In 2014, Cook Up Something New

To Clients, Partners and Friends of martinwolf | M&A Advisors,

According to disruptive innovation guru Clayton Christensen, established companies have a hard time inventing new business models when they need to. As a result, game- changing opportunities often pass them by and new market entrants ascend to leadership.

This happened in the 1980s in the IT industry when PCs displaced mainframes and minicomputers. It’s happening now as tablets, smartphones and the cloud are displacing PCs and on-premise datacenters.

In the early days of disruptive innovation, it’s hard to pick winners and losers. It’s sometimes even difficult to predict the actions companies will take to gain a foothold in the new world order.

From my vantage point looking back on 2013, here are five disruptive deals I could not have imagined a year ago.

1. In February, Dell announced it was going private as part of the largest tech leveraged buyout deal in history – the first in a series of significant go-private deals in North America in the space that continued throughout the spring.

2. In June, CDW, a technology services provider that went private in 2007, went against the grain and returned to the public market, raising about $396 million through an IPO at a valuation premium of 39% over its peer group.

3. In late August, Microsoft announced that it would buy Nokia’s devices and related services business and license its intellectual property for about $7.2 billion.

4. In October, IBM gave up an eight-month legal challenge to the CIA’s decision to award a $600 million contract to Amazon to provide cloud datacenter services to the spy agency.

5. In November, Chinese technology services provider ChinaSoft International paid
$42 million to acquire Catapult Systems, a premier Microsoft-focused consulting company based in Austin, Texas.

What do these major deals mean for companies in the global IT industry in 2014? It means you should expect more of the unexpected.

And if you had any doubts about it before, be assured: now is the time to reinvent your business model – or be left behind.

Surviving in the post-PC era

For any company whose fortunes depend on PCs, 2013 was a bad year. For Dell, it was a very bad year – but with a pretty good ending.

When Dell’s proposed LBO was announced last February, the company already had been trying for several years to make a complex transition from products to solutions and reinvent its business model, primarily by acquiring companies with higher value offerings. But having to answer to Wall Street every 90 days had been holding Dell back, especially when some of its acquisitions went south.

This was a key driver behind founder Michael Dell’s decision to partner with Silver Lake to take the company private. As a private company, Dell could make decisions that would be good for the long-term prospects of the business away from the public eye.
The result could be a transformed business that would potentially be a lot smaller, but could have higher margins and rising value.

It was a long haul and there were moments when it appeared the gambit would fail. But finally in late October, the deal was completed. Dell went private after investors raised just shy of $25 billion.

We didn’t know it when the Dell deal was announced, but there were more go-private deals on the horizon involving companies in the PC supply chain.

VARs turned services providers choose private equity
In April, two companies that started out as VARs and are transitioning to become services providers – CompuCom and Softchoice – made similar decisions to Dell, electing to stay or go private to complete their complex transitions. Before I continue, I will note that we have sold assets to CompuCom and done multiple transactions with Softchoice.

CompuCom announced that Thomas H. Lee Partners would purchase the company from Court Square Capital Partners for a rumored $1.1 billion. Softchoice announced that it would be acquired and taken private by Birch Hill Equity Partners for about $412 million.

For CompuCom, this actually marked the third time it had been acquired by a private equity firm since 2004, each time at a higher valuation. An infusion of capital, going private and a new – yet experienced – management team had been instrumental in helping CompuCom dramatically change the makeup of its business, increase gross margins and grow its enterprise value. In fact, CompuCom can serve as a blueprint for other VARs seeking to reinvent their business models.

While CompuCom’s journey began in 1999 and unfolded over a dozen years, what set Softchoice apart is the speed at which the company is making its transition from products to services. Over just 16 months prior to its acquisition, the company introduced its first cloud services offering, its first North American-wide managed services offering and completed a key acquisition, UNIS LUMIN, a Cisco networking and managed services provider. Softchoice also was doing a superb job of leveraging existing customers to sell new offerings and move up the value chain.

Despite their many differences, what Dell, CompuCom and Softchoice had in common was the need to transition to survive. For all three, going private provided the essential cover needed to execute on decisions that sometimes take a long time to bear fruit.

A successful IPO in a lukewarm market

In contrast, CDW, a privately held technology solutions provider, went in the opposite direction to raise capital for its transition. Despite an unreceptive market for IT IPOs for the past decade, CDW broke through last summer, going out at $17 a share.

So far, CDW stock has held its value. The company’s stock price as of December 31, 2013 is $23.36 per share. For the third quarter of 2013 – its most recent reported results
– CDW reported profit of 0.50 a share on $2.9 billion in revenue, handily beating analysts’ earnings estimates of $0.47 per share.

Public or private, 2013 proved that moving up the value chain requires both access to capital for organic growth and acquisitions and good relationships with customers that companies can leverage to sell higher value offerings.

Meanwhile, back at Microsoft
The announcement last summer that Microsoft will be buying Nokia’s phone business made it clear that even as CEO Steve Ballmer prepares to exit, far from abandoning its new strategy to become a devices and services company, the company is doubling down.

Success is by no means guaranteed. Just as launching its own tablet and selling it direct in the United States put Microsoft in direct competition with its OEM PC hardware manufacturers, getting into the smartphone business pits Microsoft against the other Windows Phone makers, including Samsung, HTC and Huawei.

