Leap of Faith M&A: Mind the Gap

There is an Interesting Post on the difficulty in valuing tech M&A targets highlighting the Facebook-Whatsapp acquisition. We previously discussed the Transaction offering some tentative observations. I agree trying to value or price early stage targets with no earnings is difficult. I, however, strongly disagree with the assertion that such deals cannot be analyzed and we should rely on the judgment of successful entrepreneurs like Facebook’s Zuckerberg because tech is different and not subject to the laws of economics. I am always suspicious relying upon “great men” because of the difficulty distinguishing between luck and skill. Besides, the jury is still out on how this acquisition performs. Furthermore, the “they can afford it anyway” argument made in the FT post is dangerous-I think Hewlett Packard blew itself up using such an affordability argument in its disastrous acquisition program.

The tech “is different” canard was used during the 1990s dot.com boom, and did not have a happy ending-remember EToys and Pets.com? Early start-ups without sales, let alone earnings, lack intrinsic value and are difficult to evaluate. Their price depends on what buyers are willing to pay. The absence of a valuation anchor means tech is subject to substantial mispricing risk. Option pricing methods can help analyze such situations.

Option pricing methodology is tricky and subject to misuse - akin to trying to value lottery tickets. The keys to option value include

1)     Skill: does the acquirer have the skill to develop? Many tech investors (Venture Capitalists) acquire not to develop, but to hold a portfolio of deeply out-of-the money options and hope for the best on one of the investments.

2)     Exclusivity: does the option offer exclusive rights to the acquirer e.g. R&D, patents, etc.? If not it has no value.

3)     Sustainability: how long do the benefits last - what is the “T” or product life cycle?

The keys in tech M&A, just like in regular M&A, are the ability to identify winners in advance and acquire them at a reasonable price. 

The complications in tech M&A are

1)     The story (sizzle) dominates while the numbers (performance) lags.

2)     New metrics cloud the analysis. Remember “it is the cash stupid”!

3)     Paradigm shifts occur - AKA  _hit happens.

4)     Information is lacking.

Acquirers must guard against the growth trap of assuming rich future follow-on investment opportunities that can justify anything. The problem is the future opportunities fail to deliver sufficient returns. This is especially true in the tech area with its short product life cycles.

Beware the “this time is different” justification for tech M&A. All investments, tech included, have to produce sufficient cash at some time to offset the current investment. Tech is difficult, but not impossible to evaluate given the information uncertainties and short product life cycles. Nonetheless, that does not justify taking a leap of faith. Keep in mind the difference between flying and falling - at first not much, but then a lot. The same is true for leap of faith M&A.

j

Schumpeter's Ghost and Jensen's Modern Industrial Revolution

Joe's recent post on Schumpeter inspired me to revisit a modern version of the same points, this time by the father of modern corporate governance, Michael Jensen.  Read what Michael wrote over two decades ago about 'The Modern Industrial Revolution'.  Keep in mind that this was written at a time of rapid change in business as the hostile takeover wave of the 1980's had shaken managerial complacency.  The degree of rapid change two decades ago seems sloth-like in view of the digital revolution that has encompassed the last two decades.  As we have noted, changes in technology provide one of the catalysts for increased merger activity.   But that increase in merger activity can  be associated with positive or negative shareholder wealth changes.   Joe noted the problem of large bureaucratic firms chasing growth through mis-guided acquisitions in an attempt to recapture growth.  Note the parallels in Jensen's article, and how applicable these arguments are today as they were over twenty years ago.

The Modern Industrial Revolution, Exit, and the Failure of Internal Control Systems

Abstract:      
Since 1973 technological, political, regulatory, and economic forces have been changing the worldwide economy in a fashion comparable to the changes experienced during the nineteenth century Industrial Revolution. As in the nineteenth century, we are experiencing declining costs, increasing average (but decreasing marginal) productivity of labor, reduced growth rates of labor income, excess capacity, and the requirement for downsizing and exit. The last two decades indicate corporate internal control systems have failed to deal effectively with these changes, especially slow growth and the requirement for exit. The next several decades pose a major challenge for Western firms and political systems as these forces continue to work their way through the worldwide economy.

The complete article can be downloaded here.

All the best,

Ralph

BTW, this starts the second full week of an 'international sabbatical tour' that begins in New Zealand and traverses Australia, Thailand and Singapore before concluding in December in Amsterdam for the Acquisition Finance Course with Joe. See the complete description here.  International corporate governance and merger activities share many common, and many disparate themes across nations.  I'll be noting these perspectives, particularly as they relate to merger activity in Europe.  

Microsoft and Noikia

Joe's recent post on Schumpeter and HP inspired a few thoughts, especially when I read about Microsoft and Noikia merging.   

The Microsoft/Noikia deal had been rumored and had died a few times before the recent announcement of the deal. (See That Microsoft-Nokia merger you've been predicting? It's no go.)

But now the deal is on.  Really?   Is this another case of lost margins chasing growth through ill conceived merger? Harry McCracken's Nine Thoughts about the Microsoft -  Noika deal is quite on point - and also consistent with what Joe noted about creative destruction and ill conceived deals.  Read the McCracken post here.

Of course, Microsoft is no stranger to acquisitions, having completed more than 150 deals since 1987.  It is, of course, easy to make acquisitions when times are relatively good and one is awash with capital. It is more difficult to integrate these firms and continue to use them to generate growth at acceptable margins.  

Ralph

Tech Wreck - Dell, Apple and HP: A Developing Story

Technology based firms like HP (transformational M&A), Dell (Management led LBO) and Apple (huge cash reserves) have generated plenty of recent headlines. What they have in common is a maturing industry, slower growth and increasing over capacity that is common to the creative destructive process is dynamic economies. The consequences of these developments are pressured margins and falling stock prices. This has created a strategy-value gap. Essentially, the current strategy no longer creates the highest and best results because it no longer fits evolving market opportunities. This presents a huge governance challenge for boards facing management teams unable or unwilling to change.

The competitive advantage period these firms previously enjoyed has shrunk to zero as their markets and products became commoditized. Thus, the source of value has shifted from growth opportunities to assets in place. The emphasis is no longer growth but returns and profitability. This shift gives rise to the following fundamental changes:

1) Increased emphasis on capital allocation as free cash flows rise due to falling investment requirements. This produces significant agency issues as management may be tempted to waste resources in over-priced acquisitions as occurred at HP.

2) Ownership and management changes in the areas of consolidation based M&A, LBOs by frustrated management and spin-offs and divestment of SBUs that no longer fit.

3) Increased shareholder distribution thru dividends and stock repurchases of excess free cash flow.

4) Higher leverage to maximize tax benefits and increase managerial discipline over cash flows and balances.

5) Improved focus reflected in the reduced number of SBUs. This reduces cross subsidies and improves capital allocation.

6) New incentives added to improve accountability.

7) Enhanced governance through new more active and experienced board members.

All of the above will be driven by heightened shareholder activism by investors,such as Einhorn at Apple, seeking to improve shareholder value. Some of this will be ugly-proxy fights, litigation, transaction challenges, and ultimately possible hostile take-over attempts.

The net result will be the tech industry as the new hotbed of deal activity going forward. Firms, management and boards will struggle to adapt to an evolving industry environment. Not everyone can succeed, but for those who can the rewards will huge. In the meantime, investment bankers, lawyers and bloggers will be busy. Much more to follow.

J