The market has seen a recent surge in mergers and acquisitions. In the first three quarters of 2015, there have been as many as 45 M&A deals, each of which were over $10 billion. Of those, 33, totaling almost $860 billion, targeted US companies.
The technology industry alone saw $240 billion in such deals, three of which were in the semiconductors sector (Intel – Altera, NXP – Freescale, and Avago – Broadcom). Some analysts ascribed this accelerated consolidation in the semiconductors sector to over-all industry maturity and a further commoditization of semiconductor products.
Another trend in the IT industry may also have contributed to record-breaking consolidation, namely cloud computing. More and more non-technological industries are realizing the great potential of the cloud as an extension – or even replacement for – traditional data centers.
Similarly, the data storage sector saw a string of large acquisitions that included the $19 billion Western Digital acquisition of SanDisk, and of course Dell’s $67 billion acquisition of EMC, which has already been labeled “the biggest M&A deal in history”. Here again, commoditization of such services and over-all industry maturity seem to be the main factors.
EMC itself is not new to M&A activity – although in the past they were on the acquiring side of deals. Historically, the company grew at least in part by acquiring startups and smaller mature companies ranging from Data General through Legato, Documentum, VMWare (later spun off in an IPO), RSA, Data Domain, and Isilon, to name a few. SanDisk, too, has acquired a number of companies along the way, ranging from Ms-Systems to Fusion-Io.
In light of these trends, it would be interesting to see what influences the decision-making process of the acquiring side in such deals – in particular, how the targets are picked.
Recent academic research provides some insight into the common features among acquisition targets. In “Accounting Profitability and Takeover Likelihood”, for instance, authors Ali, Kravet, and Li examine how accounting profitability factors into acquisition decision making.
The paper was presented at the 2015 AAA Annual Meeting in Chicago and was recently discussed at a research seminar at Bentley University.
According to the paper, firms with above-average industry-adjusted ROA are more likely to become acquisition targets. The positive (non-linear) correlation between positive industry-adjusted profitability and acquisition likelihood is partly attributed to earnings management and opportunistic management. The theory is further supported by two main arguments:
- Managers are driven by potential increase in their compensation and by the likelihood of becoming directors in other firms, and
- Managers have incentives to show future earnings growth which is more likely if the target company is highly profitable.
Moreover, the paper argues that the correlation between accounting profitability of the target and the likelihood of being acquired is even more pronounced when the acquiring company had numerous sequential quarters of earnings growth and when the acquisition target is relatively small. In other words, managers prefer winners that can be acquired quickly and that bear a relatively low risk of hurting the combined results post-acquisition. This conclusion is somewhat counter-intuitive. One would think that weaker companies would be more likely to put themselves up for sale. Further, one also notices the spate of acquisitions in the technology space involving companies that have minimal revenue or even none at all.
Last but not least, a company is more likely to grow through acquisitions when it is sitting on a surplus of cash and has limited organic growth potential.
Going back to EMC and its almost two-decade history of acquisitions, we can clearly see all the factors mentioned above playing a role in some of the deals. Documentum, VMWare, RSA, and Data Domain were clear leaders in their respective markets. Both VMWare and RSA were operating in explosive growth markets that continue to grow even today, almost 10 years down the road from the point of acquisition for RSA and almost 15 years from the acquisition of VMWare. At the same time, EMC’s traditional market of enterprise storage underwent heavy commoditization that ultimately contributed to EMC becoming an acquisition target for Dell.
Another factor that might have made RSA so attractive for EMC was the ongoing SEC inquiry into its stock options back-dating practices that may have temporarily depressed the stock value of RSA. M-Systems experienced similar issues prior to its acquisition by SanDisk.
To summarize, likely acquisition targets tend to be growing companies in growing markets that have been hit by issues unrelated to their business – for instance, accounting or reporting troubles.