The move also reaffirms the message Microsoft sent to its channel partners when it announced it would enter the tablet business back in the summer of 2012: we’re unhappy with your lack of innovation in tablets and smartphones, and we’re making big changes. We’re going to launch our own line of tablets and we’re going to sell direct, at least in the United States.

This announcement caused massive disruption in Microsoft’s partner network at the time, and uncertainty intensified in 2013. Despite a relative lack of success in the tablet business, all year long Microsoft has been tweaking its channel programs and partners, tacking actions designed to cull weak partners and generally diminish the importance of partners in its new businesses.

In September, Microsoft announced the most recent major overhaul of its partner programs. In a nutshell, the cloud is now definitely center stage and tablets and smartphones along with it. Managed services partners now have a place to call home.

All along, I’ve cautioned Microsoft channel partners that to continue to grow revenue and enterprise value, they will need to develop new solutions, new markets, new strategies and new vendor-partners. Going into 2014, my advice still stands, with another added dimension.

This year, I would add to my caution that all vendors with robust channel programs – not just Microsoft – are taking hard looks at their channel partners and making tough choices about who to support with additional resources and who to starve.

Bottom line, if you’re not at the center of your partners’ competencies and strategies going forward, to quote John Houseman playing fictitious Harvard Law Professor Charles W. Kingsfield in the classic movie Paper Chase, “Look to your left, look to your right. One of you won’t be here next year.”

Not every cloud has a silver lining
While the PC hardware business and its supply chain continued sorting itself out, the cloud wars reached a fever pitch last year, with companies competing fiercely for contracts that could define their market positions for years to come. Taking a page from Christensen’s disruptive innovation playbook, it would not have been surprising for an upstart cloud vendor to win a big contract by vastly underbidding an established leader.

But it should surprise you that a company that sells everything from toys to toilet paper bested a well-established federal contractor for a $600-million contract to provide cloud services to the CIA – now here’s the real shocker – with a bid that was 58% higher.

I’m talking about Amazon and IBM. And while I know that calling Amazon an upstart is a stretch, it is no less shocking that company ended up winning the contract – the first time the company known as the world’s leading public cloud company won a major contract to provide private cloud services.

So why did Amazon win the contract? A chart in the GAO memo announcing the decision tells the story. Of the 8 criteria visible against which each company was evaluated, Amazon beat IBM on 5 and tied on 1. Crucially, the overall proposal risk for Amazon was judged to be “low,” while the risk of IBM’s proposal was deemed “high.”

We have all heard of “high risk, high reward.” When the CIA is the buyer, apparently “low risk” pays off with a “high reward.”

A turning point in China
For the last two years, I’ve been observing and writing about China as a potential threat to India’s leadership in IT services. It’s something that Indian IT executives worry about and Chinese IT executives aspire to. But until 2013, there was no strong evidence that China’s IT companies are ready to take their place on a global stage.

The main issue was that Chinese IT companies thus far have been unable to pull off cross-border acquisitions of any notable size – which is essential in a go-global strategy in a maturing industry. Most successful deals have had valuations of less than $20 million, and truthfully more in the USD 8-10 million range. Instead, they need to be in the range of USD 50-100 million.

This was not for lack of trying, but negotiating and closing cross-border acquisitions is difficult even for experienced buyers. Chinese IT companies are relatively new to the game and their inability to close deals tended to make potential sellers wary of offers from them.

That could be changing, as evidenced by ChinaSoft’s acquisition of Catapult Systems, for the following reasons:

• ChinaSoft paid nearly $42 million for the Catapult – double the price of previous similar transactions.

• Catapult is an emerging leader in the Microsoft-focused consulting space – a well-respected company with a strategic management team.

• Catapult’s revenue for the 12-month period ending September 30, 2013 was
$62.3 million, an increase of 24% over the same period a year prior, with a gross margin of 37.2% and an adjusted EBITDA margin of 9.5%.

• The combined company will be one of the most accredited and certified Microsoft partners in the world.

This acquisition is a bold move by ChinaSoft, and if the companies successfully integrate, it could serve as model for other Chinese IT companies.

What to do in 2014
Now, I am going to digress a bit. In early November, one of the greatest disruptive innovators of our time, Charlie Trotter, died of a stroke at the age of 54. As many of you know, Charlie was not a tech or IT guru, but a restaurateur. Long before farm-to-table was commonplace, he went to local sources for his ingredients and offered equally appealing vegetarian menus.

Once in an interview, Charlie attributed his success to being “unrelenting in trying to pursue a single goal: to refine and redefine what we stand for as a restaurant.”

He went on to say, “It’s also about never growing complacent. I have long ascribed to the idea that if it ain’t broke, break it. So, we continue to find ways to push the envelope.”

This idea of “if it ain’t broke, break it,” should be the watchword of the IT services industry in 2014. Because if you are not the company doing the breaking, I assure you a competitor, customer, partner or supplier will be breaking you.

After all, times change, and no one wants the same thing over and over and over again, forever. It’s akin to eating the same meal everyday. Even the best food will lose its appeal eventually.

So, a word or two of advice for 2014: listen to the late, great Charlie Trotter… and cook up something new.