High-tech's spree: big IT companies are buying up small fry to head off competition.

Joe Tucci has a bold thesis about the current wave of technology mergers and acquisitions. The chief executive of data storage giant EMC believes the CEOs running today's large information technology companies--IBM, Microsoft, Cisco Systems and EMC--would rather buy a boutique upstart with disruptive technology than let it grow into a competitor. EMC has done just that in the last two years, eating up small companies like hors d'oeuvres as it extends beyond its bedrock data storage hardware into software and consulting services.

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Tucci's opinion is sort of a "twice burnt, thrice shy" theory. Over the course of his career beginning in the late-1960s, when the young Brooklynite was fresh out of Manhattan College and earning a paycheck as a systems programmer at RCA, Tucci observed two profound industry shakeups. The first was in the early-1970s, when he was working at Sperry-Univac, which bought RCA in 1971. "The only IT companies at the time were the big mainframe manufacturers like IBM, Sperry Burroughs, NCR and Xerox," Tucci says. "Then, lo and behold, this crop of mini-computer companies like Wang, Data General, Digital Equipment and Hewlett-Packard emerged in the late-1970s and early 1980s, and quickly built great market cap. As they grew and became stars, the rest of us, other than IBM, were rather non-stellar."

A decade later, the same phenomenon again unsettled the market. "In the early 1990s, another new crop came up, companies like Sun, Compaq, Microsoft, EMC and Dell that largely were in the microprocessor space," Tucci explains. "Just as mini-computer companies displaced mainframe companies the personal computer began displacing minicomputers, and these companies quickly built market share and market cap. Each wave of disruption displaced the previous wave."

Never again, Tucci vows. "CEOs like me--John Chambers [of Cisco] and Kevin Rollins [of Dell]--will not let this happen again," he explains. "History has taught us we can't be complacent. We're old enough to have seen the prior acts of this play and know how it will end." Consequently, when a bright little fish pops into view, tech CEOs like Tucci are more than likely to eat it. The possibility that Hewlett-Packard could be split after the firing of Carly Fiorina runs counter to the consolidation trend, but other tech giants are sticking to the acquisition path.

Certainly, EMC, Cisco, Microsoft and IBM have the balance sheets and cash to buy most any upstart with technology that they either don't have in the pipeline or have neglected to spend R & D dollars developing. EMC ended the first quarter of the year with $7.4 billion in cash, while networking pioneer Cisco has a cash horde in the $20 billion range. Both companies' bingeing on small fry has contributed a good portion to the more than $198 billion spent on mergers and acquisitions in the technology arena in 2004, an enormous jump from the $48.7 billion reported in 2003. Cisco alone spent a whopping $796.5 million on a dozen deals.

Last year saw more than 1,951 deals in all, up from 1,455 in 2003, according to New York-based technology consultants The 451 Group. This year promises more of the same, with large IT companies eyeing small fry for a variety of reasons: an improving economy giving them more cash: increased demand from enterprise buyers of IT systems, networks and applications; the impact of market saturation and competition; and a broadening in how IT companies define themselves.

These factors in varying degrees are at play at Microsoft, which has invested heavily in acquisitions that bulk up the security of its Windows operating system, MSN network and other products (and offer the company a new product category to boot); IBM, which has virtually forsaken hardware for the business performance transformation services market; and Cisco, seeking to continually fill gaps in its networking technology via acquisitions. "The really big players are going out and buying whoever the leader is in a particular area of technology, either to fill a gap or where they see the potential for competition arising," says Tony Rizzo, director of M & A research at The 451 Group. "Guys like Tucci are shaking the market in ways that keep smaller companies from becoming bigger companies. What's interesting is that the smaller guys are not complaining."

Cisco's 2003 acquisition of Linksys Group, a southern California firm that makes networking equipment for homes and small offices for $500 million is one example. Its recent $450 million acquisition of Wi-Fi switch startup Airespace--for which Chambers overpaid, according to Rizzo--is another. "Almost across the board, they tend to pay 10 to 20 percent more than these companies are valued, but they have fairly deep pockets to do it," he says.

However, adds Simon Yates, senior analyst at Forrester Research, "Cisco has found that it is sometimes easier for them to buy a new technology than to build it themselves."

EMC has been driving the consolidation. Starting in 1999 with the acquisition of Data General, EMC has evolved from a provider of high-end data storage systems into a company with a portfolio of information management and storage systems, software and services. Overall, EMC has acquired roughly two dozen companies since the late-1990s.

But it is in the last 18 months where EMC has truly splurged, spending $4 billion to buy companies such as backup software player Legato; Documentum, an enterprise content management software company; VMWare, which does Intel-based virtual computing software; Dantz, an information storage and management leader; and network management vendor SMARTS.

EMC also is indirectly compelling industry consolidation. By acquiring Legato, for example, Veritas--Legato's primary competitor--was pressured to shop itself around for a buyer sporting a wallet the size of Tucci's. Microsoft's growing ambitions in security also squeezed the company, eventually propelling Veritas into the arms of information security provider Symantec, which recently bought it for $13.5 billion.

