The Trouble with Technology M&A

Source: Suzanne Miller

U.S. M&A volume may be at the lowest level since early 2003, but technology deals are on a tear. Cisco Systems Inc., Oracle Corp., Microsoft Corp., Facebook Inc., SS&C Technologies Holdings Inc. and Dell Inc. have already cranked out $11 billion worth of deals among them through mid-April, while the industry has churned out $30 billion. That’s the biggest volume since the first quarter of 2006, according to Dealogic, and second only to activity in the oil and gas industry in recent months.

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While other industry CEOs may be holding out for signs of greater global prosperity, tech companies can’t afford to wait. Broadly speaking, the technology industry, perhaps more than any other, is in the vortex of profound change where companies must innovate and grow or face obsolescence. One of the key tools to survive in such a dynamic climate is to buy — that is, M&A.

Unfortunately, M&A in tech has often gone awry, more so arguably than in other industries. In January, McKinsey & Co. published an M&A study looking at the past decade of deal-making among top global companies. It found that among eight major industries, tech companies did the worst job by far of delivering shareholder returns (excess total returns to shareholders, or TRS), especially in big transactions. No single measure tells the whole story, of course. M&A metrics are notoriously tricky because M&A itself makes up only part of a company’s overall performance and few companies break out results from deals. Still, shareholder returns do provide circumstantial evidence as to how well acquisitive companies perform over time and, by extension, how much value investors are getting from deal-making.

For tech companies, those returns look discouraging. McKinsey’s corporate finance practice team found that of eight major global industries, high-tech companies underperformed their indices by a dismal 6.7% from December 1999 through December 2010. Consumer discretionary was a distant second, underperforming by 2.8%. Moreover, high tech underperformed in other growth strategies as well — “programmatic” (serial purchases), “selective” (occasional purchases that make a cumulative difference to market cap) and “organic” — except for tactical deals, where it outperformed by 1.2%. Tactical deals are done occasionally, tend to be small and don’t make a significant difference to market cap.

Executing M&A is difficult in every industry, including those in which the underlying technology is stable. But trying to do larger-scale M&A in tech is like shooting arrows in a hurricane. The pace of technological change, the sheer number of global competitors and the complexity of products and markets create tremendous uncertainties. Traditional technology incumbents, in particular, are finding it tougher to pursue strategies mapped out a decade or more ago. They’re running as fast as they can over a shifting landscape as consumers toss away landlines and PCs for newer, portable technologies — smartphones, tablets — and look to the cloud to connect all their gadgetry. You can also use IT services by Anova IT, to help you with all your technology questions.

As fast-developing technologies become essential for dreaming up new products and winning new customers, companies are caught up in patent wars. Last year Google Inc. bought more than 1,000 patents from IBM Corp. for an undisclosed price to protect itself from legal assault. Nonetheless, Oracle is currently suing Google for $1 billion over claims it violated its Java-related intellectual property in developing Android, Google’s popular operating system for smartphones.

The pressure to grow affects every tech company. For that, M&A remains the favored growth lever. Take Round Rock, Texas-based Dell, a traditional hardware manufacturer and marketer, and a classic example of a tech company under intense pressure to change as the market rapidly evolves. “Dell now wants to be the owner of intellectual property, not just a reseller. On the PC side, for more than a decade they’ve been reselling other people’s IP,” says Morningstar Inc. analyst Michael Holt. “But in terms of who holds the value in the PC chain, it’s the Intels, Microsofts, the memory manufacturers. Dell does a really good job putting it all together, but they don’t own all that intellectual property, so they’re taking a markup on competing on operational efficiencies.”

In response, Dell has been revving up its deal machinery, which was largely dormant before hiring IBM dealmaker David Johnson in 2009. This year alone, Dell has made five small to midsized acquisitions — its M&A haul for all of 2011. Most of these transactions have been in higher-margin networking, storage and services businesses. Dell, like other tech companies, doesn’t break out results for acquisitions. But Johnson is upbeat about the growth of storage company Compellent Technologies Inc., which Dell acquired for $820 million in 2010. Dell, he says, has expanded Compellent’s physical presence from 1-1/2 buildings to three in less than a year. “We’re taking midsize companies and leveraging Dell’s distribution and scale, and it seems to be working,” he says.

