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Analysis of “Top 10” IT Leaders’ Market and Business Performances

Let the M&A Games Begin

Mergers and Acquisitions: Key to Growth in Crowded Marketplace

PHOENIX, June 20 - Mergers and acquisitions… They seem to be the key to growth in an increasingly crowded IT marketplace.  Driven by hungry investment bankers, the M&A’s are the long-awaited accelerator to our 1990 Industry Stratification trend.

As Oracle and PeopleSoft are battling it out in a $6.3 billion hostile takeover attempt by Oracle, Sun Microsystems CEO Scott McNealy ostensibly sought to squelch the rumors that his company was a takeover target, a CBS Market Watch reported yesterday (June 19), quoting from an Italian financial newspaper (Il Sole 24 Ore).

McNealy’s comment could have come right out of the “Wag the Dog” film.  “Deny, deny…” is a surefire way to fuel rumors, according to the politico character played by Robert DeNiro.  “There is no B-3 bomber”-denial was actually the launch of a series of speculative stories about the phantom B-3.

The fact that Sun's shares were at $5.32 when McNealy made his comment, up 58% since April 1 mostly on account of takeover rumors, didn’t hurt the Sun insiders’ interests, either.  Some, including the CEO McNealy, have already cashed in on it. 

McNealy, for example, exercised 1.6 million options on Apr 25 at a cost of $1.38 million, according to insider trading reports.  Three days later, he sold them for $5.26 million - netting a tidy profit of $3.88 million.

Furthermore, as you have seen from our earlier reports, IBM and HP have both used M&A’s to grow.  Last year, they gobbled up PriceWaterhouseCoopers and Compaq respectively.  And there’ll be probably more such megadeals, both this year and next.

The “key to IBM’s growth beyond 2004 will be savvy acquisitions,” we wrote in a recent Annex Bulletin that contained our five-year forecast for Big Blue (see “Save, Spend and Split,” May 8).

“The main reason for such an impressive revenue “gold” medal sweep by the newcomer, of course, was HP’s acquisition of Compaq, completed just over a year ago,” we said in “A Cinderella Story” (May 23).  “Since Compaq had a bustling services business, thanks mostly to its 1998 takeover of Digital Equipment Corp. (DEC), HPS grew by leaps and bounds practically overnight” (also see “From Obscurity to Stardom”, May 13).

“Accenture is the only company among the Top 6 whose growth has been mostly organic (internal),” we also noted in our annual report on top global IT services firms (see “A Cinderella Story,” May 23). 

Who’s Next?

So is Accenture, therefore, going to be the next big acquirer?  Or now that it’s a public company, might Accenture become the target of yet another IT predator?  Or will some other company grab the next mega M&A headlines? 

Well, we can’t read the minds of acquisitive CEOs.  Nor can we speculate about various “poison pill” takeover defense strategies by the target firms.  But we can tell you what kinds of deals would make sense to us, based on our Industry Stratification model and the financial records of the top IT competitors.

To illustrate the point, we selected 10 leading IT companies, and performed various financial analyses of their scorecards in the 1998-2003 period.  You will find hardware, software and services vendors among our “Top 10” (Accenture, CGE&Y, CSC, Dell, EDS, HP, IBM, Microsoft, Oracle, Sun Microsystems - in alphabetical order).

As you can see in Table 1, the Top 10 represent nearly $300 billion in aggregate revenues, over $700 billion in market capitalization, and more than $150 billion in equity.  They have grown their revenues at a compound annual rate of 8% in the last five years [IBM happens to be the only Top 10 competitor whose revenues actually declined(!) - see the chart].  The Top 10 also grew their equity at 17% per year, and their market cap at 2% annually in 1998-2003.

So who are the potential buyers and the potential targets among the Top 10?

Well, from our Industry Stratification criteria, the hardware and software companies should be the primary buyers.  They are sliding down the food chain of the industry at whose top are the IT services vendors - the most likely acquisition targets. 

But buyers must also have substantial capital - both in terms of equity and market cap. 

Put the two criteria together, and you come up with Microsoft, IBM, Dell, Oracle and HP as the most likely buyers.

(IBM and HP, of course, play in all IT markets, including services.  But they are not likely to sell their service operations - the strategic “crown jewels” of these two IT giants).

Which leaves Accenture, EDS, CGE&Y and CSC as possible acquisition targets. 

The Sun Saga

And what about Sun, the grist for the latest takeover rumor mills?  Well, in our humble opinion, Sun should also be actually a buyer, not a target - at least from a strategic standpoint.  But its $7.4 billion equity and the $17 billion market cap are hardly the kind of war chests that would be big enough to handle the eventual multi-billion M&A megadeals.

So we agree with McNealy, albeit for different reasons. 

The Sun CEO told the Italian financial newspaper Il Sole 24 Ore that a takeover bid for Sun was “nonsense” because the company was too expensive for any U.S. suitor to acquire. McNealy said estimated Sun's market capitalization at $17 billion and an acceptable premium would bring any acquisition cost to at least $25 billion (see CBS Market Watch, 10:19am 06/19/03).

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We think such rumors make little sense because even at $17 billion market cap, Sun may be too expensive a target, especially for a company that has been reporting operating losses on declining revenues. 

In the latest quarter that ended March 30, for example, Sun’s revenues dropped by 10%.  Its operating loss during the first nine months of its current fiscal year amounted to $2.7 billion.

