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Tech Industry

Why we need a high-tech shakeout

How many high-tech companies have folded their tents since the bubble burst? Not enough, say experts at McKinsey.

The technology industry badly needs a shakeout: A consolidation of the myriad providers that sprang up in the 1990s would benefit both the industry and its customers. Yet because of the interlocking interests of executives and board members, this catharsis probably won't come from within. Interlopers from the edge of the industry or beyond will probably drive the change.

During the 1990s, the boom in high-technology spending spelled prosperity for new and established companies alike. The popularity of enterprise-resource-planning (ERP) and electronic customer relationship management (e-CRM) systems, preparations for the millennium bug," personal-computer upgrades to take advantage of the Internet and expanding corporate networks, demand for cell phones and personal digital assistants, and the telecommunications companies' rush to build new networks--all of these factors created about $1 trillion more in demand than trends would have suggested in 1989.

Now this demand is gone, and we know there was less benefit from the technology purchases than the new-economy prophets would have had us believe. The overhang of capacity is significant. In software, for example, the number of companies increased by 15 percent during the 1990s while the market grew by 12 percent. For these companies to meet the projected consensus earnings reported by Zacks Investment Research, average net margins would have to increase by 94 percent, to a record 18 percent.

At the same time, software investment rose to 11 percent of worldwide capital spending during the 1990s. Although software may gain a slightly larger share over the coming years, the sheer scale of the industry will probably limit growth in demand to a maximum of 8 percent to 12 percent.

Yet the companies formed are still with us. Some are substantial businesses with good long-term prospects. They will invest through this downturn and emerge as leaders; think of Intel riding out the perilous financial times of the mid-1980s as the initial PC bubble burst. Many companies, though, are investing for a future they cannot reach. They need to be restructured--downsized, merged, acquired or liquidated.

Many companies, though, are investing for a future they cannot reach. They need to be restructured--downsized, merged, acquired or liquidated.

But the restructuring hasn't happened. Managers and boards of high-tech companies share an interest in maintaining their positions. Because high-technology companies favor executives in the industry as board members (for their expertise), these informal coalitions cross company boundaries. The investment bankers and private-equity firms that might propose a restructuring fear disrupting their relationships with this community and reducing the odds of winning future business from it.

In fairness, these executives and directors are also cautious because of the conventional wisdom that hostile deals do not work in high technology and that most mergers have not been successful. This exaggerated belief is grounded in a misreading of history. When the last extended downturn hit in the 1980s, a much smaller high-tech industry was populated by a fraction of the number of companies that compete in it today. More important, the installed base of enterprise technology was smaller, so predictable revenue streams for support and maintenance were neither as large nor as stable as they are today.

Moreover, the potential benefits of consolidation are quite substantial. Most enterprise-software companies, for example, spend 25 percent to 35 percent of their revenue on selling, general and administrative expenses. If companies selling to the same customers were consolidated, the new company could slash these outlays. Customers would benefit as well: The plethora of vendors has left most IT organizations with confusing and expensive choices.

Further, many companies are investing in research and development for product lines that have a dimmer future than management would like to believe. These outlays can run to an additional 15 percent or so of revenue. Coolheaded managers can find savings here as well.

Last, a number of companies are trading at or below the value of the cash on their balance sheets. There is economic value to harvest either by finding tax-efficient ways to return that cash to investors or by merging companies to channel it to businesses with a brighter future.

In the larger context, restructuring could spur the industry to do a better job for customers. Customer spending will probably pick up when enterprises become convinced that they can get top- and bottom-line benefits from their technology investments. Companies need tailored solutions and help to make their organizations, business practices and processes more productive. Many small technology companies cannot accomplish this.

What will it take to open the gates to restructuring?

Most likely the industry will require outside intervention. Much as T. Boone Pickens and Drexel Burnham Lambert shook up the energy and other industries in the 1980s, people and companies outside the circle that formed during the prosperity of the 1990s, may show the way.

Most likely the industry will require outside intervention.

Many leaders of the restructuring of the 1980s are reviled for the excesses of that period, but their actions ultimately made U.S. industry more competitive, laying the foundation for the burst of productivity and growth that blessed the U.S. economy for much of the 1990s.

This is a task worth undertaking. As the industry works through the current slump, conditions are ripe for a return to average annual growth rates of 8 percent to 10 percent. Top companies will outperform those levels. The sooner the restructuring gets under way, the sooner there will be a chance for better times

For more insight, go to the McKinsey Quarterly Web site.

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