While Johnson has won plaudits for his M&A acumen and integration skills, some analysts think it’s too early to say whether a strategy of serial small deals will give Dell the scale it needs to compensate for a slowing PC business and new competitors.

“The landscape of players in the marketplace continues to change dramatically as companies become very big and realize that to achieve growth objectives, they need to make much bolder moves to move the needle more than before,” says Marco Sguazzin, principal for mergers, acquisitions and divestitures at Deloitte Consulting LLP in San Francisco. “The competitive lines between these companies have been redrawn. Where there were once strong partners, they are now often competitors in the same space. You now have [new] competitive battlefronts.”

A good example: the 10-year partnership between Dell and storage giant EMC Corp. Late last year, Dell said that it was ending its agreement to resell EMC storage products two years early — turning the two companies into competitors as Dell builds out its presence with deals like Compellent.

At the other end of the spectrum are companies such as Apple Inc., which is reshaping competition not so much because it’s good at M&A — it’s not particularly acquisitive — but because it has created scalable products snapped up by consumers. In fact, Apple has been developing strategies so transformative that it really belongs in a class by itself — for now, anyway.

To get a sense of what’s really going on in various technology subsectors, we have used data from Dealogic and Standard & Poor’s Capital IQ to extend McKinsey’s TRS methodology over the past five years (see table, page 35). The table features companies that have been the most active dealmakers by volume and/or number of deals and measures their total shareholder returns (which includes capital gains and dividends) earned against their subsector benchmarks.

What leaps out is how dramatically M&A varies from company to company, from subsector to subsector, when it comes to TRS. Apple, for instance, which is the most valuable company in the world by market capitalization, has produced an annualized 23.5% in excess TRS the past five years, leaving everyone else in technology behind. In the first quarter, Apple sold 35 million iPhones — almost double from a year ago. Again, most of this success is not due to M&A. Over the past five years, it has made only 15 deals — mostly small ones; Dell and Hewlett-Packard Co. have made 25 and 39, respectively.

Apple is unusual. Another tech power, Google, has become one of the more acquisitive tech companies, with at least 103 deals over the past five years. It has gained a reputation for making many small, smart deals that fit its mission, and it’s outperformed its Internet software and services sector benchmark by 3.7% TRS over the past five years. That’s a country mile ahead of Yahoo! Inc., which has underperformed by 12%. Yahoo! has also been highly acquisitive, but it has been criticized for failing to integrate what critics have described as a thicket of disparate deals done back to back. “You need to know what strategic problem you’re trying to solve with M&A,” says Werner Rehm, senior corporate finance expert at McKinsey in New York.

The experiences of Apple, Google and Yahoo! reflect the limits as well as the benefits of M&A. The potential for succeeding often depends on strategies already in place. Much of Dell’s and Hewlett-Packard’s problem is that they’re entrenched in the low-margin PC world, which has been shredded by Apple (and Apple-like) products. As a result, Dell and HP have respectively underperformed the index by 21% and 23%. Even IBM, which has done well with IT consulting and software businesses built through M&A — it outperformed by 8% — feels the drag from hardware, despite selling off its PC business eight years ago. As a seller of large computers and servers to businesses and government, it saw a 6.7% decline in hardware sales.

“There’s been a recognition that the old-school tech vendors — IBM to Dell — haven’t been able to figure this market out yet,” says Robert Enderle, analyst at Enderle Group in San Jose, Calif., of Apple’s ability to “consumerize” technology. “It’s a problem for everyone. Microsoft was unbeatable in the 1990s, but the last decade got rolled over by Apple.” In systems software, Microsoft has underperformed by 2%. “Microsoft is a great company. It’s just a question of how do they capture the next generation,” says an M&A banker. “How do you fit into the cloud? They’ve got to do more M&A.”

In fact, Microsoft did just that last year, though to mixed reviews. In May, it splashed out $8.5 billion in cash to a group led by private equity firm Silver Lake for the Internet communications company like Leased Line Providers and Skype Technologies SA, a move some see as designed to give it a bigger push into the consumer market and ease its dependency on enterprise clients going forward. These kinds of megadollar deals have a tendency to make people squirm — especially when the price seems steep compared to future revenue. Some analysts warn that Microsoft simply won’t be able to generate enough revenue and profit from Skype to compensate for the biggest price it’s ever paid for an acquisition.

