Managing Director & Partner
Five years is an eternity in the technology industry—the business world equivalent of a “dog year”—compared with other, less volatile and tumultuous industries. So it is a great accomplishment for a company in the industry to achieve a top-ten TSR ranking over five years (2011–2015) and an even greater achievement to do so in back-to-back five-year periods. Avago Technologies, now known as Broadcom, as well as Acuity Brands, Largan Precision, and Seagate Technology did just that. All four were also top-ten finishers in the 2010–2014 rankings. (See Exhibit 1.)
A five-year time frame obscures other impressive achievements of companies that have fundamentally changed their business trajectories. Microsoft, for example, did not break into the five-year top ten but recorded annual TSR exceeding 30% from 2013 through 2015 on the strength of a fundamental business model transformation. (See “Microsoft: Mobile First, Cloud First.”)
Microsoft demonstrated that technology stocks can have second acts. After flatlining from 2003 through 2012, Microsoft’s stock price has been surging on the strength of its “mobile first, cloud first” world view and investor confidence in CEO Satya Nadella. In the two years following Nadella’s February 2014 promotion to CEO, the stock rose by nearly 60%.
With the PC business in decline, Microsoft wisely shifted to the cloud and focused on customer satisfaction. The journey has been marked by steady progress and tough decisions, such as the restructuring resulting from the acquisition of Nokia.
Today, Microsoft is fundamentally different from the company it was just a few years ago. In the company’s most recent fiscal year, cloud revenues reached $9.5 billion, a 64% improvement over the prior year. It was only a whisker away from becoming the first company to hit $10 billion in reported cloud revenues. Furthermore, Microsoft has converted more than 23 million consumers to Office 365, its cloud-based productivity suite subscription service, increasing subscriptions by more than 50% year over year.
Microsoft has relied on M&A to round out its intellectual property portfolio and acquire talent and capabilities that will support growth in the medium term—not just prop up sales in the short term. Even Microsoft’s proposed acquisition of LinkedIn, its largest deal to date, is more about building capabilities and functionality than generating immediate revenues.
Likewise, after its stock fell sharply starting in mid-2014, Qualcomm generated shareholder returns exceeding 40% from its lows in 2016. This spike reflects investor confidence in the recovery of Qualcomm’s core mobile business and its transformation, which will streamline costs and expand its business into growth areas such as IoT and connected cars.
The top ten generated outsize sales growth and multiple expansion, and six of the ten squeezed out margin improvement, too. As we explore later in this article, several companies made smart moves into IoT and other growth areas, improving both sales and multiples.
Over the five years analyzed in this report, other factors were also at play. Several companies benefited from the growth in connectivity. Others relied on M&A for value creation.
Smartphone and Connectivity Suppliers. From 2011 through 2015, revenues from smartphone sales grew by 27% annually, and technologies such as near-field communications started to take off. Four of the top ten—Avago Technologies, NXP Semiconductors, Largan Precision, and Murata Manufacturing—benefited from this growth by making the parts that enable connectivity and smartphone features.
The history of the technology industry shows that favorable tailwinds don’t last long. The challenge for these companies over the next five years will be to pivot into adjacent or new businesses as smartphone sales growth flattens.
Successful Strategic M&A. M&A often has a bad rap as an approach that destroys value. Recently, however, investors have started to The 2016 M&A Report in deal making. Indeed, several of the top technology value creators are showing that M&A can provide entry into new markets, sources of growth, and access to innovation and new talent pools.
Other companies in the top ten have also been active. (See Exhibit 2.) In fact, the entire technology industry has been at the forefront of global M&A. Deal volume from 2013 through 2015 increased by more than 25%. In contrast to other industries, in which many acquisitions are aimed at market share or cost savings, the purpose of many technology deals is the acquisition of innovation and talent. SoftBank, for example, just announced a $32 billion acquisition of ARM Holdings, a UK chip designer, as a way to jump-start its IoT business.
The technology industry has been a popular target of shareholder activists, who have attacked such companies as Apple, Dell, and Oracle. Indeed, from mid-2014 through mid-2016, more than 20% of all activist events associated with S&P 1500 companies involved technology companies.
In recent years, activist shareholders have gone after 80% of the US companies in the bottom quartile of TSR performance. Activists will not go away, because their tactics have been working. The stocks they have targeted have generated outsize returns. One study found that targeted stocks recorded a median excess annualized return of 16.6% during periods of activism.
The lesson here is simple but harsh: a technology company with sluggish sales, shrinking multiples, low dividends, and high capital spending is at risk.
But senior managers who think like activist shareholders can anticipate their demands and prevent their cage rattling. Activists commonly demand a combination of four actions:
The key for senior executives is to get ahead of such demands by assessing their value creation strategy through the eyes of an investor and to double down on investor communication and dialogue, not only with the activists but with all shareholders. Traditional investors are becoming more sympathetic to the activist agenda and are deciding whether to support management or the activists on the basis of their confidence in each side’s story and performance.
And, of course, strong value creation is the best prevention of all.
If technology companies do not actively manage their business portfolios—through both acquisition and divestiture—activist shareholders will do it for them. This is precisely what happened to eBay, which, under pressure from shareholder Carl Icahn, spun off PayPal to shareholders. (See “Shareholder Activism.”)