If Sun were a takeover target, the above would imply that it is that just because it’s doing poorly (i.e., because it is a turnaround opportunity).  That’s a flawed and perverse logic.  Once upon a time, Digital Equipment Corp. (DEC), for example, was also considered a turnaround opportunity.  And what happened?  Instead, DEC is turning in its grave.

DEC was gobbled up in 1998 by Compaq, which was swallowed up in 2002 by HP.  Bigger fish feeding on smaller fry... 

Is that what may be in store for Sun?  Most likely.  But Sun does have a “crown jewel” of its own - Java - that both Dell and HP have just added to their PCs.  Yet Java seems to heading the way Unix was in the 1980s.  It is becoming a de facto industry standard while making little money for its owner/inventor.  Once Sun or somebody else figures out how to cash in on Java, the company’s value may indeed sore… for a good reason, for a change.

Meanwhile, takeover rumors involving Sun may continue to generate more ink than cash, except for media companies that feed off such rumors, or for Sun insiders who cash in on current relatively high stock prices.

Microsoft, The Predator?

And then there is that recurring rumor - that Microsoft may make a play for Accenture, just as Computer Associates, for example, launched an unsuccessful bid for CSC five years ago (see “CSC: A Mouse That Roars,” Nov 1998). 

Earlier this week, for example, we handled another media call about the supposed Microsoft-Accenture deal.  So let us try to dispel such gossip, at least on the basis of common sense and reason.

Yes, an acquisition of a major IT services company would make sense for Microsoft.  The move would elevate the largest software company in the world up the IT industry’s food chain. 

And yes, Steve Ballmer, Microsoft’s CEO, is on Accenture’s board of directors.  So he has access to both the data and the ears of Accenture’s leaders.

But such an acquisition would come at a cost.  High cost.  First financial…

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With a market cap/equity ratio of 27.7, Accenture already tops all other Top 10 companies in our survey.  Dell, Oracle and IBM follow with market cap/equity ratios of 16.4, 11.1 and 6.0 respectively.  Microsoft is next with a 4.8 ratio.  CGE&Y, EDS and CSC are in the cellar (see the above chart).

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If you look at the market cap/revenue ratio, Accenture and Sun are both in the middle of the Top 10, with 1.4 ratios.  Microsoft, Oracle and Dell lead the Top 10 in this category, with ratios of 8.9, 7.4 and 2.3 respectively.  EDS, CGE&Y and CSC are again in the cellar (see the above chart).

So if Microsoft wanted to make a play for an IT services company, there are many cheaper targets than Accenture… such as the above three services firms, for example.

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EDS, for instance, with revenues almost double those of Accenture, even after its recent stock surge (see the chart), has a market cap of only $12 billion (vs. Accenture’s $16 billion).  CSC, with revenues about the same as Accenture’s, has a market cap less than half of Accenture’s (just under $8 billion).

Furthermore, regardless of which IT services company Microsoft were to acquire, the software giant would also pay a price in its own business.  A number of its partners and customers may feel disenfranchised and disenchanted.

Microsoft’s takeover would make even less sense from Accenture’s standpoint.  Why would a company that’s already on top of the industry’s food chain want to step down a tier and be gobbled up by a software giant?  Why would a services vendor have to battle an implied bias for its parent company’s software? (the problem that IBM and HP services operations face, for example, both in terms of software and hardware).

Wouldn’t it make much more sense for the two companies (Microsoft and Accenture) to continue their cozy relationship, including that at the board level, and their arms length partnership as it exists today?

To us, continuing the status quo makes more sense for both parties.  On the other hand, common sense and reason haven’t always prevailed on Wall Street, have they? J


Of course, the preceding still leaves room for all sorts of other M&A plays.  And not just between the would-be hardware/software buyers or their probable IT services targets.  Some intra-services industry acquisitions may also be in order, such as last year’s IBM-PwCC deal, for example.

The fact that CGE&Y, EDS and CSC are hugging the cellar in two important value categories (market cap/equity and market cap/revenue) makes them interesting targets for all sorts of companies, including some of their competitors.  Of the three, CSC, a company that has itself grown mostly through acquisitions (see “Less Than Meets the Eye,” May 16), seems to us as the most likely target.

First, because it’s relatively cheap.  With a market cap/equity ratio of 1.7 and the market cap/revenue ratio of 0.7, CSC seems like a bargain compared to its higher-priced competitors. 

Second, and more important, CSC is now going back to its roots - the federal government business.  So competitors that are absent from or not very strong in that segment may find CSC strategically appealing, especially in today’s global war economy. 

IBM, for example, got out of the government business in 1994.  So Big Blue would be one possible CSC buyer.  HP and Accenture may also consider this play, especially as they are both strong in Europe, the market in which CSC has been suffering market share losses.

And so on… As we said at the outset - “Let the M&A Games Begin.”  Our musings on should give only a foretaste of megadeals to come.  So join the fun and games.

Happy bargain hunting!

Bob Djurdjevic

For additional Annex Research reports, check out... 

2003 (IBM): “Save, Spend and Split” (May 8), “Shrunk by the Marketplace” (Apr 17), “Turnaround Continues...” (Apr 15), “Start of a Real Turnaround?” (Jan 17).

2003 (Global): Exodus from Equities (May 27, 2003)

Last three Heptathlons: Annex Research IT Services Heptathlon 2002 (May 21, 2002)IT Services Heptathlon 2000 (May 11, 2001)1999 IT Services Heptathlon (Apr 17, 2000)

Or just click on and use appropriate  keywords.














































Volume XIX, No. 2003-13
June 20, 2003

Editor: Bob Djurdjevic
Published by Annex Research

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