“I don’t know the word ‘quit.’ Either I never did, or I have abolished it.”
martinwolf Annual Letter
To Clients, Partners, and Friends of martinwolf | M&A Advisors,
2015 was a huge year by every measure. From the announcement of the biggest tech M&A transaction in history to the first interest rate hike in nine years, so much has changed since our last letter one year ago.
At the time, I wrote on five main themes:
1. The tremendous growth of annual deal activity
2. Increasing uncertainty in the global economy
3. The rise of Chinese and Indian IT companies on a global scale
4. The reinvigoration of the PC industry
5. Expectations of continued, high-value M&A activity in 2015
Looking back on the letter today, it’s clear that the stage was being set for a hugely consequential year: one in which significant value could be found if you knew where to look.
The tremendous deal activity of 2014 became this year’s record $4.5 trillion (a 42% increase). Uncertainty in the global economy has uneasily settled into a new normal, especially dampening the once-bright BRIC prospects. And the PC industry is adjusting to its own new normal, prioritizing higher value offerings and consolidating to cut costs in a low-growth environment.
In this letter, I’ll talk about key developments this year for the overall economy, the IT industry, and finally for our firm. In January, we celebrate our 19th anniversary—and I have no doubt our 20th year as a firm will be our best one yet.
In a press conference earlier this month, Janet Yellen announced that the Fed was raising its benchmark interest rate to between 0.25 percent and 0.50 percent. In her announcement, she was careful to announce that the increase did not signify a dramatic shift in monetary policy—the median projected target interest rate for 2016 was 1.375 percent, and much emphasis was placed on the ‘gradual’ path to expect as the economy feels out the change.
We’re not convinced that the Fed will go through with all four expected interest rate increases—it remains to be seen how the economy performs over the next twelve months. Consequently, we do not expect a major disruption to M&A markets because of interest rates, particularly in the lower mid-market space.
According to Yellen, the long-awaited increase was due to the “considerable improvement” in the US labor market and other economic statistics. But “considerate improvement” does not mean that the economy has regained its pre-recession vigor.
We’re not convinced that this raise was data-dependent. With its statements throughout the year, the Fed created a culture of expectation that boxed itself in—and if it had not increased interest rates, we would have seen a significant negative impact in the markets.
Real threats remain for the US economy. Dodd-Frank has led to an overall lack of liquidity, limiting the availability of banks to play market maker. Low-to-modest growth continues to characterize many US industries, and a record low labor force participation rate reveals there is much more to go.
The New Normal: Low Growth Across the Globe
But while we may be the one-eyed man, we rule over a land of the blind. From major economic blocs like the European Union to the once-promising BRIC association, there are major weaknesses imperiling a broader recovery. The European Central Bank announced this month that it would be expanding its bond-buying program (though not as much as some observers pushed for) amid major concerns that economics are just one of several existential threats facing the shaky political union.
Even India, the standout economic performer among a faltering BRIC plagued by low growth, political corruption, and falling mineral and natural resources prices, needs to do something to its legal and regulatory systems. Its peers have their own problems. China and Brazil battle low growth and high pollution, with Brazilian President Dilma Rousseff facing impeachment.
There is opportunity for the struggling economies. The relative ascendancy of the US economy has brought with it the ascendancy of the US dollar, making it increasingly costly for large US companies to conduct their global operations and creating the possibility for cost arbitrage benefitting European and Asian companies.
Another major story for 2016 has been the major decline in oil prices, with a barrel today trading as low as in the mid-30s. Declining oil prices have long been thought to have a stimulus effect on consumer products. Recently, that has not turned out to be true—as people are hesitant to believe this is a permanent shift, oil savings are being used to pay down debt rather than increase consumption. Historically, declining oil has been the sign of impending recession, but it’s not clear whether that is the case today. Between fracking in the US and the prospect of Iranian oil flooding on the markets, there is a global oversupply. This also has a direct impact on IT. Global oil companies, historically large IT consumers, have prioritized paying dividends and buying back stock to stabilize their share prices (even if it means borrowing money). Today, as resources continue to dry up, capital expenditures are being cut, leading to decreased IT spending for the foreseeable future.
