High-tech hostilities: Waiting for the trigger

From the McKinsey Quarterly
Special to CNET News.com
September 16, 2004 6:00 AM PDT

The rules of economics don't apply to the high-technology sector--or so it might appear to anyone who has been waiting for a high-tech shakeout.

Growth has slowed, profits have shrunk, and investors are eager for the billions of dollars in potential value to be had from mergers, acquisitions, downsizings and liquidations. All signs point to an imminent restructuring, yet so far not much has happened.

There are certainly formidable barriers to the consolidation of high tech, but the same was true of defense, banking, automobiles, petroleum and indeed every sector that has restructured. Fundamental economic forces ultimately prevailed, however. In high tech too, the barriers are starting to erode. While they might delay change a little longer, restructuring is inevitable--and likely to happen sooner rather than later.

It's time for technology executives to gain a better understanding of what restructuring means for them and to move forward with plans to thrive as it gathers steam. To do so, these executives will have to understand how the unique dynamics of their individual industries shape what companies can achieve in the imminent restructuring. Some high-tech industries are under greater pressure to regroup than others.



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For example, in storage software and hardware, where technology is relatively mature and incentives for consolidation relatively high, companies might choose to reap scale advantages by acquiring peers or to reposition themselves in an evolving industry structure by making acquisitions across segments. In the sector as a whole, high-tech executives must be prepared to make more deals than they have in the past, for history shows that deal makers are most successful when moving proactively. And executives should be aware that hostile deals, hitherto rare in this sector, are likely to become more common.

Finding the hot spots
Technology is a huge sector that spans many industries and markets. The pressures on companies are mounting fast, though the specter of consolidation won't haunt each of them equally. Indeed, some segments have already consolidated. Where once there were a fair number of operating systems for PCs, midrange computers and mainframes, for instance, now there are only a few. The database software industry has gone the same way. But other industries, by the very nature of the value propositions their niche companies provide, will probably remain fragmented. Vertical-specific applications are an example.

We wanted to get a better sense of how imminent consolidation is, so that executives could assess the position of their own industries and of other segments, within or outside their industries, that they might wish to enter opportunistically. Thus we investigated the extent to which the economic forces driving consolidation were at play in 21 of the high-tech sector's leading industries. The indicators we looked at included each industry's fragmentation levels, maturity (as measured by growth rates), and profitability. We also considered incentives for consolidation, such as the need for scale to justify larger capital expenditures and the importance of scope to meet the changing needs of customers.

We found strong signs of impending restructuring in 11 of the industries we analyzed. These hot spots account for more than two-thirds of the sector's revenues?a fact that speaks volumes about its ripeness for consolidation. In IT services, for example, professional and outsourcing services seem to be poised for an across-the-board restructuring. Software is vulnerable in particular areas, such as , storage, network and systems management and security, middleware, and software for application servers. In hardware, the targets are PCs and notebook computers, networking gear, and storage systems; in semiconductors, they are logic, memory, and semiconductor equipment.

Most technology mergers have been small, friendly affairs financed by the acquirer's stock, but we expect that picture to change.

While economic forces take effect, companies will jockey for increased scale or scope or for some combination of both. As in any sector, scale-driven mergers, to streamline fixed costs over greater volumes and to satisfy the demand for bigger and more stable suppliers, will mostly take place between companies competing in the same industry.

Customers' needs will also influence mergers undertaken for advantages of scope. Indeed, deals of this nature have already been done: In response to financial pressures and to the clamor of capital markets, companies that manufacture technology products have been acquiring service firms. We expect such mergers to proliferate as companies expand their breadth of product or service offerings to position themselves as preferred suppliers for big customers, to chase new profit streams, and to hunt for cross-selling and multichannel synergies.

The semiconductor equipment industry, for one, is likely to see both scale and scope come into play as companies prepare to serve fewer and bigger semiconductor manufacturers, only some of which will be able to finance next-generation research and fabrication plants. Consolidation has already taken place in certain pockets, such as deposition, diffusion and lithography, but the industry as a whole remains fragmented; only a handful of companies, including Applied Materials and Tokyo Electron, have significant positions in more than one or two areas.

