M&As Speak Volumes on Industry Evolution

We often hear about channel consolidation, but consolidation is happening at the vendor level, too, and it’s mostly a result of the shift from conventional products to services-based offerings.

By Larry Walsh

The industry was rocked over the past week by reports that EMC has been shopping itself around for a “merger of equals” with such companies as Hewlett-Packard, Dell, and Oracle. Reports are sketchy about what’s actually happening, but what’s known is that EMC did engage in extensive talks with HP, and there’s still a possibility that either HP or Dell could join forces with the storage giant.

Why would a company such as EMC, with a market value of approximately $60 billion and revenue of $23 billion, consider giving up its stand-alone status in favor of consolidating with a company like HP? A handful of reasons: value accretion, slowing growth, acquisition of new technologies and capabilities, economies of scale, and customer procurement. Simply put, mergers and acquisitions are a means of growing a business quickly and, in theory, decreasing costs.

[ctt tweet=”Mergers & acquisitions are a means of growing a business quickly and, in theory, decreasing costs.” coverup=“e1dk2_”]

In the case of EMC, there’s another factor at play: shareholder value. Activist investor Elliott Management is pressuring EMC to return value to its shareholders. Initially, it was thought that EMC would cave to the pressure by selling off its 80 percent stake in VMware. But merger talks have spurred broader speculation that a much bigger deal is needed to satisfy investors.

A challenge all vendors face is growing in the face of technology commoditization and the increasing cost of sales. The challenge is particularly acute for the likes of EMC, as it’s much harder for a multibillion-dollar company to move the needle than it is for a smaller organization. In the case of EMC, the growth projection for 2014 is just 3 percent. Consolidation through mergers and acquisitions can spur more dramatic growth by opening new revenue streams and market opportunities.

But the EMC merger speculation is more about the shift from traditional hardware and software products to services-based IT delivery. Margins on hardware, which makes up the bulk of EMC’s revenue, have been falling for years. Solution providers tell 2112 that hardware profitability declined by as much as 20 percent in 2013, and it’s projected that the downward trend will continue into 2014 and 2015. The shift to services – cloud, managed, and outsourced – is expected to offset hardware declines. For many vendors, however, the cloud is actually resulting in a net loss. While it’s easy to say conventional hardware sales are shifting to cloud, it’s not a one-to-one exchange. Fewer dollars are spent on cloud infrastructure services than conventional on-premises server deployments. Some vendors have attempted to address this by targeting hosting and service providers; but the demand isn’t there. Cloud companies have a far easier time scaling infrastructure than individual companies.

Consider what’s happening at IBM. According to analyst firm Gartner, in 2013 overall server sales – a mainstay of the hardware segment – grew 2.1 percent, while revenue decreased by 4.5 percent. IBM held the No. 2 spot in global server market share, at 26.5 percent, and was the top revenue producer, earning more than $5 billion in sales. But despite those figures, IBM experienced a sharp decline in sales and market share. Its server business fell a shocking 29 percent, while nearly every other server vendor posted at least a small positive change.

At the same time, IBM has invested billions of dollars in cloud infrastructure and services. Today, IBM is earning more than $3 billion through cloud services – just a fraction of its overall sales. And the sale of its x86 server business to Lenovo will, in IBM’s estimation, result in more sales of its hosted infrastructure services. In essence, IBM is trading servers for clouds.

What would a merger between EMC and HP, or EMC and Dell, look like? On paper, either of those deals would create a powerhouse whose portfolio consists of endpoints, servers, storage offerings, security solutions, and software. Ten years ago, this probably would’ve been viewed as a “can’t lose” proposition. Today, though, the value from such a merger would have to come from consolidating back-office resources, product development and supply chains.

Truth is, the hardware business isn’t going away anytime soon, but it is getting much harder to make money in a hardware-based business. Cisco, for example, has undergone a series of contractions as it manages the decline in hardware value. Dell went private to avoid Wall Street pressure while it shifts from its PC-based business to enterprise infrastructure and services. And the potential EMC merger is yet another sign that even the big vendors are under pressure to retain value in legacy products while building out the next generation of a services-based business.

Larry Walsh, The 2112 GroupLarry Walsh is the founder, CEO and chief analysts of The 2112 Group. You can reach him by email: lmwalsh@the2112group.com; or follow him on social media channels: Twitter, Facebook, LinkedIn.