Others worry the same could prove true for Facebook, where CEO Mark Zuckerberg made an apparently solo decision to spend $1 billion on Instagram Inc., the two-year-old app-based photo service with just 13 employees, 30 million users and no revenue. What’s more, the $1 billion price tag is twice what Instagram was valued at in a recently closed Series B venture round. Facebook, which is not yet public, has no TRS and so isn’t included in our numbers.

Some observers insist that boards of tech companies, well aware of their mediocre M&A track records, are beginning to wise up as shareholders demand more accountability. Companies are putting more focus on improving best practices and hiring top talent to get them there faster, much as Dell did with IBM’s Johnson. Even startups fresh from public offerings such as Mountain View, Calif.-based social network group LinkedIn Corp. have recognized the need to do deals to grow faster. In 2010, LinkedIn hired Robby Kwok from Yahoo!, where he had spent eight years as a senior executive, to jump-start its M&A group.

Matt Porzio, vice president of product marketing at IntraLinks Inc., the New York seller of cloud-based data-sharing and collaboration services, says tech companies are starting to balance the pressure to grow with the need to think more cautiously about the results of deals. One sign: They’re starting to deliberate longer on M&A. He says tech companies are now averaging a month more to close deals than other industries. “People want more information to get comfortable because [in the past] companies were overpaying and not getting value. Boards are holding corporate development more accountable now.”

Others agree that as boards demand greater accountability, there is a growing sense of caution and an inclination to do smaller deals, which can be easier to manage and extract value from. “Deal sizes are coming down as companies attempt to augment existing platforms rather than taking big bets,” says Ben Druskin, chairman of global media and banking at Citigroup Inc. “It’s about adding more technologies that can scale throughout their client base. These do not have to be large companies, but should be very strategic.”

Another cautionary sign: Deal sizes are slipping. Porzio says tech deal sizes averaged around $319 million for the six months through January, down from $713 million in earlier 2011.

Still, can tech companies really improve M&A performance? Technology advocates say the sector has unique differences many studies overlook. For instance, large tech companies tend to trade more like industrial companies because their growth rates can be weighed down by sheer size, which makes it trickier to grow price-earnings multiples as quickly. They use their cash hoards (they tend to have more than do other industries) to spend on a mix of acquisitions, share buybacks and dividends to pump up returns.

Many large acquisitions have also focused on traditional cost cutting rather than core growth, others say, a criticism directed at HP. Not so long ago, HP, under former CEO Mark Hurd, was considered one of the industry’s top dealmakers with a string of major acquisitions to its credit. Now the company stands accused of profligacy and starving R&D. Last August, under the short-lived reign of CEO Léo Apotheker, successor to Hurd, HP agreed to buy Autonomy Corp. plc for $10.3 billion and weighed getting out of the PC business and unraveling its Compaq Computer Corp. purchase — a scheme that cost Apotheker his job.

Apotheker’s situation — the pressure to launch rapid-fire transformative deals — is the kind of challenge many others face. The upshot is that CEOs are feeling under the gun to constantly seek out new revenue sources, most often through M&A. Some argue that tech CEOs should be given some slack in balancing this need to grow against profit margins that are continuing to compress. “Studies that suggest 75% of all deals fail to meet objectives or are not accretive sometimes don’t take into account the declining baseline [for profit margins],” says Deloitte’s Sguazzin. “The problem is how to measure it.”

Others say companies should get credit for all the bad deals they rejected — something no one can quantify. “What if Microsoft had bought Yahoo! Inc.?” asks Morningstar’s Holt. In 2008 Microsoft was willing to spend almost $50 billion to buy Yahoo! to revive growth in its online advertising business. The deal would have reportedly tripled Microsoft’s share of online queries and helped close at least some of the gap with Google in search and advertising.

Today, Yahoo! is worth half of what it was at the time. Microsoft might well shudder to think of what might have been. But does looking back really count when it comes to adding up performance points? Probably yes, given that it’s these kinds of decisions — whether to spurn or embrace a deal — that shape companies’ long-term strategies.

Some decisions are luck. But as technology companies enter their next cycle, where competition is enough to give any self-respecting M&A chief instant migraines, they’ll need a lot more than luck to get by. There are signs that tech companies may be wising up. Time, and perhaps a better industry TRS, will tell.
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