2015 in IT: A Story of Consolidation
With low overall growth and blockbuster M&A, the real story is one of consolidation. The smallest segments are the fastest growing. SaaS, Cloud and Analytics companies see growth rates of 40 percent and above, while traditional software, equipment reselling and professional services firms are instead seeing growth rates between 2 and 6 percent, according to industry tracking firms like Gartner.
Because organic growth in these markets is so slow (especially with unfriendly economic conditions such as those in Europe and Asia), 2015 has seen a pattern of acquisitions aimed at reducing costs and securing top-line and profitability growth.
CSC’s acquisition of UXC brought the solution provider increased profitability and access to a new market at a meaningful discount thanks to the deterioration of the Australian economy. Capgemini’s acquisition of IGATE earlier this year provided similar benefits in the North American market.
Last year, we commented that we were seeing more consolidation among professional services providers than we’ve seen in ten years. This year, the trend only increased.
We continue to think that the cloud is very disruptive in a negative way for many of the people who are reading this. While the cloud revenue model can be very lucrative, a successful transition requires transforming the capital structure behind how products and services are delivered across the IT supply chain.
A key component of the solution provider business model involves wrapping high- margin services around low-margin product offerings and financing operations through product sales. But the cloud model precludes this approach, negatively affecting both growth and top-line—and thus cash flow. While in some cases profitability increases, it’s difficult to increase the value when the top-line declines and financing tightens.
New vs Old
Another interesting trend that we’ve seen this year has been the changing face of IT. Today, the big movers are FANG: Facebook, Amazon, Netflix and Google—not Cisco, HP, Oracle or the other storied names of Silicon Valley.
That doesn’t mean that the traditional names are down for the count. Instead, it means that maintaining a top market position requires significantly transforming one’s business. On the product side, Dell has been the biggest example. Fresh off its record-breaking LBO of two years ago, the company announced in October another record-breaking transaction—a bid for cloud computing provider EMC. It’s a very clever and opportunistic move, and we expect it to be successful.
In the software space, both Oracle and Microsoft are moving to transform their business away from the license sales model toward a recurring or cloud focus. Oracle is undergoing its transformation, but currently it’s finding that its newer revenue is not growing fast enough to cover the decline of its traditional software sales. We expect eventual success, in no small part due to the company’s strong install base
Microsoft has seen a dramatic change since Satya Nadella took over as CEO, and today we see it as better positioned. It’s a meaningful player in many segments, and aside from its debatable Xbox initiative, it is trying to allocate its resources in a way that creates maximum value both with products in the channel and cloud initiatives.
Apple faces the same need to transform. The company, famous for its track record of innovation, needs to prove to investors that it is more than just a cell phone company. It’s making steps in the right direction by embracing the trend of “smart” everything and focusing on its services such as music and storage. But BlackBerry, Nokia, Motorola, Sony and GoPro were all market leaders before they stopped innovating and their margins deteriorated. Apple must continue being transformative to avoid a similar fate.
What This Year Has Meant for Us
This year has been a very good year for our firm, with successfully closed transactions involving providers of Microsoft products, Microsoft services, Oracle products, Oracle services, and outsourcing solutions; a non-core division of a Fortune company; and other supply chain assets located in Australia, Canada, India, Ireland, the Netherlands, Singapore, the UK and the US.
We’ve also proud to highlight the content brought to you this year through our martinwolf Intelligence network:
• Five thought pieces about major industry trends published via LinkedIn
• Ten interviews with leading industry executives through our Executive Perspective series
• Sixty-eight Spotlight emails detailing noteworthy M&A or other business news And, of course:
• Quarterly market and industry analysis in our IT Index publication
• Quarterly commentary and industry multiples in our Valuation and Deal Insights publication
• Weekly Tracker and Scoreboard publications detailing financial statistics and notable transactions
As we look forward to our twentieth year as a firm beginning in January, I want to thank you for the role that you have played in our success. I wish you all Happy Holidays, a Happy New Year, and, as always, Happy Selling! Sincerely,