Monday, November 10, 2014

Choose Wisely

I am fascinated with the technology industry-not because of the technology itself, but the pace of industry change. Company life cycles are measured in years compared to decades in other industries. The half life of T (The competitive advantage period) is frequently less than 5 years. This allows us to observe and study how firms are handling maturity. The basic choice is to grow old gracefully by curtailing investments and returning excess cash to shareholders, or try to spend your way back growth.

This was best put by Google’s Larry Page FT who stated his firm, although still growing, risks irrelevancy if it is unable to keep pace with market developments. He hinted at setting up a holding company structure to make diversifying bets (acquisitions) like Warren Buffett’s Berkshire Hathaway. Firms like IBM and Microsoft have chosen to age gracefully and return cash to shareholders who are then free to find the next tech generation of winners. Others, such as Facebook, are seeking transformational M&A to retain their growth status. The problem firms like Google and Facebook who chose to fight aging is they risk an arms race with other cash rich tech competitors battling for supremacy in an evolving digital environment. This leads to ill advised over priced transactions like Hewlett Packard experienced in its 14 year computer adventure which it recently decided to end thru a spin-off of its disparate divisions.

Tech firms considering reinventing themselves by acquiring should consider the following:

1)     What is strategic motivation? Growth alone should be a consequence of strategy not a strategy itself. What competitive advantage in terms of products, technology, market extension, pricing power, or cost advantages are to be gained?
2)     Are there alternatives to acquiring (i.e. internal development)?
3)     Can you identify appropriate targets? These include targets that can exploit market developments-quickly and efficiently scale operations. You acquire firms not technology.
4)     Can you acquire at a reasonable price (i.e. not overpay relative to value)?

It is difficult to value early stage or rapidly growing targets, which often lack an intrinsic value. Rather, their price is determined by what buyers are willing to pay based on current, potentially overheated, market conditions. The lack of an intrinsic value anchor makes such transactions prone to be over priced. Buffett believes firms lacking an intrinsic value are worth only what some other buyer is willing to pay for them. Hence he believes they are speculative and not long term investments. This is the reason he avoids tech firms now just as he did during the 1990s dotcom boom.

You can inject an element of discipline thru a reverse engineering process. This involves solving for the level of sales and profits needed in 5-10 years to justify the offer price. Keep in mind the caveats. First growth requires investments (CAPEX, R&D and working capital). This investment reduces free cash flows and ultimate value. Second time is not your friend. The more distant the cash flows either initially planned or due to delays, the lower the value. See my previous post applying this approach to the Facebook-Whatsapp Acquisition. Whatsapp reported 1H14 sales of around $15mm and a loss of $235mm. They claim the potential still remains, but realization is delayed. The potential growth needed is huge and preliminary results are not encouraging.


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