Who Will Be the Next Tech Gorilla?
I don't know if this was already posted
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Barron's online
Who Will Be the Next Tech Gorilla?
By MARK VEVERKA
Which nascent small-cap phoenix will rise from the Nasdaq ashes to become the next 800-pound gorilla? We wish we had a nickel for every stockpicker, professional and amateur alike, who claims to have bought Cisco before it was better known than the restaurant supplier of the same name, though a different spelling.
The same holds true for all of those folks who contend they owned JDS before it even considered marrying Uniphase. Or those who built positions in EMC back when most people thought owning storage meant holding shares in U-Haul. Because gorilla stocks are made, not born, there will be others. And they are likely to be in segments or sub-segments of information technology that do not exist today, says Stephen Smith, vice chairman of Broadview Holdings, a boutique investment bank that specializes in technology mergers and acquisitions.
Before Microsoft, there was no other software developer like it. Before Cisco, there was no other networking gear maker like it. And before JDS Uniphase, there was no other telecommunications component company like it. And so on, Smith says.
But how does a fast-growing tech concern catch the fancy of Wall Street and build the shareholder value necessary to crush those competitors in its path? Through mergers and acquisitions, Smith says. "JDS became a gorilla through an aggressive acquisition program. And there are going to be a lot more gorillas in the future," he argues.
Of course, there is an obvious self-serving benefit to preaching growth-throughacquisition when you're in the M&A advisory business. But Smith says he learned the hard way as head of business development at a Bay Area technology firm that moved too slowly on a plan to merge and was left in the dust.
Thus, the title of Smith's compelling study: "Make Dust or Eat Dust." In it, Smith chronicles how aggressive acquirers, such as chipmaker PMC-Sierra and optical component maker JDS Uniphase-each with solid technology and operations in its own right-outpaced their competitors to become the gorillas in their respective sectors.
But first, some background. The total number of publicly traded information technology companies in the U.S. swelled to 1,510 from 1,069 in 1996, largely owing to the red-hot IPO market at the end of the decade. Despite all of the money that poured into technology funds during the boom, only 319, or about 20%, of those companies, have market caps over $1 billion. The majority of the companies, 669, are micro-caps with less than $100 million in value, while the remaining 522 companies sport market caps somewhere in between.
Smith's basic message: Small and mid-cap companies have a big problem. They are incapable of attracting investors because the new rules of Wall Street favor big, liquid gorillas. "There is a structural problem in our public equity business; therefore, most firms only want to pay analysts who bring in underwriting or sales and trading business," Smith says.
That makes it more difficult for fledgling tech stocks to attract analyst coverage, which is integral to institutional ownership of their shares. Broadview does not underwrite offerings or provide brokerage services, which puts Smith's firm "in a position to talk about the lack of emperor's clothing" on Wall Street. The problem has been exacerbated in recent years by the disappearance of the "Four Horsemen" investment boutiques that specialized in tech banking. Now they are all divisions of international financial conglomerates that focus on bigger customers. Robertson Stephens (FleetBoston), Alex. Brown (Deutsche Bank), Hambrecht & Quist (J.P. Morgan Chase) and Montogomery Securites (Bank of America) have all lost their independence. And as a result, emerging technology companies have lost their sponsors in the marketplace.
Thus, being a small or mid-cap presents a Catch 22 for money managers because their floats are too thin. And institutional money managers can't afford to toy with illiquidity. "They can't get out of them. So they don't get into them," Smith says. "The market pays attention to size."
That's an understatement. The big-cap tech stocks in the Nasdaq universe captured about 88% of the trading volume.
But what are small and mid-cap tech companies to do about it? Smith maintains that they have four choices: Become a gorilla, become a buyer, sell to a gorilla, or sell to someone. Between 1996 and 2000, the companies that engaged in any of the four "external" options outlined by Smith saw their median share prices appreciate about 4%. All tech companies saw their average prices rise about 1% during that time frame, but those that engaged in no external development saw their shares fall 11%, Smith says. Whatever it is, these fledgling tech concerns should not sit still and do nothing. "You don't want to wake up and find out that your competitor is merging with a gorilla," Smith admonishes.
Of all of the gorilla success stories, Cisco has to rank at or near the top. The company's ability to digest operations and meld cultures has been extremely successful-if not the model of the industry. "I would speculate that the Cerent deal has paid Cisco's shareholders many times over." Cisco bought the small, privately held optical components maker in 1999 for $6.9 billion in stock. "Without Cerent, Cisco would be a fledgling instead of a powerhouse."
But the explosive rise of JDS Uniphase may best illustrate Smith's message. Between 1996 and 1998, then-Uniphase of San Jose was barely a blip on tech managers' screens. It wasn't until it began its M&A binge in 1999, including its mega-merger with JDS Fitel of Canada, that its shares began to take off, soaring as high as 153.42 in 2000.
The company's market cap has risen from $756 million in 1996 to $39.36 billion at the end of last year, which is off its high because of the tech wreck of last year. In 1996, JDS Uniphase's market cap was 8.7 times revenues. At the end of 2000, it was more than double that at 19.8 times revenues, Smith notes.
Another striking example is that of PMC-Sierra and Dallas Semiconductor, both makers of networking chips. In 1996, these two competitors were of similar size with Dallas Semiconductor sporting a market capitalization of about $540 million and PMC with a market value of about $410 million, according to Broadview. At the end of last year, PMC's market value bulked up to $12.7 billion while Dallas Semiconductor grew to $1.4 billion. The difference? PMC bought out eight companies, which propelled its compound annual growth rate to 134%. Meantime, Dallas Semiconductor stayed on the sidelines, and enjoyed respectable compound annual growth of 23%. The point here, Smith says, is that Dallas Semiconductor is a fine company that performed quite well. But its shareholders didn't benefit in the same way as those who owned PMC.
"Both companies did alright. But the one that was aggressive did better," Smith notes. One of the big problems for some potential buyers, and understandably so, has been the sky-high valuations that the best nascent tech firms were fetching. But the tide has shifted from a seller's market to a buyer's market. "This market correction has really created a buying opportunity. And the big guys who are flush with cash [Intel, Cisco, Broadcom] are going to take advantage of that," Smith says. "I think Intel will do plenty of deals. They are the gorilla."
Says Smith: "It's easier when the IPO market is dead, as it is right now, and when valuations are down, as they are now. I think in general, the gorillas are licking their chops."
As deregulation-induced blackouts rocked and rolled their way across the power grids of Northern California last week, Silicon Valley tech execs were scratching their heads, wondering why they even bother trying do business in this energy and housing challenged neck of the woods.
While the Golden State is involuntarily forgoing candlepower for candlelight these days, isn't it good to know that Exodus Communications' Internet server farms are stationed in a place where electricity is scarcer than Land Rovers?
If it weren't for all of the backup power systems intended to keep factories running in the event of major shakers, the likes of Cisco and Intel would be up Dry Creek without paddles. It takes a lot of juice to make chips and routers, but here in the epicenter of the information age having enough electricity to run the break-room coffee pot apparently is asking too much from public policy makers.
What's more, as if working in the dark wasn't enough of a distraction, kamikaze truck drivers are ramming big rigs in to the state capitol just as our august solons are burning the late night oil trying to find legislative solutions to our energy mess. California Gov. Gray Davis reportedly has his eyes on the White House. But if he doesn't find some affordable electricity soon, the lights in his campaign office will be the first to go dark.
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