The Acquisition of VMWare: An Analysis

The Acquisition of VMWare: An Analysis

Merger and acquisition activity has been on the rise in the first quarter, with a significant portion of these deals occurring between information technology (IT) companies. One such deal is the acquisition of VMWare by EMC, amounting to $625 million. This acquisition allows EMC to expand its core data storage device business by incorporating software technology that enables multiple operating systems to run simultaneously on the same server or workstation. As an analyst, it is essential to evaluate the potential benefits and risks associated with this acquisition.

To assess the value of the acquisition, we must consider the projected growth rate of VMWare’s profits. At the time of the acquisition, analysts projected a constant growth rate of 2 percent for the foreseeable future. Additionally, VMWare’s annual net income was reported to be $39.60 million.

To determine whether the acquisition is beneficial, we need to compare the projected growth rate with EMC’s estimated opportunity cost of funds, which stands at 9 percent. The opportunity cost of funds represents the return that EMC could have earned if it had invested its capital elsewhere.

Using the constant growth formula, we can calculate the intrinsic value of VMWare:

Intrinsic Value = Net Income / (Cost of Capital – Growth Rate)

In this case, the cost of capital is 9 percent, and the growth rate is 2 percent. Plugging in the values, we get:

Intrinsic Value = $39.60 million / (0.09 – 0.02) = $495 million

Comparing this intrinsic value to the acquisition price of $625 million, we can see that EMC paid a premium for VMWare. From a financial standpoint, this may raise concerns about the overvaluation of the acquisition.

However, it is important to note that this analysis was done under the assumption of a weak economy and a constant growth rate of 2 percent. If EMC had credible information that an economic expansion period was imminent, which would boost VMWare’s projected annual growth rate to 4 percent for the foreseeable future, our conclusion would change.

With a new growth rate of 4 percent, we can recalculate the intrinsic value of VMWare using the same formula:

Intrinsic Value = $39.60 million / (0.09 – 0.04) = $792 million

Comparing this revised intrinsic value to the acquisition price reveals that EMC’s purchase of VMWare is now justified. The acquisition price of $625 million is lower than the intrinsic value of $792 million, indicating that EMC is acquiring VMWare at a reasonable price.

Furthermore, an economic expansion period would likely lead to increased demand for IT services and software technologies, which would benefit VMWare’s business prospects. This favorable market condition strengthens the case for EMC’s acquisition.

In conclusion, when analyzing the acquisition of VMWare by EMC, it is crucial to consider both the projected growth rate and the prevailing economic conditions. Under the assumption of a weak economy and a 2 percent growth rate, concerns about overvaluation arise. However, if credible information suggests an upcoming economic expansion and a growth rate of 4 percent, EMC’s acquisition becomes justified and potentially advantageous.