Saturday, August 18, 2012

The Best Takeover Candidates in Tech

Weak markets always bring up opportunities, and none more so than in the M&A space. While it’s never a good idea to buy a stock solely for its takeover potential, I think that potential acquirers are looking at exactly the same valuations that other investors are. Although naturally, their decision is motivated more by strategic concerns, so in this article I’m going to stick to discussing firms on good evaluations and with a key rationale for the acquirer. If you like the stock anyway, then some takeover possibility adds some spice.

To do this properly, we need to look at who might be doing the acquiring. I’ve identified six names. Their net cash positions and market capitalizations are shown below.

CompanyMarket Cap ($bn)Net Cash ($bn)
This article will focus on Cisco, IBM and Oracle. I will submit a future article concerning the others in due course.

NetApp a Good Net Add?

According to IDC Storage Tracker, NetApp (Nasdaq: NTAP) is the third largest player in the external disk storage market. It has a low-teens market share, compared with mid-teens for IBM (NYSE: IBM) and nearly 30% for EMC. Hewlett Packard and Hitachi are hovering above and below the 10% market share mark, respectively.

The stock is a perennial target for takeover speculation and its troubles over the last year have made the stock cheap on traditional metrics. NetApp trades on an EV/Ebitda multiple of 6.5 and a forward PE of 14.6, but that is half the story. It has a market cap of  $11bn and net cash of $4.14bn, so if it generates similar free cash flow to last year –around $1.1bn -- any company buying NetApp would effectively get it for $5.76bn or around half the current market cap. In other words, it would be on a forward PE of 7.6 if you took out the cash. Not bad at all.

The downside is that the company recently gave poor guidance and talked of a lack of visibility. It may well be losing market share to EMC and IBM. With regards to acquirers, I think IBM is the most likely. It would immediately push its market up to close to EMC and it’s in a market place that IBM knows very well. Market consolidation is usually a good thing for margins and a deal would make sense. Cisco Systems (NASDAQ: CSCO) is also a possibility as it’s a longtime partner of NetApp. Oracle (NASDAQ: ORCL) could also be in the hunt because much of NetApp’s business is in storing Oracle’s database data.

A fast Growing Network Play

F5 Networks (NASDAQ: FFIV) has 47% of the market share for Application Delivery Controllers, which are devices in the data center that help corporations optimize the delivery of applications across the network. With the increasing demands on networks coupled with the possibility of huge unexpected spikes in usage, its products are seeing strong demand. Video rich applications require much more bandwidth and no corporation likes to see its website down or its network applications not functioning properly. The company competes with the likes of Citrix Systems and Radware and is doing well so far this year.

Cisco also competes in this marketplace, but it chooses to bundle its Application Control Engine into its data-center and WebEx solutions. These are actually two of Cisco’s fastest growing solutions. The implication is clear. With a market cap $8.1bn a $490m in net cash, F5 is easily affordable for Cisco and it could be an acquisition that immediately generates synergies and strengthens Cisco’s position in a key growth area.

Another potential acquirer could be IBM. It is already a partner of F5 in offering network performance optimization solutions. Moreover, F5 CEO John McAdam formerly worked at IBM after his company was sold to it 1999. Whilst IBM does have debt, it has averaged $16.1bn in free cash flow over the last three years. A deal for F5 would not stretch its balance sheet and buying a company forecast to grow revenues at 20% for the next two years is a good way to get growth at a reasonable price.

Brocade Finally Finding a Buyer?

Next up is Brocade Communications Systems (NASDAQ: BRCD), a network solutions provider that is a constant source of takeover speculation. Dell is believed to have taken a good look at it previously, and Oracle is often mentioned as being a potential acquirer. A deal for Oracle would give Oracle a complementary networking product. However, one problem would be that a lot of Brocade’s switches for data storage solutions are sold through the likes of Hewlett Packard, Oracle and IBM. If any of these companies bought Brocade, they might have an issue selling to a rival company in future. I suspect this means that Cisco could be the most likely acquirer. Other potential acquirers include Hitachi or even Chinese giant Huawei.

Cisco is being increasingly challenged within its core switches and routers divisions by companies such as Huawei. So as part of a drive to restructure and return to its core business, purchasing Brocade would make sense. The company trades on an EV/Ebitda multiple of just 5.3 and it tends to throw off cash.  It is also widely believed to be up for sale and the current market weakness has only made the price cheaper. Well worth a look.

I’ll be back with more ideas in due course.

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