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Profit from a Shakeout


By Hal Plotkin
CNBC.com Silicon Valley Correspondent
Jul 23, 2001 02:41 PM

Stocks as a group may well frustrate investors for the next few months. But if past is prologue, today’s weakness will translate into tomorrow’s strength. You can profit if you pick the most-likely consolidation candidates.

“We’ve seen all this happen before,” says David Jacquin, head U. S. Bancorp Piper Jaffray’s technology and communications merger and acquisition team. “You get a speculative excess followed by capital coming into a sector, then a correction followed by a lack of liquidity.”

We’re in that final phase now, Jacquin told a group of about 60 CEOs and venture capitalists gathered at an invitation-only event held this week at Menlo Park, Calif.’s Sand Hill Road Quadrus Center, which is home to dozens of investment banks.

In a show of hands, the venture capitalists confirmed that these days most of them are making few if any fresh, first-round investments in start-ups. Instead, the attendees confirmed that they are now in a clean-up phase, with the emphasis shifting to salvaging whatever value remains in the last crop of companies they took public.

In this climate, acquirers are often willing to pay higher premiums for smaller public companies, in large measure, because valuation levels have decreased so substantially, says Jacquin.

As many investors discovered recently, it was hard to make money holding over-valued stocks. But at least some stocks are under-valued now in terms of what company-buyers are willing to pay, say the M&A experts. And that means investors can cash in on the spread between current share prices and their eventual acquisition prices, but only by picking the right names.

“You have to be very careful, though, and remember that some of the companies [that look under-valued] will go out of business,” says Jason Hutchinson, Piper Jaffray’s managing director for M&A. “You could end up with nothing.”

In particular, he says, investors should avoid the stocks of smaller firms that have been hit by class-action shareholder lawsuits, particularly those alleging improper manipulations of their stock prices. An adverse judgment, he says, could eliminate any remaining shareholder value virtually overnight.

Citing client confidentiality concerns, the Piper Jaffray M&A managers refused to reveal the names of any specific takeover candidates or acquiring firms now receiving their advice. But they did offer up a set of guidelines that investors can use to ferret out those hidden gems for themselves.

The takeover managers say that software and semiconductor firms will likely continue to lead the M&A pack. So far this year, software firms accounted for 30 percent of all mergers and acquisitions while semiconductor firms accounted for 27 percent.

“When the automobile industry got started early in this century there were a hundred or more auto companies,” says Jacquin. “Now, [in the U.S.], we’re down to three.”

The current shakeout in the software and semiconductor sectors might not be that extreme, says Hutchinson. But he quickly adds that he would be astonished if, 12 months from now, many of the smaller companies he tracks had not been acquired or merged into other firms.

In general, Hutchinson says investors should look for small-cap or micro-cap software or semiconductor firms with healthy gross margins and burn rates that won’t exhaust their cash reserves through at least the middle of next year.

“It’s okay if a company is losing money,” he says. “What’s important are the gross margins, you want to know the company has the ability to generate good margins.”

Acquiring companies are usually interested in cherry-picking smaller companies that have high-margin products that will be additive to their own growth, he says.

Cash on hand is another critical consideration, he says.

“You had lots of companies go out [through initial public offerings] and raise a lot of cash, but they still need partners or other technologies,” he says. Large cash positions are important, in part, because they give takeover candidates the elbowroom needed to negotiate the best possible acquisition price, which, in turn, rewards their shareholders.

The other crucial thing to look for, says Hutchinson, are strong relationships with customers that would be coveted by other players in that sector.

“Look at who their customers are and compare them with the competition,” he says. “You should also make sure they have a good reputation for customer service. Companies are often purchased because of customer relationships.”

If you can find all those ingredients, a small cap name with a strong cash position, healthy gross margins and a good list of customers, you’ve found a firm that could be a highly sought-after dance partner, say the M&A managers.

That will require a lot more painstaking research and analysis than many investors have been accustomed to, particularly over the past few years. But those willing to make the effort stand a far better chance of cashing in on the current shakeout rather than falling victim to it.

The recession of the late 1970’s, notes Jacquin, led to the merger mania of the 1980’s.

“It fueled one of the greatest periods of M&A in history,” he says. “M&A’s will play a major role in leading us out of this bust, too.”

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