a reverse merger, prompting several sell-side analyst downgrades.

Given the specificity of these public reports around the reverse merger scenario, we feel it is important to comment publicly at this time before Dell goes too far down the road in pursuit of a strategy that would effectively amount to a bailout of Dell and would be highly detrimental to VMW's shareholders. We ask that the independent members of the board of directors (the "Board") of VMW reject any proposal for a reverse merger with Dell as we do not believe this one-sided strategy is in the best interests of VMW shareholders. If the Company is looking to pursue an acquisition strategy, there are a number of other attractive acquisition candidates that are far better suited to advance the Company's strategic objectives.

We Believe a Reverse Merger Would Destroy Substantial Value for VMW Shareholders

As a significant shareholder of VMW, we have serious concerns about a reverse merger with Dell and the value it will destroy for VMW shareholders. We believe this view is shared broadly by other shareholders, as evidenced by the substantial sell-off in the stock immediately following the surfacing of these press reports. Most notably, over January 29 and January 30, 2018 when the first of these reports emerged, VMW's stock dropped 21%, and then fell 12% over March 1 and March 2, 2018 when a second round of press articles circulated reporting the same.

The reverse merger scenario is highly concerning for the following reasons:





      (i)       It would derail the ongoing resurgence of VMW's prospects just as its strategy increasingly resonates with investors
(ii) It would create a public company that would not appeal to a growth-oriented investor base, and would likely trade at a steep discount to VMW on a standalone basis
(iii) It would only serve the interests of Dell at the expense of VMW's minority shareholders, as VMW's cash and cash flows would go towards servicing Dell's debt instead of towards share buybacks or strategic acquisitions that would create value for all VMW shareholders

We Question the Rationale of a Reverse Merger with Dell and Believe VMW has Vastly Superior Strategic Alternatives

It is difficult to understand the rationale for a reverse merger with Dell from a VMW shareholder's perspective. Dell and VMW are already seeing strong topline synergies through a coordinated go-to-market effort. Dell confirmed this on its March 8, 2018 earnings call, stating it was quite "pleased" with progress here. We do not believe a reverse merger would drive additional topline synergies versus the current structure. Moreover, we do not believe cost synergies will be significantly additive given the different touch points for customers between VMW and Dell. VMW is highly strategic for its customer base. In contrast, Dell remains business-unit focused. A reverse merger would dilute VMW's rising mindshare and importance among the C-level suite of its customer base.

From Dell's perspective, we can certainly see the appeal. Dell is currently facing several challenges including competitive dynamics in its Client Solutions Group, the impact of enterprises deploying software-defined storage, hyper-converged, and modular solutions based on server-centric architectures, a heavy interest burden and private equity investors that may be looking for liquidity. VMW's strong balance sheet (including repatriated offshore cash) and VMW's healthy cash flows would be very appealing for Dell. This does not change the fact that VMW is much better off considering other strategic alternatives instead of a reverse merger with Dell.

In recent years, VMW has expressed a clear growth strategy to investors that prioritizes three IT markets: (i) Software-Defined Datacenter, (ii) Hybrid Cloud, and (iii) End User Computing. We believe VMW's future success will depend on the Company's ability to provide differentiated, software-centric solutions in each of these markets. We fail to see how an acquisition of Dell has any strategic merit for VMW in this context, as we are doubtful that Dell's legacy, hardware-focused businesses can further VMW's ambitions in any of these growth pillars. We believe this opinion was confirmed by the comments that VMW's CEO Patrick Gelsinger made at a recent conference regarding acquisitions, where he stated "We [VMW] feel like we sort of have everything that we need. So it's not like I have a big hole in my portfolio, as you suggest, that I need to go fill… it's all about accelerating and adding to, not needing to fill any holes." 1

Despite CEO Gelsinger's recent comments that would suggest otherwise, we do acknowledge that the Company may decide in the future to pursue acquisitions to further its product vision. However, we do not believe that Dell should be considered among these inorganic options. Instead, we believe it a more prudent use of capital for VMW to acquire software assets such as those listed below, as each of them have a more compelling acquisition rationale than an acquisition of Dell. In contrast to Dell, each of the prospective acquisition targets listed below is a share leader in a growing market that would fit into VMW's current three-pillar strategy. Furthermore, an acquisition of any of the companies below would likely be accretive to VMW's revenue growth and free cash flow, thereby driving stock price appreciation - making each far more financially compelling than a combination with Dell.

