loopback0 – Douglas Gourlay's Blog Data Centers, Virtualization, and Cloud Computing

L, U, or V – the case for mid-cap consolidation

LUV, not the airfield in Dallas popularized by Southwest's 'Free LUV' campaign but instead a few letters often used to describe the macro-economic climate we are operating in right now.  Everyone wanted a 'V' - the sharp drop followed by a quick bounce-back, I don't think we are seeing this.  The opposite extreme is the 'L' - again a sharp decline but this time relatively flat and no foreseeable return to the previous high.  Right now many folks seem to thing we are operating in a 'U' - sharp decline, protracted period of weak performance and a return to previous levels in a couple of years.  In the  IT infrastructure segment I tend to agree with the 'U' view, largely because IT infrastructure tends to be a lagging indicator of economic recovery and many organizations will constrain budgets to last through the downturn and then have an elastic reaction spending quickly during a period of economic recovery to break-away from their competitors.

But this time is different than 2001-2003, there are a few other factors at play.

1) Cloud computing is taking off. We can all argue the size, the velocity, and innumerable other factors relating to 'the cloud' but there are a few seminal truths - many new companies are trying to get started buying as little IT infrastructure as possible.  Why buy a server when I can host the VM somewhere for less, save my capital, and have global access to the application?  The list of reasons to embrace cloud/hosted applications and infrastructures is a long one and better left to other pundits, lets accept that it is happening.  If it is happening there will be a power shift in IT spending, if there are a smaller number of larger customers buying power is consolidated.  Discounts structures often go up and the top talent both in pricing and contract negotiation as well as in IT architecture often flock to the 'largest and coolest'.

Imagine a world where 80% of the compute and storage capacity is owned and operated by less than one-hundred firms who operate this critical infrastructure in the most resilient facilities possible and provide it as a service to every other business while maintaining all the critical processes and systems to ensure the businesses stay solvent.  The balance of power between the vendors and the customers may shift over the next three to five years.

2) The tech titans are taking shots at each other.  I'm not going to turn this into a discussion about 'who started it' or 'who pulled the trigger first'.  While we were in the 90's through mid 2000's there was an incredible amount of innovation as IT consumerized and came to the masses.  Cost was engineered out, technology was simplified, green screen monitors became flat screen high-definition displays, technology became common-place and approachable.  Growth for large infrastructure companies came from several sources - GDP was the main one.  Every company will argue about why their market/segment/product will have a growth curve that will be super-linear to GDP on the upturn, and then point to macro-economic decline when they have a bad quarter.  It's what we do.

Around 2006 though the number of innovative new markets with large enough opportunities to create a $1B+ top-line revenue stream started becoming fewer and further between.  The barrier to entry for IT infrastructure start-ups was getting larger and larger stymying new market creation and the customers were increasingly being pretty well served by what they had slowing down refresh cycles on mainstream infrastructure.  We can argue it is all about investment protection all day, and we all love products that last - but if you cannot build a product with enough new business value delivered in three to four years to churn your installed base after the depreciation schedule is hit you should seriously question the efficacy of your development strategy.

Big new markets were gone, so what happened - the tech titans all started looking around at each other and like a scene from a mafia movie saying, 'Hey...  what are YOU doing?'  To each titan the other has something that looks 'interesting'  whether that be telephony, services, networks, servers, storage, consumer, operating systems, etc.

3) Where are the VC dollars on infrastructure? At some point in the past few years the VC well started getting dry - I think it was a failure-based inhibition that slowed investment down.  For the path of many companies in the infrastructure market the barrier to entry, especially for a silicon based system became incredibly high. Many of the companies funded in the early part of this decade did not have the glorious IPOs or liquidity events that were the hallmark of the late 90's.  The investment pool got nervous, and frankly the low-barrier to entry web based, service-based, and to some degree software-based start-ups received an increasingly larger percentage of the IT focused venture funding.  Investments in hardware-based infrastructure, especially silicon based became, well... hard.

So how do these factors combine?

For the tech titans to continue to grow they have to move into each other's core markets unless there is a rapid rebound followed by sustained GDP growth.  The investors want to see share price growth and it is hard to grow a company with over $20 Billion in sales at the rates investors would like to see.

The titans will make more 'platform' buys- companies with established revenue bases, loyal customers, and footprint in their markets. The target acquisition profile will be a mid-cap with a loyal customer base that enables the titan to garner enough share in the new market to justify the premium, but lets face it - buying public companies can be cheaper than buying private ones.

There are not a lot of startups- the ones that can be successful will have two very interesting dynamics - no one chasing them from behind, and a hungry set of potential acquirers that will often bid each other up to get their hands on the innovation, technology, and entrepreneurial team.

I personally think we'll see the 'U' with a period of elastic IT spending starting in 2012 through 2013, and in a timeframe bordering that by a year or two will be a wonderfully fun period of tech consolidation.  It's a good time to be an M&A lawyer specializing in tech or maybe an investment banker brokering these transactions.

dg