VMW's Valuation Disconnect With EMC

"The market can stay irrational longer than you can stay solvent."

True, but you would think that market's would start becoming a little smarter after the major collapses of the dot-com bubble. I of course was still in high school; but no business education is complete without learning about some great collapses. 3Com (COMS) spun off Palm (PALM) with an IPO that generated a significant amount of hype. While 3Com held a major stake in the company, Palm shares were driven so high that they accounted for more than 3Com's entire market value. In other words, the market valuation of Palm implied 3Com's core business (ex-Palm) was worth less than zero. Obviously, we know exactly where Palm went when the bubble popped.

The typical corporate finance interview question for this case is usually: "Does this violate the expectations of market efficiency?" One might be tempted to answer yes, but the answer is no. Right after an IPO it is nearly impossible to short shares. Intelligent market participants could not profit from the absurdity of the situation.

Fast forward about 7 years to VMWare (VMW) and EMC (EMC). Again we have a much hyped spinoff that has risen from an IPO price of $29 to $107 in about one month. At current prices, if VMW represents approximately 75% of EMC's market capitalization. If VMW were to outperform EMC by another 30%, EMC's core business would have an implied value of zero. Again, it is very difficult to short shares given the small float of VMW shares (EMC holds 86%). However, options are traded and intelligent investors can buy puts or short calls.

A number of sources including Seekingalpha and Barron's have pointed out the disconnect and I am looking for opportunities to make some fast money. There are only two possible explanations here: EMC is grossly undervalued, or VMW is grossly overvalued. If we were to take on a simple hedge, we would short .75 shares of VMW for every 1 share of EMC we bought, and then short a competitor of EMC for the remaining .25.

The AllStar Portfolio has taken a large bet that VMW is about to take a significant fall as the market assumes a state of rationality. The fact that the company is at a market cap of $42 billion at 116x forward earnings is not even core to our thesis. Obviously, we have thus far, and expect to continue to take heavy losses as VMW shares are on a tear. However, the valuation disconnect is too enticing to ignore. As a mock portfolio, we do not face the risk of margin calls that would occur in the real world with a trade like this. Yet, we also have a much shorter time horizon for this trade to pay off. VMW reports earnings on Oct. 24. More importantly, the lockup period will expire 180 days after the IPO. Stay tuned.

Neal Sangani

Disclosures: I purchased puts on VMW today. My comments are for educational purposes only.