M&A's huge year

A glut of investment capital, stronger stock markets and weak IPO demand are fueling a boom in tech mergers and acquisitions

By Russ Arensman, photo by David Toerge -- EDN, January 1, 2006

Agilent Technologies considered a range of options last year while deciding how best to sell its 40-year-old semiconductor division. Other chip makers were interested in buying some, but not all, of the division's product lines. Agilent also contemplated an initial public offering (IPO), but the prospects weren't encouraging, because investors have had little appetite for technology IPOs in recent years. The test-and-measurement company, which is divesting its noncore businesses, eventually opted to spin off most of its chip business to private equity investors Kohlberg Kravis Roberts (KKR) and Silver Lake Partners for $2.66 billion in cash.

Those two leveraged-buyout (LBO) firms are now the proud owners of Avago Technologies, the world's largest privately held semiconductor company, with $1.6 billion in annual sales, 6,500 employees and some 40,000 customers worldwide. Company officials plan to cut costs by at least $100 million a year, boost profits and eventually repay investors by taking all or part of the company public again when business and market conditions allow.

Meanwhile, Agilent struck separate deals to sell its storage-chip business to PMC-Sierra for $425 million and its 47 percent share in LED joint venture Lumileds Lighting to Royal Philips Electronics for $948 million plus repayment of $5 million in debt.

M&A is back. The Agilent divestitures weren't even the largest deals of 2005, but they contributed to the biggest surge in technology mergers and acquisitions since the industry's record-setting buying-and-selling frenzy that peaked in 1999 and 2000. This year's annual Electronic Business list of the top 50 electronics M&A deals boasts more than a dozen transactions worth more than $1 billion, versus just four during 2004 (see the "Top 50 Electronics Mergers & Acquisitions" list, below).

Investment bankers and industry executives attribute the increased tech M&A activity to a convergence of multiple factors. First, buyers are flush with cash. A stronger stock market and economy have boosted corporate war chests, and low interest rates have led to a glut of investment capital at LBO firms, hedge funds and venture capital firms. Confidence is returning along with the cash. As the tech bust recedes in the rearview mirror, investors are becoming increasingly enthusiastic about electronics deals.

Finally, market conditions are pushing companies to consider acquisition deals: Wall Street investors are shying away from all but the biggest and most solid IPOs, and the rising cost of regulatory compliance is making it difficult for small, independent public companies to justify staying that way.

Although some are starting to worry about the possibility of an overheated M&A market, most industry observers believe that conditions are ripe for continued strong growth at least through 2006. "We speak to dozens of investment banks, and nearly every one of them expects it to be as busy, if not more so, next year. Their pipelines of pending deals seem to be stuffed full," says Tim Miller, general manager of the 451 Group, which tracks technology M&A activity. Tom Taulli, a finance professor at the University of Southern California (USC), echoes that view: "It's going to be a huge year for M&A in 2006."

Rising tide

By any measure, worldwide tech M&A activity in 2005 was up significantly over 2004. Miller notes that more than 2,500 major technology and telecom deals were announced worldwide through mid-November 2005, up nearly 30 percent from the total for all of 2004. In value terms, the $285 billion worth of deals recorded through mid-November was up 38 percent from the 2004 full-year total.

Within the electronics industry, computing and peripherals company acquisitions recorded the biggest increase in 2005. Investment bank Jefferies Broadview estimates that the computing and peripherals sector climbed from 14 percent of electronics M&A deals during all of 2004 to 23 percent during the first three quarters of 2005. Other leading sectors included network infrastructure, with nearly 29 percent of the 473 deals through the third quarter, and semiconductors, with 22 percent (see the "Leading M&A Sectors" chart, above).

Private equity firms such as KKR and Silver Lake Partners are responsible for much of the rising tide of M&A deals. Although they are relatively new players at the table, they have built up substantial cash coffers and are acquiring a taste for technology M&A (see "Gaining Leverage," January 2005, below). Investment bank America's Growth Capital (AGC) estimates that buyout firms financed 25 percent of all technology acquisitions in 2005, up from just 5 percent in 2003. A recent AGC report notes that with more than 200 private equity funds now larger than $1 billion, "the availability [of money] and pressure to do deals [are] extremely high." The 451 Group counted 51 private equity technology deals through mid-November 2005, compared to 25 during all of 2004.

Financial investors aren't the only source of capital that's fueling increased M&A activity. The improving stock market and a somewhat stronger economy also are contributing to the rebound. Bob McNamara, Jefferies Broadview's managing director, says U.S. tech M&A activity closely follows the Nasdaq composite index, which was nearing the 2,300 mark in early December, its highest level since May 2001. "We definitely have a recovery going on in the Nasdaq," he says, which bodes well for technology deal makers.

Such signs of economic strength are prompting companies that hoarded cash throughout the industry's downturn to look for ways to either deploy it or return some of it to shareholders. Software giant Microsoft, for instance, issued a massive $32 billion one-time dividend in late 2004 and still is sitting on more than $40 billion in cash. "There's a lot of cash on the sidelines," says USC's Taulli. And as companies such as Oracle, Cisco Systems and Sun Microsystems begin using some of it for acquisitions, he adds, it provides "a sign of confidence from the bigger players that the time is right to engage in this type of activity."

Many of those players have another motivation for buying. At the size they've reached, organic growth is becoming more difficult to achieve. Taulli notes that it's a struggle for big companies such as Cisco, IBM and Microsoft to continue expanding in markets they already dominate. "They're hitting the wall in terms of growth," he says. That forces the giants to constantly look for new markets to sustain their growth, and often M&A is the easiest way to enter them.

