Be Wary of Tech Merger Mania

09/29/2009 2:15 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

The stock market got all excited Monday by big acquisitions announced by Xerox (NYSE: XRX) and Abbott Laboratories (NYSE: ABT). Xerox announced that it would buy Affiliated Computer Services (NYSE: ACS) for $6.4 billion in cash and stock and Abbott said it would buy the drugs business of Solvay (OTC: SVYSY.PK) for $6.6 billion in cash.

That news helped stocks reverse recent weakness: The Standard & Poor’s 500 closed up 1.8% and the Dow Jones Industrial Average climbed 1.3%. The two deals came after news of acquisitions like Dell’s (Nasdaq: DELL) $3.9-billion cash offer for Perot Systems (NYSE: PER).

Now, I can understand why the market as a whole would get excited at the news. Mergers and acquisitions push up stock prices. Dell, for example, has offered a 70% premium to buy Perot Systems.

But the recent trend in technology acquisitions worries me. The deals suggest a--what shall I call it—lack of strategic vision. At best, we can hope just Xerox and Dell are running in fear to strategies that have worked for competitors over the last decade. At worst, it’s a sign that the biggest companies in the sector are running out of growing room.

Dell’s purchase of Perot and Xerox’s purchase of Affiliated Computer Systems have a lot in common.

In both cases, hardware companies are buying service companies. That makes sense on one level, since the service business is growing faster than the hardware business, it’s more profitable than the hardware business, and the revenue stream is more stable and predictable.

How do we know that? Because first IBM (NYSE: IBM) and then Hewlett-Packard (NYSE: HPQ) have already gone down this road and demonstrated that it leads to an improved bottom line.

IBM was the pioneer of this strategy. Under chief executive officer Sam Palmisano, who took over that slot in 2002, IBM has made more than 50 software and service acquisitions. And in the process, the company has seen revenue grow by 37% and—this is the really attractive part of this strategy—pretax margins have climbed to 33% from 22%, according to Morningstar.

In 2008, Hewlett-Packard adopted a similar strategy with the purchase of Electronic Data Systems for $13.9 billion in cash. Services are now one-third of Hewlett-Packard’s revenues, and—this is another really attractive feature of this strategy—the company’s service business was the only unit at Hewlett-Packard to grow revenue during the company’s July quarter. Yep, service revenue does hold up better than hardware when growth is slow.

So, you can see why Dell and Xerox want to go down this path. But you have to worry about how long it took these two companies to see the writing on IBM’s walls. Hewlett-Packard had a hard enough challenge as the second company down the trail that IBM blazed. But Dell and Xerox are going to be numbers three and four. And they’ll be at least a year behind HPQ.

And, of course, IBM isn’t standing still. In July, the company purchased SPSS (Nasdaq: SPSS), a maker of advanced analytic software that will increase IBM’s ability to mine data for its biggest corporate clients.

And you’ve got to wonder at the quality of the companies that Dell and Xerox are buying. Perot Systems, the company that Ross Perot founded in 1988 after he sold Electronic Data Systems to General Motors in 1984, doesn’t have nearly the scale of EDS. That company had been building its client list since 1962.

Affiliated Computer Systems, the company Xerox is buying, is a leader in back-office outsourcing. That gives the company a solid overlap with Xerox, since a lot of back office work involves electronic documents and their printing and storage. But this isn’t exactly the platform that Xerox can use to transform a struggling hardware company into an integrated provider of hardware, software, and services.

That‘s the model that IBM has used so successfully and that Hewlett-Packard is equipped to duplicate. Dell and Xerox are paying a lot of money in deals that will barely edge them down the path.

Wall Street fully expects that other hardware and software companies—Cisco Systems (Nasdaq: CSCO) and Oracle (Nasdaq: ORCL) are the two names I’ve heard most often—are looking to make service acquisitions, too. The short list of acquisition candidates includes Computer Sciences (NYSE: CSC) and Accenture (NYSE: ACN).

(For more on Cisco, see my September 25th buy recommendation on the stock in Jubak’s Picks.)

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