VMware Inc: Alternative Acquisition Targets
                 
 
Estimated

CY2018 | VMware Pro Forma

        Acquisition TEV       Revenue Growth       FCF Accretion
VMware Inc (Standalone) 9% --
 
Red Hat (News - Alert) Inc $33B 11% 11.1%
Palo Alto Networks Inc $21B 12% 22.4%
Splunk (News - Alert) Inc $18B 12% 7.2%
Tanium Inc (Private) ~$5B >9% N.A.
Rubrik Inc (Private)       ~$3B       >9%       N.A.
Based on Bloomberg consensus estimates. Assumes a 25% premium to the March 8, 2018 closing stock price of publicly traded companies. Assumes VMW funds an acquisition using $10B of balance sheet cash, raises debt with a 4.25% p.a. interest rate and realizes synergies equal to 20% of targets' LTM operating expenses.
 

We Believe a Reverse Merger Presents Other Serious Issues for VMW

The Board of VMW must also consider the following limitations that we believe the Company will face if it pursues a reverse merger with Dell:

  • Effect on Employee Retention: VMW competes for talent with high-growth technology companies in Silicon Valley. If combined with Dell, we expect VMW's ability to attract the best and brightest to be substantially diminished. Business Insider published an article on March 5, 2018 citing the departure of Jeff Jennings for Google, writing that the "exit of a star executive like Jennings is likely to raise further scrutiny about the risks of such a merger on VMware's leadership ranks" and that the "departure has stirred internal rumblings that other top talent could flee VMware if Michael Dell proceeds with a potential reverse merger."
  • Ability to Partner More Broadly: VMW currently partners (and may consider partnering in the future) with hardware and other IT providers that compete directly with Dell. We question whether these fruitful partnerships can be maintained, or new partnerships initiated, if VMW reverse merges with Dell.
  • Disruption and Integration Risk: A reverse merger of this scale would disrupt VMW's current business for a significant period of time and require substantial management attention. We believe management should be focused on other initiatives, including those discussed above, that will create long-term value for all VMW shareholders.

Sell Side Research Community Consistently Negative on a Potential Reverse Merger

The sell-side research analyst community has been unanimous in its opposition to a potential reverse merger. Below are some quotes from reports published in the last two months:

  • Morgan Stanley (March 2, 2018): "…the prospect of a reverse merger with Dell may continue to hang on the stock…an evaluation of software assets bundled into larger technology conglomerates clearly shows the lower valuation accrued to those assets…"
  • GBH Insights (March 4, 2018): "…the potential Dell reverse merger being discussed would be a major gut punch and value destructor to the VMware growth story."
  • Deutsche Bank (March 2, 2018): "We remain negative on the reverse merger option, based on the prospect for VMware multiple compression, shareholder churn and the business damage (exec/employee attrition) that would come from merging a resurgent indie software firm into a hardware conglomerate."
  • Bernstein (March 2, 2018): "We would expect that the combined company will trade very differently and that many of the current investors in VMW and even DVMT are probably not going to want to own the combined company."
  • William Blair (March 2, 2018): "For the board to argue that a reverse merger is in the best interest of all VMware stockholders, not just Dell, seems dubious. Still, we recognize that VMW stock has now become event-driven with the strong current fundamentals less relevant."
  • Baird (January 30, 2018): "We view employee morale as a potential risk in the event of a reverse merger. Share-based compensation is a significant portion of VMware employees' total pay, and a reverse merger could put pressure on VMware shares."
  • Oppenheimer (March 2, 2018): "…we caution that the Dell uncertainty could create an overhang near-term and any change in ownership status could lead us to reevaluate our thesis"
  • FBN Securities (March 5, 2018): "… many leading software companies are hitting 52week highs, so if the Dell deal does not happen, there is ample upside"

We are confident that the independent members of the Board are keenly attuned to VMW's standalone prospects and strong business trends and that you fully appreciate the responsibility of serving as a fiduciary to the Company's minority shareholders. We thank you in advance for considering our views and look forward to continuing our dialogue. Towards that end, we would request a meeting with the independent members of the Board so that we may discuss in more detail our views on this matter on behalf of VMW's minority shareholders. We look forward to hearing from you and to working cooperatively to ensure that long-term value is created for all VMW shareholders.

Sincerely,

Josh Resnick
Managing Member
Jericho Capital Asset Management L.P.

About Jericho Capital Asset Management L.P.

Jericho Capital is an investment firm based in New York focused on the technology, media and telecommunications sectors globally.

________________________________
1 Comments made at the Citi Global Technology (News - Alert) Conference on September 7, 2017


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