M&A motivations

Smaller players-the little fish getting snapped up by the heavyweights-have their own reasons for turning to M&A. The most common is a weak IPO market that's forcing most technology company investors to rely on M&A as an exit strategy. "There's really not a great public market for technology right now," says Roland Van der Meer, a partner at communications venture capital firm ComVentures (see the "M&A Trumps IPOs" chart, above). People are getting hurt: Last year chip distributor Memec Group was unable to complete an IPO to reduce its debt and repay the investors that had financed the company's management buyout from German utilities giant Veba in 2000. And in late November 2005, China's third-largest chip maker, Actions Semiconductor, raised just $72 million from selling shares on the Nasdaq, less than half of what it had initially hoped for.

Institutional investors are reluctant to take risks on IPOs, says Taulli, and that's forced startups and even midsize companies to find other ways to generate returns for their investors. It's also difficult for smaller public companies to get attention and analyst coverage from Wall Street investment firms, which have slashed their research staffs in recent years.

This isn't the dot-com bubble at all. Acqusitions in technology today are being driven by some clear business strategies."
—David Carney, Deloitte Consulting

More-stringent audit and internal accounting controls required by the Sarbanes-Oxley Act (SOX) have further increased the pressure on small and midsize companies. "There are significant advantages to operating a firm privately instead of as a public company," says Loren Lancaster, managing director of the Core Capital Group investment bank. He estimates that public companies now spend at least $2 million a year on SOX and other reporting requirements. For a large company, that's a frustrating but manageable sum, but for many smaller businesses, it can be enough to sink the ship.

Charles Welch, managing director at investment bank SVB Alliant, says that many companies simply may be too small to remain public. If your company's market capitalization isn't at least $500 million, "with a path to $1 billion," he says, it may be better to consider selling or merging with another midsize company. That's precisely what many companies have been doing. The 451 Group's Miller notes that, as of mid-November, 143 public companies or units of public companies had been sold in 2005, compared to just 71 the previous year.

Price pressures

The combination of surplus investment capital with increasingly motivated buyers and sellers is creating a fertile climate for deal making. Transaction prices are beginning to escalate, but surprisingly, many companies are still finding attractive deals.

For instance, after Memec's failed IPO, electronics distributor Avnet stepped in and acquired the company for $676 million, a very modest 0.3 times trailing 12-month revenues. The acquisition brought Avnet $2.3 billion in added sales while significantly strengthening its business in Japan and the rest of Asia. Avnet CEO Roy Vallee says his company negotiated "an attractive transaction for our shareholders," in part by using Avnet stock to pay more than $400 million of the purchase price. That arrangement allowed the seller, U.K-based Permira Funds, to share in the deal's longer-term value to Avnet, whose shares have risen nearly 30 percent since then, from $18 to more than $23.

Valee notes that the Memec deal was negotiated privately, thanks to a longstanding relationship between Permira and Avnet. Both companies purchased parts of Veba's business five years earlier and had stayed in touch in the intervening time. "We had built a level of trust and respect, and that made it easier," he says.

However, increased competition is clearly raising deal prices. AGC estimates that the median sale price of technology companies has risen during the past three years from 1.4 to 2.2 times trailing 12-month revenues, which is still less than half the 5.7-times multiple recorded in 2000. Competition between rival buyout groups pushed the final price of Agilent's chip division to about 1.5 times annual sales, a solid win in light of Agilent's track record of lackluster semiconductor profits and its diverse assortment of product lines. Avago CEO Dick Chang is pleased with the deal, conceding that "we certainly still have a very complicated story."

Most industry observers feel that electronics transactions have been reasonably priced, especially compared to a few deals in the Internet sector (such as eBay's purchase of Internet phone service provider Skype for up to $4.1 billion, or 68 times 2005 sales) that are beginning to approach the frothy levels of the dot-com boom. Van der Meer says electronics companies are selling for between 1.5 and five times their expected annual revenue, depending on their technology, intellectual property and sales momentum. Cisco's $6.9 billion purchase of Scientific-Atlanta, for instance, was less than three times Scientific-Atlanta's sales, when the TV set-top-box maker's $1.6 billion cash reserves are factored in. "There's good value to be had. The prices are not so dramatically high that they scare buyers away," says Van der Meer.

Caution warranted?

Despite the healthiest conditions in years, some fear that the recent market growth may not be sustainable. Core Capital's Lancaster says his firm is concerned that a weaker U.S. economy could slow M&A growth next year. He worries in particular that rising energy prices and interest rates, along with a slowdown in home refinancing, could dampen U.S. consumer spending and spill over to the technology industry. "We're cautioning sellers," he says. "If you're thinking about selling, do so now, as opposed to waiting another year."

Others, however, see more reasons for optimism than for concern. "There aren't any significant clouds on the horizon right now," says AGC's Howe. "There's more cash, more confidence, more capital." Another reason for optimism, says David Carney, a principal with Deloitte Consulting, is the industry's traditional source of growth: innovation and new technology. He expects the race between cable, telecom and wireless companies to deliver "quadruple play" packages of voice, video, wireless and broadband data services to sustain tech M&A for years. "Nobody's got everything yet," he says, "but companies are building all four of those capabilities." He expects that competition to bring "massive investment" to electronics makers.

As for the risk of an overheating market, Carney contends that the current upturn in M&A is far removed from the industry's excesses of early in the decade. "This isn't the dot-com bubble at all," he says. "Acquisitions in technology today are being driven by some very clear business strategies." The big shopping season may be over for consumers, but most expect that businesses will keep buying for some time to come.

Will M&A activity continue to grow in 2006, or is a slowdown on the horizon? Send your thoughts to feedback@eb.reedbusiness.com.

TOP 50 ELELTRONICS MERGERS AND ACQUISITIONSAnnounced 1/1/05 - 12/7/05

Russ Arensman (arensman@rof.net) is a Colorado-based business and technology writer and editor.

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