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August 27, 2010

Tech Sector Watch: Is Mega Merger the Inevitable Solution?

By EconMatters

While the fierce 3PAR bidding war is becoming even more exciting than a live Sotheby auction, the most active market sector in terms of consolidation is undeniably Technology, and there is a reason for this wave of M&As.

At the forefront of any analysis it is always important to follow the money. This is the real driver of this trend that has been going on for the past year, and will only intensify over the next four months.

So, who has all the money in the world to spend on major technology purchases? The answer would be large corporations and big governments with both the money and need to cut costs to be more efficient and productive through more advanced technology infrastructure.

Law of Diminishing Returns & Survival

Tech sector is not immune to the Law of Diminishing Returns, which means margins will inevitably continually come down as technological products and services become commoditized. The high margins are always in the new growth areas of technology that have yet to become commoditized. Thus enter all the hoopla over cloud computing. This is an area that will produce the high margin growth opportunities in technology for at least the next five years.

All the big players want to make sure they get in a better position to fully capitalize and compete in this new area of high margins. It is the death of a technology company to be left in the realm of commoditized product offerings. The battle over 3PAR between HP (HPQ) and Dell is really about the future survival in the technology arena.

Dell – Too Late in the Diversification Game

Dell should have been thinking along these terms five years ago the way HP has diversified itself along the higher margin spectrum to offset the commoditized portion of their business portfolio. Instead, Dell has failed at becoming competitive pursuing its strategy of the past three years of trying to come up with “cool” products to drive higher margins----a la Apple (AAPL).   

Now, Dell is trying to play catch-up in an attempt to duplicate HP’s successful transition from strictly a commodity provider to that of a value added business enterprise based revenue model. Well, Dell is probably too far behind and don`t have enough resources at this point to go this route, in my opinion.

And this little 3PAR dogfight is just a microcosm of what is taking place in strategy sessions all over Silicon Valley, and boardrooms across the world as technology companies constantly have to fight to stay relevant.

Not Enough Margins to Go Around

The problem is that there are not enough resources to go around in the high growth areas. There are too many big players fighting for the same territory, whereas it was much easier in the past to divide up the space and say Dell and HP do hardware, Cisco does routers and Networking, IBM does large mainframe and consulting, etc. All that has changed as the sector has become intensely competitive, with every player increasingly encroaching onto each other’s turf, particular in the higher margin categories.

But here is the rub--there can only be high margins with few competitors. As more competitors fight for the same space in the category, inevitably margins for the category start shrinking.  As such, there will continue to be these smaller deals in tech as companies try to position themselves to better compete in these high margin growth areas. However, this is really just missing the forest for the trees.

The bigger picture is that the tech sector is still relatively fragmented with too many big players competing for the same high margin growth categories, and not all of them are going to survive. Some of the big players will need to consolidate with some of the other big players in the sector in order to preserve any kind of pricing power. Otherwise, ultimately they will all be reduced to low-margin commodity providers, even in the currently attractive high margin category.

A Short List Fitting the M&A Prerequisites

The list of big technology players includes Microsoft, IBM, Oracle, Cisco, Apple, HP, Intel and Google. Some firm on this list most likely will need to be subsumed under the umbrella of one of the other in the group.

One prerequisite of acquiring another big player is a healthy stock price and market cap. Since these deals will be so big to be all cash, a firm`s market cap and stock price will become crucial in stock swap conversion ratio, which will be a major component of any deal. For example, HP`s current market cap--just under $89 Billion—is the smallest on the list, and thus precludes them from being a major player.

The second element will be a perceived strategic fit between both firms. A third requirement will be a bold leader who is ahead of the curve, and fighting the battle of next five years, instead of just this year. Another component may include a lack of attractive organic growth prospects in the acquiring firm. But in general, the stronger company will acquire the weaker company.

Remember, in these deals it is not where the two firms are today, they may seem like alliances with no true synergies, but it is where both companies are heading three years down the line as future competitors.

On a side note, a smaller firm can actually acquire a much larger firm and be quite successful. Several come to mind, but it is more risky, and given the current economic environment, will be a concern for boards in considering this type of bold move.

Potential Deal Scenarios

Microsoft, IBM, and Apple are the strongest companies on this list. I would have included HP on this list a couple of months ago, but as noted earlier, their current low stock price precludes them from being active as a major acquirer.

Apple is sitting on tons of cash, but acquisition actually goes against their fundamental strategy of seeking growth organically. Furthermore, Apple is so distinct in developing products that fit in with the Apple Culture that the only firm on this list that I could envision Apple acquiring would be Cisco, as the other possibility—Intel--would probably have anti-trust issues that would be insurmountable.

IBM could acquire HP much easier from an anti-trust perspective than, say, Oracle, but both acquisitions would make for strategic sense along different lines. Meanwhile, the most likely deals for Microsoft would be them buying Cisco or HP, as these are the only two with a strategic fit and without as much anti-Trust concerns.

An Oracle – HP alliance would be intriguing, but again I think Oracle is too small to acquire HP, but from a business enterprise software and hardware standpoint maybe three years down the line there would be some excellent sales synergies to be gained from this combination.

A Cisco –HP alliance would make considerable strategic sense, but neither of them is in a position to acquire the other--Cisco is not quite large enough to acquire HP, and HP stock is still in crisis mode to be the acquirer either.

Intel and Google are sort of stuck in the middle as both want to branch out into other areas and diversify their revenue streams, as both have not succeeded so well with their organic growth initiatives outside of their core competency over the last five years. 

However, both Intel and Google either lack enough synergies for the others to acquire, or are problematic from an anti-trust perspective. Furthermore, I don`t foresee either firms realizing they need to make a bold acquisition to genuinely diversify their revenue streams until it is too late, and they have both become commoditized players in technology.

Anti-trust Not As Problematic

Let me mention here that anti-trust issues are not as problematic for these types of Mega Mergers as people might think. The tech sector has become very crowded with at least six to eight major players in a given category instead of two or three major competitors in the old days. This fact reduces anti-trust concerns to a deal being done in many potential scenarios.

Fight for the Greener Grass

So yes, in technology, the grass is greener on the other side. And everybody has their hands in everybody else`s kitchen so to speak. Apple wants to start making video game players, Microsoft wants to create a great smart phone, Amazon wants to make all encompassing Tablets, HP wants into storage, Dell wants to be like HP, they tried being like Apple, etc. But in the end all these companies are going to merge into the same high growth areas, and fight it out with distinct winners and losers.

And the advance of cloud computing is only highlighting the fact that there are too many big players, and not enough available high margin growth areas for all to flourish. Eventually, some will have to team up with others, some will be relegated to low margin commodity players, and only a handful of the strong-and-fit-to-survive will emerge at the finish line as Mega Tech Giants that dominate the high-end of the technology landscape in the future.

Disclosure: No Positions
EconMatters, Aug. 27, 2010
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Item Reviewed: Tech Sector Watch: Is Mega Merger the Inevitable Solution? Rating: 5 Reviewed By: EconMatters