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Tuesday, October 10, 2006

The Incredible Shrinking Tech Sector

by William Trent, CFA of Stock Market Beat

We noted last week that Oracle (ORCL) should get credit for recognizing the trend early and snapping up prize properties Peoplesoft and Siebel before the competition really woke up.

Earlier, we outlined the reasons for consolidation in the tech sector:
The software industry had too many companies chasing too few dollars, and balance sheets too strong to cause any competitors to bite the dust. There is only one way to fix that situation, and that is for an industry leader to soak up the excess capital by leveraging its own balance sheet to acquire other companies - for cash, not shares. Oracle has been pursuing that fix, beginning with the PeopleSoft acquisition and most recently with the buyout of Siebel Systems.

The need is perhaps even greater within semiconductors, who could use the same type of discipline:
As we have noted frequently, semiconductor manufacturers are… well… manufacturing too many semiconductors. What’s worse, they continue to order equipment to manufacture even more semiconductors at a faster rate than the underlying demand can support. Although some companies are starting to get the hint (Intel said it would “avoid” $1 billion of new equipment purchases it had originally planned for next year) there are many who still don’t get it. Perhaps the only way to slap some sense into them is to buy their company and take away their cash hoard.

Well, the takeover talk has been heating up lately. MergerTalk-Strong appetite for Tech buyouts seen continuing
The strong appetite by private equity firms for technology deals shows buyouts in that sector are only going to continue — with the focus on semiconductors and software.”In terms of tech LBOs (leveraged buyouts), I would suspect there are a couple of elephants yet to be bagged,” said Brenon Daly, financial analyst at technology research company The 451 Group.
He sees these coming in the semiconductor sector and expects a large buyout of a chip company in the next few months.

The technology sector has become more attractive as company earnings have become steadily less volatile compared with the boom-and-bust years of 1999 and 2000. In addition, diminished valuations since those bubble days have made acquisitions cheaper.

Meanwhile, increased pressure on company boards from hedge funds eager to increase returns is encouraging some companies to opt out of the public eye altogether. For smaller companies, the added expense of complying with stricter reporting standards under the U.S. Sarbanes-Oxley Act of 2002, is also a factor.

That thought worries Forbes:
Yep, it’s a great time to be a privately held company. But what happens if, 20 years from now, all the great companies have gone private? Some half-trillion dollars in LBO and private equity funds, just sitting out there, suggests this could happen.

A happy turn for American democracy and capitalism over the past 25 years has been the vast growth in the number of shareholders. During the late 1970s only 12% of Americans owned stocks. Now half do. Broad ownership of stocks and land is the core of a strong, politically and civically engaged middle class. But the current movement to take American businesses private threatens to reverse this mass-shareholder trend. If large portions of the middle class begin to feel alienated from the capitalist class, I predict bad things will happen. South American-style populism could take root.

Owners of a company should, of course, have the right to decide if their outfit will be publicly held or privately owned. But these days, in the aftermath of Sarbanes-Oxley, the balance is out of whack. And if the balance stays out of whack–if every company wants to be private and none public–that will be bad for the future of American democratic capitalism.

What Forbes misses is that whether any particular company is public or private has little bearing on the number of stock market investors. As long as there is money to invest there will be places to invest it. Given the recent trends in savings rates, there is less money to go around. Thus it only makes sense to have fewer companies in which to invest the meager remaining investment funds. Like the fundamentals of the semiconductor industry itself, the investment opportunities in semiconductors ultimately come down to supply and demand - and if there are fewer shares to buy (with a given level of demand) those shares should perform better.

The author may hold a position in the securities discussed. A current list of the author's holdings is available here.

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