Forget the Verizon-AOL deal. The big wave in tech M&A is just getting started.
It's been a while since such an insignificant M&A transaction has generated as much fuss as we're seeing for Verizon's $4.4 billion acquisition of AOL. Within the broader tech M&A market – in which buyers spent $439 billion last year – this just isn't that big of a deal. In fact, the most notable thing about it is the buzz it's generating inside the tech industry. Or rather, what that can mean for a coming wave of M&A activity.
AOL has built itself a cozy niche of programmatic advertising, which – more than its news sites and its prehistoric dial-up business – is the heart of its future operations. The company has turned around somewhat, but its options for further growth are limited. The deal is a happy exit for Tim Armstrong, but as Sarah Lacy pointed out, the gobbledygook offered as strategic rationale is far from persuasive. Verizon is just doing this because it can.
AOL doesn't mark a big strategic shift for Verizon, it's more like a late afternoon snack when it's feeling peckish. Verizon needs new revenue streams to keep growing so why not try a growing industry like – hmm, let's see - how about mobile video ads? AOL's $126 million net income last year was equal to 1.3% of Verizon's $9.6 billion. If anything, this is Verizon experimenting with new ideas, albeit ones that are only tangentially related to its wireless subscriptions.
And it's an affordable experiment. This is a company that two years ago paid $130 billion to Vodafone to buy the 45-percent stake in Verizon Wireless it didn't already own. Last quarter alone it spent $10.4 billion on 181 spectrum licenses in FCC auctions. That's enough to acquire two AOL's with enough change left over to buy a garden-variety unicorn.
The all-cash AOL deal may drain Verizon's cash reserves, but consider that Verizon generated $10 billion in operating cash flows last quarter - on top of $113 billion in total debt. At that level, what's another $4.4 billion in loans, especially when interest rates are as cheap as they've ever been?
The one thing that stands out for me about this deal is the inordinate amount of attention the business press is paying to it. Much of this has to do with the last time somebody entered an M&A transaction with AOL, which turned into what is often called the worst deal in history. But AOL is not the same company it was 15 years ago – just as the Internet today is radically different from the Internet circa 2000. The Internet, in fact, has grown up. AOL has grown down.
Sentimentality – or nostalgia, or whatever you want to call the tendency we in the press have of treating some companies like they were celebrities – is not a very accurate yardstick for measuring the value of M&A deals. A month ago, Nokia merged with Alcatel-Lucent in a transaction valued at four times the Verizon-AOL price. Yet the news was comparatively muted, presumably because both companies were aging, troubled businesses. And who gets worked up about that? The slower growth Verizon and AOL are both facing are tame by comparison.
What's most interesting about the Verizon-AOL deal has little do to with what it means for either company, but rather what it means for tech M&A as we rumble through 2015. All the pieces have been laid into place for a new wave of merger mania. All the firewood and kindling packed neatly together just so, just waiting for the right spark to set the bonfire blazing.
In January, 451 Research, which focuses on the tech M&A market, surveyed tech companies and found that 58 percent of acquirers expected to pick up the pace of dealmaking in 2015, while 77 percent of investment bankers expected higher-priced transactions. KPMG, Intralinks and others found similar pent-up intentions to buy in 2015, following what was the busiest year for tech M&A since 2000.
Tech giants are sitting on unprecedentedly high mountains of cash. The bulk is locked up in overseas accounts, but investors look at overall cash on hand when evaluating a company's ability to make a big-ticket acquisition. With interest rates at near historical lows, borrowing money to finance a takeover may not only seem feasible, but prudent.
Then there's the defensive factor: Younger tech companies that can't really be called startups anymore are commanding high valuations in private rounds of financing. Two-year-old Snapchat is worth as much as 30-year-old AOL. Publicly traded tech giants from Google to Microsoft to Facebook have the financial wherewithal to prepare themselves for these lither, well-funded rivals. And once a wave of merger mania gets started, it will become harder and harder for them to sit on the sidelines.
There is only one catch – a bit of business wisdom that any CFO who paid attention in MBA courses will surely remember: Most M&A transactions (and by most, scholars mean somewhere between 70 percent and 90 percent) will fail. That is, they will destroy value for shareholders rather than enhance it. Culture clashes, innovation-stifling policies of parent companies and misalignment of strategies are the chief reasons behind the failures.
This may be the real reason why so many acquisitions happen at a high premium to the market value. The companies being bought can see the strategies and cultures don't fit together, but once the price gets high enough they decide, oh what the hell. Verizon is paying a 19-percent premium to AOL's closing price Monday. Take that into consideration when deciding whether this deal makes strategic sense.
History seems to be no match for corporate FOMO when it comes to M&A manias. Every cash-rich company has their bucket list of dream acquisitions, and once some celebrity-like big names start to be taken out, a bidding frenzy will ensue. That scenario is especially likely this year, because it's widely expected that the Fed will taper off its liquidity-friendly policies later in coming months, pushing up interest rates and quite possibly pulling the plug on the stock-market rally. If you want to make that prized acquisition, the clock is ticking.
This rarely ends well. During the last wave of merger mania, companies like IBM and HP entered into bidding wars that left some saddled with overvalued acquisitions that never really delivered on the stated promise. Until now, the tech M&A market has been more potential than reality. All it will take is another high-profile acquisition or two – Google buying Twitter? Microsoft buying Salesforce? Yahoo buying Foursquare? AT&T buying Yahoo? - to get the bonfire raging.
The ameliorating factor is that most of the coveted companies are those so-called unicorns that are not only impossibly valued, they have the cash necessary to stay independent. Once the stock market starts to descend, however, they may be more open to acquisitions.
Business cycles move faster in tech than in other industries. But they typically climax in waves of consolidation, whether those consolidations make strategic sense or not. Like it or not, that's the history of M&A, and it's the way M&A, bizarrely, works. The real takeaway from the Verizon-AOL deal is this: Many of the smaller, well-known tech names that are happily independent today could well find themselves swallowed up by a larger company by next year.