Tuesday, November 6, 2012

Two Hot Takeover Sectors

Everyone loves a bit of takeover speculation and I am no different. While I don’t think it’s a good idea to chase a stock purely because it is a potential takeover, it should be an influencing factor in an investing decision. After all, everyone wants to know how value might be realized. I think there are two stand out sectors of the market that are ripe for M&A activity. They are cloud computing and biotech/pharma. I thought it would be interesting to outline why so investors could generate some ideas.

Three Reasons Why These Sectors are Hot

Biotech and cloud computing have three things in common which make them attractive.

First, the potential buyers are cash rich and or highly cash generative. For example with IT if you total the net cash positions of Cisco, Microsoft (NASDAQ: MSFT), Google and Oracle (NASDAQ: ORCL) it comes to over $125 billion. That’s enough to pay Greece’s debt off and then go buy Hewlett-Packard! And while IBM may not be as cash rich right now, it does generate about $16 billion in free cash flow every year.

It is a similar story in pharmaceuticals where there are a host of highly cash generative but low growth large cap stocks out there.

The second reason is that both sectors face game changing technology. They either adapt to it or they suffer. Cloud computing is changing the way software is sold and taking sales away from traditional on-premise license software vendors. Not only do the vendors benefit from higher client retention ratios and lower marketing costs but, the users benefit from ongoing service and more flexible purchasing options. It is a win-win scenario that is transforming the software business.

With pharma/biotech there are a number of medical advances which are spurring R&D and some new classes of drugs which are having great success in clinical trials. Some examples of which are genomics, antibody research and drug classes like Janus Kinase inhibitors (JAK) and Protease inhibitors (PI).

The third reason is that these changes are largely secular in origin. This means that buyers can/must make acquisitions because prospects are not dependent on macro conditions. I need not dwell on why this is the case for biotech however a few words on cloud computing are necessary.

Simply put if you are selling a traditional software solution but your rival is selling a more popular software as a service (SaaS) option, he is likely to take market share and generate growth irrespective of where the economy is going. He will generate growth and improve his operational performance even with flat industry growth. You have no choice but to respond.

Latest Developments

The cloud computing sector has been surging this year and much of it with M&A activity. SAP kicked off proceedings by buying human capital software service company SuccessFactors for $3.4 billion. Now Larry Ellison does not like being beaten by SAP. Not in enterprise software, not in yachting, not the law courts, not in alpha male boasting, and definitely not in the cloud either. Within a few months Oracle bought Taleo (a rival to SuccessFactors) for $1.9 billion and ever since Oracle has been pushing its cloud capability.

IBM recently joined the M&A party by buying (you guessed it) human capital management software service firm Kenexa for $1.3 billion. As usual Microsoft appears to be late to the party with its $1.2 billion purchase of corporate networking firm Yammer.

These deals show how important SaaS offerings are becoming. In fact they are so important that companies are having to buy niche providers in service areas (as above with human capital management software) where they may not necessarily be strong in order to stay competitive.

Turning to pharma/biotech, the industry is faced with a unique combination of problems. If it isn’t the FDA getting tougher on approvals it is increased development and marketing costs. If it isn’t reimbursement issues and austerity measures it is patent cliffs and generic competition. Top line growth is hard to come by in the industry and the only answer is to buy growth.

Bristol-Myers Squibb recently paid $5.3 billion for Amylin after previously buying Inhibitex for $2.5 billion in January. Watson Pharma is buying Actavis and GlaxoSmithKline made a hostile move for Human Genome Sciences. I think the trend will continue and I can easily see Pfizer (NYSE: PFE), Novartis (NYSE: NVS) and AstraZeneca getting more involved. Pfizer did buy Wyeth a couple of years ago but it has been divesting businesses since, most recently by selling its nutrition unit to Nestle. More sales are planned and the company appears to be in a position to start acquiring in order to strengthen its focus.

Meanwhile AstraZeneca has been very quiet thus far and has the firepower to do deals. Novartis is in a very interesting position. It bought Fougera Pharmaceuticals for $1.5 billion in order to strengthen its generics business (Sandoz) and I think more deals are possible. It is busy integrating the $40 billion Alcon acquisition, but Novartis is a company with fingers in many pies. It has a tendency to do partnership deals with smaller companies that have key technologies/pipelines which if successful generate significant milestones. This is great for the company but it also puts Novartis in a very strong position should it decide to buy the company rather than pay future milestones and royalties.

In conclusion, there is more to come this year from cloud computing and biotech/pharma and this is where takeover hunters should be focusing their activities. In a future article I will discuss some names that I think are potential targets.