1% Margins, 100% Fun: Why Technology Distribution is Relevant

The “canary in the coal mine,” is what my boss used to say when describing Technology Distributors like Ingram Micro, Tech Data, Avnet and Arrow Electronics. How these players fare can be a leading indicator of what is coming down the pipeline from Technology juggernauts like HP, IBM, Cisco and leading chip manufacturers; all of whom are suppliers into the Channel. But distributors are more than just channel checks, they are the often overlooked and under appreciated engine that powers the supply chain.

Distributors are the middlemen. They do the dirty work of connecting leading OEMs to end-users through a large and fragmented reseller universe. Experts will differentiate between broadline, specialty and component distributors. This classification is not important for us now. The basic facts you need to know are:

• $35 billion in annual sales (Ingram Micro hit over $35 billion in 2007)


• 1.0 - 4.0% operating margins (Tech Data and Ingram Micro have gone sub 1% in recent quarters)


• Each major distributor has issued multiple tranches of straight debt and/or convertible securities

These are big “technology” companies with razor thin margins and high capital requirements. As such, capital structure is important and debt is used often. The capital markets and the banks play a large role in funding operations and covering swings in working capital. This requires true corporate finance advisory work from investment banks; and that makes the industry not only relevant but fun.

Unfortunately for product specialists, when business slow down, these guys are cash machines. Falling revenues lower working capital needs as inventories get worked down and there is no reason to access the capital markets. But when things get going and growth is back, the cash machine will run in reverse and banks will be happy to help. There is also a fair amount of refinancing needed.

On the M&A side, while the industry has already experienced substantial consolidation, there is room for more. And some potential transformational acquisitions could be on the horizon as the industry continues to evolve. More on this to come…

IBM adds predictive analytics with $1.2bn SPSS deal; Software M&A intensifies

On 7/28/09 IBM announced its acquisition of SPSS for $50/share ($1.2 bn equity value and $1.0 bn enterprise value) representing a 42% 1-day equity premium. The predictive analytics offerings of SPSS is expected to reside in IBM's Information Management segment. Transaction represents IBM's continued execution on its Information Agenda strategy which began as data on demand for decision support and is blossoming into real-time trend forecasting and optimization capability for businesses. The deal illustrates large software vendors' interest and ability to pay up for strategic and competitive assets.

While the 42% single day premium, which is also well above the 52-week high, seems significant in today's depressed equity markets, the transaction is in line on a revenue multiple basis (3.3x EV/NTM Revenue) and is at a discount to its BI transaction comps on a maintenance revenue basis (7.7x EV/TTM Maint Rev)

SPSS has sophisticated statistical and data mining tools for structured and unstructured data, and predictive applications for enterprise business users. These products utilize algorithmic techniques to forecast potential outcomes or generate a call to action. With the proliferation of data, software vendors are trying to capitalize on opportunity to use data not just to support static decisions, but rather to leverage the data to present precise and relevant analysis that can help enterprises execute on future business opportunities. IDC estimates Business Analytics as a $25 bn market growing at 4% cagr and IBM is looking to establish its leadership. The transaction builds on earlier Analytics acquisitions including Cognos which presented general analytics and business intelligence on historical data. Wall Street expects revenue synergies from selling SPSS solutions through the enormous IBM global distribution network and expense synergies from consolidating operations into IBM's software infrastructure.

As regards Software M&A, more will follow in the footsteps of IBM/SPSS, Oracle/SUN, EMC/Data Domain. Gone indeed, are the bull market excuses of richly valued stocks and inflated private company valuations. The market today supports some of the lowest relative valuations we have seen in a long time; so why has deal flow been muted? Confidence, surprisingly is one often overlooked attribute. Confidence as defined by public market valuations of one's own stock price and, on a related note, inability to estimate revenue and earnings. How can the corporate development team credibly present target company forecasted financials and potential synergy assumptions to the Board when the CFO's office is having a hard time signing off on the company's own next year and next quarter financials. There is a lot of uncertainty in forecasting financials and since valuations in the tech world are driven by multiples on future revenue and earnings, the current market valuations and expectation of valuations remain depressed. This is true for the acquiring company as well as the potential target and this lack of confidence in self valuation drives the hesitation in pulling the "buy" trigger. We are now seeing large software vendors build up their confidence as they sit on large cash reserves and have stronger support for public market valuations. This increase in self-confidence will spark active M&A dialogue from others who have been siting on the sidelines and potentially lead to a robust Software M&A environment.