It seems not a week goes by that someone doesn’t speculate about a leveraged buyout of some tech company, perhaps inspired by the $17.6 billion buyout of Freescale Semiconductor (FSLB), the largest tech L.B.O. ever, initiated in August by L.B.O wizards including Blackstone Group.
But Fitch Ratings Ltd., the corporate credit people, are telling investors not to hold their breath: LBOs of U.S. tech firms may be constrained because a) targets are too expensive; b) there’s not as much cleaning up that can be done at tech companies as in past because a lot have already restructured; and c) some tech markets are peaking.
Fitch looked at 21 companies across tech industries and says that after $45 billion in tech LBOs in the last two years, only two really good candidates remain: stodgy, scandal-ridden mainframe software maker CA (NASDAQ:CA), and outsourcing vendor Convergys (NYSE:CVG). Fitch says Dell (NASDAQ:DELL) could also be a prospect.
From the report:
Fitch’s analysis focuses mostly on companies with enterprise values (EVs) below $50 billion, although Dell Inc. (Dell, ‘A’/Rating Watch Negative) and Texas Instruments Inc. (NASDAQ:TXN) (Texas Instruments, ‘A+’/‘F1’ with a Stable Rating Outlook) were included despite market capitalizations in excess of $50 billion, due to their strong free cash flow and perceived ability to support significantly higher leverage.
In general, Fitch concluded that the majority of technology companies are not attractive LBO candidates because financial flexibility would be insufficient to support significant incremental debt. In Fitch’s opinion, IT distributors and electronic manufacturing services [EMS] companies would be the worst performers post-LBO, while the IT services and, to a lesser degree, semiconductors segments would be challenged to achieve any post-LBO free cash flow over the near term. However, Fitch believes that a few companies within the software and hardware segments currently are stronger LBO candidates because of their sufficient financial flexibility pro forma an LBO and solid projected internal rate of return [IRR] for the equity sponsors. Of the 21 companies reviewed for this report, Fitch believes only CA, Inc. (CA, ‘BB+’/Negative Rating Outlook) and Convergys Corp. (Convergys, ‘BBB–’/Stable Rating Outlook) are attractive LBO candidates. While Dell’s financial profile suggests it could support significantly higher debt levels, a $65 billion technology LBO would be very challenging and would be nearly four times bigger than the largest technology LBO to date.
Fitch particularly doubts the value in buying out semiconductor makers or IT services firms:
More recently, LBO firms have turned their focus on the semiconductor industry, although there has been discussions and speculation regarding certain IT services companies. Despite two recent large deals, Fitch believes levering up semiconductor companies is challenging due to expectations for significant free cash flow volatility through the semiconductor cycle. Nonetheless, Fitch recognizes that secular trends toward increased outsourcing and collaboration have lessened the capital intensity for certain semiconductor industry segments. In addition, diversified semiconductor makers serving many nontech industries (e.g., industrials, autos, defense and aerospace) generally experience more stable demand patterns, require lower levels of fixed investments, and exhibit less technology risk. LBOs are likely for semiconductor companies with these characteristics. In the case of IT Services, Fitch believes it remains difficult to significantly lever up these companies because of expectations for continued free cash flow volatility, driven by significant upfront capital expenditures for new contract signings, and the need to maintain high degrees of financial flexibility and solid credit ratings to pursue larger-scale and longerterm IT services deals.
Convergys is the most likely candidate for an LBO as the company’s valuation is reasonable and pro forma free cash flow would be positive. Prohibiting an LBO is Convergys’ inconsistent free cash flow over the past five years and the limited opportunities to significantly reduce the company’s cost structure since Convergys has restructured its operations over the past several years.
In software, the small fish will probably get eaten by Oracle (NYSE:ORCL) or another giant before LBO folks can get to them:
Fitch believes that the software industry’s high degree of recurring revenue, solid operating EBITDA margins, and consistent free cash flow, as was demonstrated by the aforementioned $11.4 billion Sungard transaction in July 2005, support the case for LBO activity. However, few attractive LBO targets currently exist, given the significant market capitalizations of leading software providers (e.g., Microsoft Corp., International Business Machines Corp. [IBM] (NYSE:IBM), Oracle Corp. [Oracle], and SAP AG (NYSE:SAP) ). In the more fragmented applications space, few providers have sufficient scale to be considered attractive LBO candidates and, in Fitch’s view, are more likely to be acquired by larger industry leaders who have near-record cash balances and remain
under pressure to supplement slowing organic growth.
Fitch believes CA is the most attractive LBO candidate within the software industry for two reasons. First, Fitch estimates the company would generate approximately $200 million of free cash flow following an LBO, which could improve by as much as $200 million upon completion of the company’s restructuring program during the fiscal year ending March 31, 2008. Second, CA’s market capitalization, while improving since delaying the filing of its financial statements due to various material weaknesses, remains below year-ago levels, reflecting the company’s relatively low organic growth prospects, perceived lack of a cohesive strategy, and recent accounting challenges.
Computer hardware vendors like storage equipment vendor EMC (NYSE:EMC), on the other hand, are caught in nasty price wars that make cash flow unpredictable, says Fitch, so they’re not safe targets:
Fitch believes LBO risk for the overall hardware industry is medium to low due to industry factors (pricing pressures, commoditization, cyclicality) that reduce the predictability of revenue and free cash flow required to prudently manage the significant degree of leverage utilized in an LBO transaction. Company-specific factors are crucial in determining the viability of an LBO within the hardware industry because the sufficiency and volatility of free cash flow vary significantly within Fitch’s hardware universe. [D]espite consistent free cash flow and ability to manage higher debt levels, Fitch believes Xerox (NYSE:XRX) is unlikely to generate an IRR of 20%–25%, due to the low growth prospects of the copier equipment market and limited opportunity for significant margin expansion through cost reduction.
Sun Microsystems (NASDAQ:SUNW) is an unlikely candidate mostly due to its limited and inconsistent free cash flow and high EV to latest-12-months’ (NYSE:LTM) EBITDA multiple of approximately 27x. Kodak (EK) is challenged by the company’s ongoing transition from higher margin but steadily declining sales of analog products to lower margin digital products, ongoing cash restructuring costs that reduce the amount of free cash flow available for debt reduction, and uncertainty surrounding the long-term viability of the company’s digital business model.
Companies that assemble computers and cell-phones for a fee, like Jabil Circuit (NYSE:JBL), have such a lousy business, no one would want them, says Fitch:
Fitch believes that none of the five companies covered in the EMS space would currently make attractive LBO candidates given the low margin operating environment, volatile free cash flows and ongoing capital spending requirements. While all companies, except for Flextronics International Ltd. (Flextronics, ‘BB+’/Stable Rating Outlook), utilized cash in the latest 12-month period, Fitch believes free cash flow would be significantly negative for all five companies when accounting for additional interest expense in an LBO scenario.
Same for their cousins, electronics distributors such as Arrow Electronics (NYSE:ARW), which ships computer parts around the world:
The potential for an LBO activity among the electronics distributor companies in Fitch’s coverage universe is limited due to cyclical revenue patterns, low profit margins and inconsistent free cash flow. While IT distributors have clearly benefited from a prolonged expansionary period and continued market share consolidation over the past few years, Fitch believes that profitability margins will remain near current levels, which are much lower than those of typical LBO candidates.