To achieve breakthrough growth, technology companies need to make bold and disruptive moves. In the article Unleashing Technology, Media, and Telecom with Digital Transformation, we identified cloud computing and data analytics as foundations of the new digital ecosystem. After the established field of mobile technologies, the cloud and data analytics are the most common venture-financed startup areas. (See Exhibit 3.) For the digital economy, the cloud is the next generation of infrastructure. Like highways, the cloud is hugely democratizing, lowering costs for all companies that participate. Data analytics, meanwhile, provides the fuel for digital applications and services, helping them perform better and in new ways. Together, the cloud and data analytics are enabling digital innovation in all sectors, including industries as diverse as automotive, industrial goods, and financial services.
In the article mentioned above, we highlighted specific growth areas for TMT companies. Here, we explore the ways that technology companies can create value in those areas. AI, IoT, cybersecurity, AR, and VR should be top of mind for all technology companies.
Artificial Intelligence. AI is just coming into its own in such widely diverse activities as surgery, industrial robots, and automated content creation through natural-language processing.
AI is a growth opportunity not only for software companies but also for semiconductor companies such as Nvidia, the largest producer of graphic processors for video games. The ability of these processors to compute many tasks in parallel can significantly accelerate complex deep-learning applications. Nvidia, whose stock has risen more than 30% annually since 2012, recently invested $2 billion in a new chip designed specifically for AI.
The Internet of Things. IoT is here, offering immediate opportunities for technology companies to sell devices—and, more important, services and software—to a wide range of companies and consumers. According to the 2016 Vodafone IoT Barometer, “28% of organizations already use IoT. A further 35% are less than a year away from launching their own projects, and more than three-quarters of businesses say that IoT will be ‘critical’ for the future success."
Cybersecurity. This poses both an opportunity and a threat for technology companies. They are in a prime position to protect their customers—but only if they first fortify their own defenses. If people lose trust in the cloud or the protection of data, they will not adopt newer waves of innovation.
Augmented Reality and Virtual Reality. A range of consumer and commercial AR and VR products, such as Microsoft’s high-definition holographic headsets, are just now coming on line. While consumer applications such as Pokémon Go are receiving the most attention, the B2B sector is perhaps more commercially relevant in the short term. Professional sports teams have begun to introduce VR into training sessions, automakers are considering ways to improve the passenger experience, and the construction industry and architects are starting to rely on AR renderings to reduce errors in reading blueprints on the job site.
The success of technology companies depends not just on seizing these disruptive opportunities but also on managing their existing businesses for productivity and growth. With technology companies’ shift to services, digitally enabled value chains are critical to achieving better margins and sales growth.
It is not surprising that software companies have taken the lead in digitizing their value chains. As they move to the cloud, their margins shrink, so their core business of writing code needs to be efficient. Even at software companies, however, many other elements of the value chain, such as sales and customer service, are not yet on the cutting edge. In fact, technology companies need to innovate all elements of their value chain:
More broadly, two of the most prevalent transformations in the technology industry are those that involve hardware to software and software to software-as-a-service (SaaS).
Hardware to Software Transformation. This is not a new story—we titled the 2013 edition of this report The Great Software Transformation: How to Win as Technology Changes the World—but it remains highly relevant for hardware companies that aim to create greater value for themselves and their customers. IBM, for example, increased the share of its revenues from software sales and licensing from 14% in 2000 to 28% in 2015 and increased margins from 12% to 22% in the same time frame.
Compared with hardware, software offers greater flexibility, ease of customization, and ability to upgrade. One reason why Nvidia enjoys a 76% share of the market for graphic processing units is that its investments in software development allow it to frequently release new drivers and updates geared toward specific games and apps, catering to the needs of AI and game developers.
The transition, however, is not easy. In the software industry, the barriers to entry are low, so market shares can shift dramatically. In addition, a hardware to software transformation has profound implications across the entire value chain.
Companies that have made the transition embrace agile software development, create new sales and support approaches, and modify their talent requirements and partner relationships. These companies recognize how software, data, and connectivity can create value for specific customer segments, because they understand their customers’ experiences, pain points, and needs. Finally, they use metrics appropriate for software businesses to measure success and enable growth.
Software to Software-as-a-Service Transformation. SaaS is both a blessing and a curse for traditional software companies. The SaaS market is growing at nine times the speed of the broader software market. Despite their lower margins, pure-play SaaS companies generally have higher multiples than their more traditional competitors. At the same time, the SaaS model requires radically different engineering, marketing, and selling skills.
Adobe Systems, number nine in the technology top ten, has done a strong job of moving its customer base of photographers, artists, and designers to a pay-as-you-go Creative Cloud model. In 2015, Adobe generated two-thirds of its revenues from subscriptions, compared with just 11% in 2011. Revenues are tracing an upward trajectory.
Shareholders have rewarded Adobe’s move toward the cloud. Adobe’s stock generated a 25% annual TSR from 2011 through 2015, and its multiple expansion is the largest of all companies in the technology top ten.
Adobe wisely built a “value bridge” that gave investors confidence that the transition to a pay-as-you-go world would work. (See Exhibit 4.) Executives communicated clearly with analysts and shareholders, publicized new metrics, and limited new development activities to the cloud-based offerings—all strong signals that the company was committed to, and confident in, the new approach.