As part of keeping up with my existing thematic viewpoints and working on new ones, I constantly read news stories, magazine articles and other publications from around the world. Over the last several months, there have been more and more features on the topic of consolidation across several different industries, from mining and biotech to industrials and technology to fertilizers and equipment companies.
As someone who got started in the investing business by looking at cyclical stocks and later migrated into technology, the predictable pattern of strong growth followed by slower growth as an industry matures, then eventual consolidation, is not a surprise; rather, it is to be expected. I suspect most people can name the top few companies – market share leaders – in more than a few industries. Not surprising, since the 80/20 rule applies, with 80 percent of the market share held by the top few companies and the balance spread across the remaining players.
In order to understand where in the lifecycle an industry is, it is important to understand what the typical stages are in an industry lifecycle:
- Early Stages: Alternative product design and positioning, establishing the range and boundaries of the industry itself.
- Innovation: Product innovation declines, process innovation begins and a "dominant design" will arrive.
- Cost or Shakeout: Companies settle on the "dominant design"; economies of scale are achieved, forcing smaller players to be acquired or exit altogether. Barriers to entry become very high, as large-scale consolidation occurs.
- Maturity: Category growth is no longer the main focus, market share and cash flow become the primary goals of the companies left in the space.
There are a number of industries, such as mobile phones, TVs, agricultural and construction equipment, autos, beverages, insurance, banking, media and more that rest between Cost/Shakeout and Maturity.
As with most aspects of investing, there are layers that need to be considered as an industry consolidates. I tend to think of them as ripple effects, similar to when you skip stones in a pond: Once the stone skips on the water, a ripple shoots across the top of the water, thereby affecting the water nearby.
This same ripple effect takes place when a company starts to consolidate within its industry and ripple effects can bee seen across that industry’s food chain of companies. As other companies respond to the consolidation wave, merger & acquisition (M&A) activity heats up and in some cases becomes a feeding frenzy, which may or may not result in sensible deals a few years later. Much like the game of musical chairs, a company is left standing alone when the consolidation music stops, and may very well be left out of the rest of the game.
That is why it’s important to proactively contemplate industry evolution and understand strategic gaps, product holes and other issues that companies must deal with through either organic growth (internal solutions brought to the market) or by acquiring a company to fill that competitive deficiency.
As noted in a Harvard Business Review study from a few years ago:
Ultimately, a company’s long-term success depends on how well it rides up the consolidation curve. Speed is everything, and managers’ merger competence is paramount, particularly during the middle stages of consolidation. Companies that evaluate each strategic and operational move according to how it will advance them up through the stages — that capture critical ground early and move up the curve the fastest — will be the most successful. Slower firms eventually become acquisition targets and will likely disappear. Most companies simply won’t survive to the endgame by trying to stay out of the contest, or worse, by ignoring it.
There are also M&A deals that deliver far less than expected, and in some cases investors have to wonder what the strategic imperative was behind such deals to begin with, at least from a consumer perspective. Examples include AOL acquiring Time Warner, which were later split apart, and Sprint (S) acquiring Nextel. for $35 billion in 2005; it recently announced that it would begin shutting down the Nextel network in 2013 as it unburdens “itself of having to operate two incompatible services.”
My industry consolidation theme looks at industries that are undergoing or are on the cusp of undergoing consolidation, and seeks to identify those companies that have strong competitive positions on their own, but may be sought after for either customer relationships, products, geographic market access, technology, intellectual property or any combination thereof. In short, a candidate for this theme has to have a distinct competitive advantage or set of advantages that would fill in a competitive gap for another company. Odds are these industry consolidation candidates will be smaller companies in terms of revenues, size and market capitalization, at least compared to potential industry consolidators.
Given corporate cash balances and the M&A outlook, it appears the strong M&A activity in 1Q 2011 is poised to continue, which bodes well for my industry consolidation thematic.