The need to consolidate will therefore inspire scale deals in the few areas that are still fragmented (automation, assembly and packaging), while demand for complete process-module solutions means that scope deals are likely across industries. Vendors will thus capture sales and marketing synergies by selling to the same customer base. Moreover, an integrated solution across related areas (deposition and etching, for example) can shorten development cycles and ramp-up times. The enterprise software market will restructure along similar lines.

Restructuring could also be triggered by companies that exit an industry altogether. This is likely to happen in the PC business if some companies decide that the benefits of merging are questionable as the industry's economics deteriorate. Finally, where mergers and acquisitions don't make sense, companies might forge alliances or transform themselves without resorting to alliances or M&A.

For investors, the coming restructuring represents billions of dollars in potential value. Our analysis of the sector determined that there are many small and midsize companies that are barely if at all profitable and which have cost structures more appropriate to larger businesses. As some of these companies drop out or are acquired, the survivors will reap economies of scale and scope. If a wave of consolidation and exits helps the remaining companies to reach the profit and cost structures of the current top three in each industry, total annual operating profits could rise by up to $18 billion. Granted, that is a very high bar and the goal isn't really achievable. But if just half of the theoretical potential were captured, raising profits by $9 billion, the sector would gain $230 billion in market value--about 15 percent to 20 percent of its total. The scope of sectoral inefficiencies and the potential for reorganization are clear.

Shape IT or leave it
The economic rationale for consolidation might be similar in all sectors of the economy, but restructuring unfolds in ways specific to each of them. In the same vein, our advice to companies begins at a general level before proceeding to specifics. We'll examine the two classic roles--market leader and challenger--before discussing the advantages of M&A for the long view and the need to prepare for more hostile deals.

When industries consolidate, market leaders and challengers can make acquisitions within their industries to create economies of scale or across industries to gain economies of scope. To know what to do and when, companies need to develop a perspective on restructuring trends and the way these affect their particular industry. To envision the likely end game, they should consider shifts in customer behavior and the factors required for success. And as they make their moves, they must evaluate how competitors will probably respond.

In sectors that are restructuring, market leaders aim to protect their position from challengers while seizing opportunities to extend their dominance; they therefore make acquisitions to head off those challengers and to increase their scale. In the high-tech sector as a whole, market leaders should defend the customer base by tightening their control of the value chain and customer relationships or by creating scale advantages in R&D and sales. Oracle, for instance, is pursuing a broader footprint and new growth in its .

If confronting the market leader directly is too risky, companies can pair up to carve out a defendable niche.

Scale offers efficiencies in large fixed costs--which are essential in industries (such as memory chips) that require massive up-front capital investment or in industries (such as software) that call for expensive R&D. Scale also extends control over the value chain. Customers gain confidence in the ability of the vendor to provide long-term support services and are more likely to choose it as a preferred supplier. HP's merger with Compaq, for example, gave HP enhanced control over its value chain, cost synergies, and access to additional customers, to which the company could now sell more comprehensive solutions. These factors should help HP compete with IBM and Dell.

Scope acquisitions can broaden the footprint of a leader and increase the dependence of its customers. Cisco Systems' growth strategy in the 1990s was based on scope acquisitions, and the company swiftly used its distribution capabilities to stake out strong positions in access solutions and security. Microsoft's purchase of and extended its reach into enterprise applications. EMC's acquisition of presaged a move away from the slower-growth and rapidly commoditizing storage-disk-subsystem market and into the system-management-software market?a core control point of an enterprise IT infrastructure. The company's decision to buy shows a similar move into content management.

For companies in some segments, such as IT services, scope deals offer an opportunity to become the prime integrator for customers' needs; IBM's acquisition of the consulting arm of PricewaterhouseCoopers is a recent example. A few words of warning should be sounded, however: If the acquisition has a different revenue model (as in the case of a hardware company acquiring a software one), the buyer must avoid compromising the target's underlying business model.

Typically, a challenger in a restructuring industry confronts industry leaders by "rolling up" smaller companies to achieve scale or by merging with another challenger, thereby driving radical cost-structure changes through operational integration and redesigned business processes. PeopleSoft's acquisition of in enterprise applications provides a good example of a challenger buying a peer to reduce operating costs. The combined company can use its larger scale to become a preferred supplier to key customers.

