In the latest Mergermarket report, several industry experts mentioned their deal flows in mid-market areas have been strong. This flies in the face of the large number of reports that M&A activity has been having a rough time this year. One sector that has suffered considerably in terms of dealmaking compared to last year has been the tech industry, while other less traditionally ‘sexy’ sectors are mentioned as being in considerably better shape. This seems surprising at first glance, given how much of a tear tech has been on lately. What’s behind this change? What’s making consumer and infrastructure deals sizzle while tech fizzles?
In a way, the tech sector’s runaway success over the past few years has contributed to its problems this year. As the market grew hotter and hotter, valuations grew higher and higher compared to other sectors. Looking at some of the industries mentioned in the Mergermarket report, we can see Software’s Forward P/E ratio was extremely high relative to other industries (see Figure 1).Figure 1 – forward P/E Ratios by Industry as of Oct 6, 2016
The Software industry is being given a forward P/E ratio of 34.5 by the market, more than twice the average of 15.3 for the remaining industries shown. Comparatively, this makes buying a software company considerably pricier than a financial services company, as you are paying $34.50 for every dollar of expected earnings in the next 12 months compared to $12.80. As this ratio has continued to grow, buying tech firms has become less and less justifiable, causing M&A activity to slow down.
In contrast, the valuations of many other industries have been less than stellar. The P/E ratios shown illustrate this and, with the US consumer apparently having turned a corner, many retail-facing industries are ripe for growth – and deals. Finding a proverbial diamond in the rough within a sector experiencing depressed prices can be a lot of work, but successfully doing so is a recipe for significant return outperformance when things turn around.
Secondly, the recent tech boom has brought many new high-tech solutions to other areas that are only now being applied en-masse. Big Data, for example, was once the domain of a few, large firms with the infrastructure and processing power to handle it, but has become commonplace in a variety of industries. From banking to grocery stores, companies facing the public are eager to learn more about their customers to build more targeted ad campaigns and improve products, while internally, this technology can help a company to analyze everything from supply chains to distribution networks and increase efficiencies.
Another hot area that has benefitted other industries has been the so-called Internet of Things. The outfitting of products with internet connectivity has helped both consumer-facing businesses and B2B applications alike, in a similar manner to Big Data, by driving efficiencies, cost-savings, and improving product usability. GE, for example, is hardly a tech company in the conventional sense but is in the middle of a massive push towards integrating improved data analysis, sensors, and other new technologies to improve both its products and production.
The democratization of these technologies has been accelerated by the most recent tech boom, and this has allowed other industries to implement and take advantage of them. Given the intense requirements for developing these products, it is somewhat unreasonable to expect a firm to produce them entirely in-house if it is outside their core competencies. The ability of these businesses to take advantage of competition in these spaces forcing prices down has created space for valuations to grow in industries outside solely just tech. As such, smaller and mid-sized companies in these industries that apply new technologies in helpful ways make juicy targets for larger, more established firms that would benefit from their deployment, acting as something of an obvious proof of concept without the risk of rolling out something they see as untested on a large scale.