What makes me say this? Cash now accounts for more than 13 percent of corporate assets, the highest since 1984, according to Standard & Poor’s. The 13 biggest cash hoarders among companies in the Standard & Poor's 500 had stockpiled more than $300 billion in cash by the end of last year. Among them: Cisco Systems (CSCO) with $40.2 billion cash on hand, Microsoft (MSFT) with nearly $40 billion, and Google (GOOG) with nearly $35 billion. At the same time, the fourth annual M&A survey conducted by Brunswick Group LLC finds that 92 percent of top bankers and lawyers polled believe that the level of deal volume will continue to rise this year following a strong first quarter in M&A volume.
But back to the ripple effect and how investors can ride the resulting waves that turn some companies into better-positioned plays and others into weaker ones.
AT&T (T) + T-Mobile USA = Case Study
To do that, let’s walk through the recently announced acquisition of T-Mobile USA by AT&T from Deutsche Telekom (DTEGY.PK) in exchange for $39 billion. If that merger is consummated, it will create the largest domestic mobile phone carrier, as AT&T adds T-Mobile USA’s 33.7 million subscribers to its existing 95.5 million subscriber base. Adding the two together, the combined company would account for roughly 42 percent of all wireless subscribers in the United States, with Verizon (VZ) being its next closest competitor with roughly 31 percent.
Assuming a merger between the two companies is consummated, the new entity is expected to achieve big savings, as it can close hundreds of retail outlets in areas where they overlap, as well as eliminate overlapping back office, technical and call center staff and reduce advertising spending. Some forecasts say the combined companies could achieve up to $3 billion a year in cost savings, which is not much higher than the $2.7 billion the two companies spent on advertising in 2010.
Now the ripple effect. While many are wondering what Verizon’s competitive response will be, others are pondering the role of Sprint-Nextel, as it has been in a weaker position dealing with subscriber loss over the last several quarters and managing several technologies, none of which are in the mainstream. While Verizon in my view is not a takeout candidate, given its size and scope of services offered, issues at Sprint, as I see it, do not make it an attractive asset.
Rather, I could see Verizon acquiring other smaller players in the space – Leap Wireless (LEAP), MetroPCS (PCS) or United State Cellular (USM). These are all likely candidates, particularly Leap, as its technology portfolio of CDMA and LTE wireless technologies would mesh well with Verizon’s portfolio.
Arguably, the clear winner of the transaction is Deutsch Telekom, which pocketed $39 billion or $9 per share, that it can use to shore up its balance sheet or utilize for other strategic purposes. Meanwhile, this and other ensuing transactions are likely to leave Sprint either standing alone when the music stops or with a less than desirable date to the dance.
On the mobile device side, I see Apple (AAPL) as being a key beneficiary should the deal close, because it can target its iPhone at 33.7 million more subscribers, while still keeping the exclusivity tag with AT&T and Verizon. T-Mobile USA offers devices from most of the major manufacturers (such as Motorola Mobility (MMI), Research in Motion (RIMM), Samsung (SSNLF.PK), LG and others), so there is little incremental gain to be had like there is for Apple.
Looking at mobile infrastructure, the merger means there is one less purchaser of equipment and services, and that more than likely translates into pricing concessions and margin pressures at companies like Ericsson (ERIC), Alcatel Lucent (ALU) and others as they seek to position themselves among the vendor shakeout. The same goes for tower companies like American Tower (AMT), Crown Castle (CCI), SBA Communications (SBA) and others.
Aside from the greater competitive pressure amongst the infrastructure and tower companies, the greater scale of the new AT&T should also improve its purchasing power when dealing with infrastructure, tower and other vendors. Keep in mind that the competitive pressures in the mobile infrastructure market will impact those that supply into that market, such as Powerwave Technologies (PWAV) and other chip and equipment suppliers.
As you can see, the impact of one merger, albeit a large one that stands to reshape the domestic mobile industry, can have a far-reaching effect, which can spell good things for a few companies – Apple, Leap and some others in this case – and pose issues for others.
In the coming weeks, I’ll be looking at candidates for my industry consolidation investing theme in several areas, some of which touch the Internet and e-commerce spaces, semiconductors, intellectual property plays and more.