Alternatively, a challenger can attempt to extend its scope by acquiring players in adjacent industries and combining the offerings into solutions, with the eventual aim of changing the basis of competition. BEA Systems, for example, started with a transaction-processing product and then, by acquiring companies such as WebLogic, gained leadership in the application server and middleware market, where we expect further consolidation.

Second-tier storage and networking vendors could also benefit from teaming up in this way, as might companies in middleware and network management. In semiconductors, several companies could combine to form a large chipmaker focused on consumer electronics. (Beyond high tech, banks such as Morgan Stanley and UBS Warburg have used scope combinations to reposition themselves as financial-services providers.) Such deals challenge the acquirer to create a compelling value proposition and to build a sales force that can communicate it forcefully enough to displace incumbents.

If confronting the market leader directly is too risky, companies can pair up to carve out a defendable niche. IT service providers could take this approach in health care, say, if they found themselves unable to compete more broadly. Aspiring niche players must assess whether they can create sustainable entry barriers based on proprietary technology, innovation, industry knowledge or locked-up customer ties.

Finally, the best way to recoup value is sometimes to sell part or all of a company. In this case, it is often wise to move sooner rather than later to get the highest value for shares and to position the company in the most attractive light, which may mean shedding noncore assets. Such moves sometimes unlock resources that can be reinvested to make a company stronger in more strategic segments.

The long view
Market reactions to merger announcements tend to favor the target; fewer than half of high-tech acquirers see their shares rise after disclosing their plans. No wonder boards and executives are wary of acquisitions. But the most successful high-tech companies--those averaging more than 39 percent annual growth in returns to shareholders from 1989 to 2001--were serious deal makers, undertaking almost twice as many acquisitions as their competitors. History also shows that companies with active M&A agendas tend to outperform their peers during and after industry downturns. Companies that avoid acquisitions often run out of steam, whereas enterprising acquirers renew and refocus themselves.



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Companies should be cognizant of, but not overly concerned with, investors' short-term reactions. Instead, they need to ensure that the long-term returns from their acquisition plans maximize shareholder value. Take Intel, which in recent years has acquired several suppliers of communications chips. Not all of the deals (for example, the acquisition of Level One Communications) have been applauded as successful by observers, but together they helped Intel establish a new communications growth platform on which the company has built a multibillion-dollar business.

High valuations can sometimes make alliances more enticing than M&A, especially if synergies wouldn't justify a full acquisition. Dell's recent alliances with and are examples of how these arrangements can be used as a low-risk step to broaden a company's scope into new segments.

Most technology mergers have been small, friendly affairs financed by the acquirer's stock, but we expect that picture to change. Oracle's attempt to acquire PeopleSoft is an early example of what could become the new reality in high-tech restructuring. Executives and boards should thus prepare for hostile takeovers, cash deals and the greater involvement of private equity firms--all common in other sectors. Furthermore, as companies reach for scale and scope, they will attempt larger deals. While a hostile takeover is rarely the preferred approach, these deals are likely to become more frequent, especially when the target's management has strong incentives to resist an acquisition that has real economic logic.

Despite the recent run-up in share prices, cash deals may also be more attractive for acquirers with deep pockets as well as in hostile situations when cash offers can give shareholders a low-risk way to take money out of their investments. Such deals will attract the interest of private equity firms, which have actively reshaped other sectors but have had only a marginal impact in technology because of high valuations and hesitant boards. These firms could become valuable partners for high-tech companies that need to offload nonstrategic assets and focus on the core business. The Clayton, Dubilier & Rice acquisition of Lexmark from IBM, in the early 1990s, is the obvious example of such an arrangement. Private equity firms are often better positioned to make the most of undervalued and stranded assets (such as service revenues from older technologies) by taking public companies private or stripping them down. Some will also pursue turnaround opportunities, as Silver Lake Partners and Texas Pacific did with Seagate Technology.

The high-tech sector is overdue for a shakeout, and the magnitude and extent of the coming shifts promise to unlock tremendous value for companies surviving the consolidation. Those that act quickly can position themselves to lead in the coming era, just as the consolidation strategy of Citigroup in the 1990s helped it gain leadership of the U.S. banking industry. How quickly the shift occurs will depend on how soon barriers to consolidation fall. Regardless of the pace, though, technology executives have a unique chance to unlock value for their shareholders.

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

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High-tech hostilities: Waiting for the trigger

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