HP Acquires Palm -- Who's Next in Tech?

Wednesday, Hewlett-Packard (NYSE: HPQ) announced it would acquire struggling handheld device maker Palm (Nasdaq: PALM) in a $1.2 billion deal. After the announcement, Palm shares are trading through the $5.70-per-share offer, indicating the market believes Palm will ultimately receive a better bid. But the Palm deal could be just the starting gun for a flurry of mergers and acquisitions activity in the technology sector. Here's why and who some of the next targets might be.

The means: Cash-on-hand
Tech companies are cash-rich: The 75 technology sector companies in the S&P 500 had aggregate net cash of $168 billion at the end of last year (by net cash, I'm referring to cash less all debt). Moreover, that cash is increasingly concentrated on the balance sheets of a small number of large companies: At the end of last year, the top eight companies in the index by net cash held more than four-fifths of the total for the sector -- the comparable figure for the same set of companies three years earlier was about two-thirds.

The firms with cash burning a hole in their pockets include Cisco Systems (Nasdaq: CSCO) and Oracle (Nasdaq: ORCL), which already have long track records of acquisitions:

Source: Capital IQ, a division of Standard & Poor's.

The motive: Slowing growth
Of course, companies could return that cash to shareholders; unfortunately, as I argued recently, the tech sector is a skinflint when it comes to paying dividends (on the whole -- there are exceptions). While the trend appears to be moving in the right direction, if given the choice, executives will (nearly) always favor expanding their dominion over paying out a dividend. Returning excess cash to shareholders is an admission that one cannot find a more productive use for it and that growth opportunities may be limited.

Nevertheless, as large tech companies grow and their businesses mature, they no longer fit the secular growth story that is associated with technology shares. Instead, their growth is increasingly tied to the state of the economy. At present, expected annualized earnings-per-share growth of the Technology Select Sector Fund ETF (NYSE: XLK) over the next three to five years is 12.65%, which is only 2% higher than that for the entire S&P 500.

When organic growth is no longer the low-hanging fruit it once was, acquisitions look more attractive to executives who feel pressure to sustain high earnings growth rates. Who are the targets in this environment? Here are two in the application/systems software sector.

Potential Target No. 1: Novell
In March, Novell (Nasdaq: NOVL) received and rejected a $5.75 per share bid from activist hedge fund Elliott Associates. The enterprise software manufacturer hasn't seen full year profitability since 2006, but its net cash per share ($2.85) represents half of the share price. Elliott's presence as a shareholder -- the hedge fund owned 7.1% of Novell as of March 1 -- has already proved to be a catalyst for change, as the company is now "in play." Whether or not Elliott makes another bid, I think the odds are favorable that someone acquires Novell.

Potential Target No. 2: Sybase
Along with IBM and Oracle, Sybase (NYSE: SY) is one of the main providers of relational databases to corporate clients, but its product/ services offering is less complete than its larger competitors. Companies are loath to switch from one database to another, so despite its also-ran status, Sybase's installed customer base is a valuable asset and, at 16 times estimated earnings-per-share for the next 12 months, the shares trade at a discount to its larger peer group multiples.

Sybase was mentioned as one of nine potential acquisition targets on an internal Oracle list from April 2003 (the list was released during an antitrust case against Oracle). Sybase is one of only three companies on that list that remain independent today (the other two are Cerner and Lawson Software); in the interim, Oracle managed to snap up three of the original nine.

Opportunity and risk for shareholders
I expect a boom in technology sector M&A transactions over the next twelve to eighteen months, during which the shareholders of target companies could earn substantial premiums. Shareholders of acquiring companies, on the other hand, need to be mindful of managements that could be overeager to spend their cash and/or equity. After all, it's very rare to find a CEO that is paid less to manage a bigger company, regardless of whether or not he/she has saddled his shareholders with the "winner's curse."

If your search for "growth stock-type" returns is contained to the U.S. stocks, you're starting out at a handicap to savvy investors. Tim Hanson explains how to make more in 2010.