On the surface, bidding $2 billion for a company that hasn’t made an operating profit in the last five years looks nuts.
Dig deeper, though, and the battle between Dell (DELL) and Hewlett Packard (HPQ) to buy data storage company 3Par (PAR) doesn’t look nuts. It’s looks insane. Sales are projected to hit all of $235 million for the year that ends in March 2011. Earnings before interest, taxes, depreciation, and amortization (EBITDA) are projected at just $21 million.
On August 28 Hewlett Packard bid $2 billion for 3Par, topping Dell’s previous bid, which topped Hewlett Packard’s previous bid, which topped Dell’s bid. Dell proposed paying $1.5 billion for 3Par. The latest bids come to roughly 95 times EBITDA for 3Par.
Aren’t these companies certifiable?
Well, if you’re even asking that question you don’t understand where we are in the economic cycle and how that’s driving company strategy in the technology sector.
This isn’t an age for valuation when companies carefully figure out how to get the best value for the cash they’re about to spend.
This is the era of Cash as Bludgeon. Cash rich companies are looking to club their poorer competitors over the head with dollars. At worst, the result of this spending will be a competitor unable to climb off the canvas for years. At best, this spending might be able to crush a competitor forever.
Put the Dell/Hewlett Packard contest over 3Par into competitive context and it starts to make sense, in spite of the insane valuation awarded to 3Par.
Once upon a time Dell was top dog among PC makers. And then Hewlett Packard began an aggressive strategy of acquisitions that moved the company not just into the top position among PC makers but built new strengths for the company in services, in storage, and in smart phones (Hewlett Packard hopes.)
By the time Del woke up to the changes in its marketplace it was left playing catch up.
Nothing sums up that competitive deficit better than Dell’s response to Hewlett Packard’s purchase of EDS, the giant information technology services provider, in May 2008 for a tad less than $14 billion. That purchase vaulted Hewlett Packard to No. 2 behind IBM in the information technology services market.
By the time Dell was ready to catch up in September 2009, the best acquisition it could come up with was a much smaller Perot Systems for about $4 billion.
The shift in relative market power during the last five years has been stunning.
Hewlett Packard has always been larger in revenue than Dell but the gap has widened. In 2005 Dell had 56% of Hewlett Packard’s revenue. In 2006 Dell’s revenue was up to 61% of Hewlett Packard’s revenue And then the slippage: to 54% in 2007, to 51% in 2008, and then a slight recovery to 53% in 2009.
No one who understands that power of technology companies to turn slight changes in revenue into huge moves in earnings will be surprised to discover that Dell’s relatively small slippage in the size of its revenue relative to Hewlett Packard’s resulted in a massive move in relative earnings between the two companies.
In 2005 Dell, on its much smaller revenue (just 56% of Hewlett Packard’s) recorded operating earnings 120% of those of Hewlett Packard. 2006 saw a huge plunge: operating earnings at Dell were just 65% of those at Hewlett Packard. And in 2007 the drop got worse—Dell’s operating earnings were just 36% of those at Hewlett Packard—and stayed there at 32% of Hewlett Packard operating earnings in both 2008 and 2009.
The 3Par bid is an attempt on Dell’s part to break this pattern with a disruptive acquisition. Owning 3Par, Dell would be able to sell its own storage systems rather than reselling those made by EMC (EMC). And that would give Dell an entry into the market for storage systems built around cloud computing technologies. (And Dell almost certainly thought that it had the turmoil involved in the August 6 departure of Hewlett Packard CEO Mark Hurd to its advantage. Maybe Hewlett Packard might be distracted. Turns out, maybe not.)
And Hewlett Packard is determined not to give Dell any chance at a turnaround in the companies’ relative fortunes. With $15 billion in cash at the end of the July quarter Hewlett Packard has plenty of cash to use to bury Dell. $2 billion? Pshaw! That’s roughly 13% of cash in the bank.
Of course, Dell isn’t exactly without resources itself. The company finished the June quarter with $12 billion in cash.
Hewlett Packard’s latest bid comes out to $30 a share. That’s about three times what 3Par was selling for before all this started. No reason it can’t go higher.
And if anybody at either Dell or Hewlett Packard starts to think this isn’t a good long-term use of their company’s cash, all they have to do is look across the technology sector to Intel (INTC.)
By relentlessly reinvesting its cash in new chip-making technologies and new chip factories Intel has relegated competitor Advanced Micro Devices (AMD) to near permanent second-class status. For 2009 AMD made a gross profit margin of 44%; Intel’s gross margin was 63% that year and in 2010 it has climbed even higher.
How do you catch up when you’re biggest and bigger competitor is making 20 percentage points more in profit margin than you are?
By the way Hewlett Packard’s gross margin lead over Dell is significant—23% to 17%–but it’s not in Intel’s class. You don’t think the folks in Palo Alto look down the valley to Intel’s headquarters in Santa Clara and dream?
In the era of Cash as Bludgeon what does a company like Intel do? Intel finished the June quarter with $18 billion in cash on hand. No way that crushing Advanced Micro Devices further would yield a reasonable payoff on invested capital.
So Intel is doing what similarly cash-rich companies (Cisco Systems (CSCO) for example with $39 billion in cash) that have crushed their competition are doing: they’re bludgeoning their way into new markets.
In Intel’s case its cell phones.
On August 26 Bloomberg reported that Intel was close to a deal to buy the wireless business of chipmaker Infineon Technologies (IFNNY.PK). Projected price about $2 billion
Intel’s chips may be everywhere in the PC and server markets, but the company is a bit player in cell phones to competitors built around designs by such as companies as ARM Holdings (ARMH.)
Buying Infineon’s cell phone unit would make Intel an immediate player. The business makes processors used in Apple’s (AAPL) iPhone and in Samsung Electronics Galaxy S phone. Intel has recently signed an agreement with Nokia (NOK) and LG Electronics aimed at eventually getting its Atom chips into phones from those companies The $430 million in revenue that the Infineon business made in the June third quarter of its fiscal year would open a lot of doors for Intel.
And the company seems determined to use its cash to make it impossible for cell phone makers not to flock to its door. On August 19 Intel announced that it would buy security software maker McAfee for $7.7 billion. The theory among analysts is that the deal would give Intel the ability to bundle enhanced security with its processors. That doesn’t seem like a high-demand item among cell phone buyers or makers right now but Intel’s strategy with its PC chips has been to add enough built in functions to differentiate its chips. I wouldn’t be surprised to see the company follow the same strategy in the cell phone market.
And to spend the cash to make it happen. Somewhere down the road.
You’ve got to say this for Intel and Hewlett Packard and Dell: they aren’t sitting around planning strategies for the next quarter or two.
Full disclosure: I don’t own shares of any company mentioned in this post in my personal portfolio. Cisco Systems and Intel are members of my Jubak’s Picks portfolio.