Tucci's appetite for small companies is based, in part, on the realities of a dwindling market for EMC's traditional big box storage systems. "Joe is being practical. He knows if EMC doesn't do some things with smaller companies, they're dead in the water," says Yates. "EMC also is in a low margin business where there's always the risk of being killed by someone who makes something that suddenly renders your hardware obsolete. Joe knew his core business had matured and he was likely to be commoditized and chewed up by small competitors. So he ate them instead."

Johnny-Come-Latelys

Everyone, it seems, is worried about a disruptive technology suddenly popping up. "The CEOs of large IT companies like EMC, Microsoft and Cisco have a greater awareness and vigilance these days when it comes to ferreting out breakthrough technologies," says Frank Gens, chief analyst at research firm IDC, based in Framingham, Mass. "They are looking far and wide for the next disruptive technology before it takes away their market share."

Once these companies eyeball an upstart with promise, they're likely to swoop in and make an offer the smaller company cannot refuse. "From an economic standpoint, big companies look at small companies and see these huge opportunities for essentially peanuts," says Yates. "They don't mind paying a premium because five years from now that little thing this company created will be a big part of their product."

Another impetus for consolidation is the need for IT players to broaden their portfolios to offer complete customer solutions. Says Gens: "We're in the middle of a total restructuring of the IT industry."

EMC and IBM are building out product portfolios that allow them to better address the high-value business needs of their customers. So is Microsoft. The company declined to comment, but Tucci says Bill Gales and Steve Ballmer are expanding the definition of their market. "Microsoft started out selling programming language and then DOS," he explains. "Then it expanded into Office Suite, MSN and X-Box. It went from PCs to servers. Any company that is successful in almost any space has redefined itself. Who would have imagined 20 years ago that Wal-Mart would be selling food and gas?"

Acquisitive companies also are buoyed by a rise in enterprise demand for technology products and services. According to a December 2004 Forrester Research survey of 1,400 technology decision makers at North American and European enterprises, "despite a generally cautious outlook for business in 2005, companies are opening their wallets more significantly," says Yates. "On average, they expect to increase their IT spending by 3.9 percent this year, up from 1.7 percent when the survey was taken in December 2003."

While purse strings are loosening, there still isn't enough growth to alter the fact that there are still too many suppliers chasing too few opportunities. "When the market is not growing very fast, the only way to grow is by taking market share," says Robert Passmore, research vice president at technology consulting firm Gartner. "EMC bought Legato essentially for its sales force. They initially had said they would push into software by growing their own internal sales force, but why take the time to grow it when you can buy an ongoing sales force instead."

Growing Demand for Big Players

Buyer habits also play a role in the industry's consolidation. They want to do business with established, large vendors. "Enterprise buyers want to reduce the number of their IT vendors to a small group of strategic partners that can package together different technologies to solve their business problems," Gens explains. "They know they can't serve their customers or create new products or manage inventories without advanced technology to do it. And the only vendors capable of doing that are the ones with broad product and services portfolios and a smattering of consulting expertise--larger companies like EMC, IBM and others."

Conversely, smaller technology vendors of uncertain financial health give pause to enterprise buyers. "They don't want the headache of managing multiple relationships, especially with small companies they're uncertain about over the long term," Rizzo says. "While the disruptive technology of the small company might be potentially useful to the enterprise, they're afraid it might cause more heartburn than pleasant experiences."

Why are the big guys having all the fun? "Small companies today know they can't take on the big companies because while they may have the product, they don't have the sales and distribution," Passmore says. "No matter how good their products are, if they can't figure out how to conquer the sales and distribution channels, they will fail."

Yates concurs. "Only big companies with lots of capital, large markets and global presence can distribute these products worldwide," he says. "They realize, 'What good is great technology if no one hears about it?'"

Further daunting upstarts are more cautious public markets and venture capital firms. "They're stingy when it comes to what they're willing to offer startup companies," says Gens. Meanwhile, venture capitalists are getting competition in the investment arena from big IT vendors.

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Consequently, smaller companies have few avenues to turn into other than the parking lots of bigger companies. Not that this is bad. "The venture capital players behind the small companies are clearly of the mind that the way to get a return on their investments is for these companies to be bought," says Rizzo of The 451 Group.

If fewer startups are going to have a chance to challenge the giants, what does that bode for entrepreneurs with a garage, a great idea and little capital? They have to get smarter. "They should recognize that large companies are like big ships--too big, rigid and inflexible to produce high quality products economically and distribute them at affordable prices," says Yates. "Rather than let the big company eat you, network with them through some sort of partnership, where maybe you develop the innovative product, hand it off to a transformer that turns it into a finished good, who then partners with a finance company to fund the distribution of it."

Yates believes Tucci is off base in believing that upstarts won't ever get the chance to become tomorrow's big shots. "No one has to sell out to a dinosaur like EMC or a monster like Microsoft," he argues. "Look at Google. They didn't [sell out]. They decided to go it alone and had enough staying power to make billions for all their employees. Now they're the big fish." Yet another exception that just may prove the rule.

Acquisition Flurry

                                                                  Deal
           Date      Target             Target Description        ($M)

Cisco       6/16/04  Procket Networks   Carrier-class routers &    $89
                                        related silicon
            6/29/04  Actona             Wide-area file services    $82
                     Technologies       software
            8/24/04  P-Cube             Bandwidth management ISP  $200
                                        software
            9/9/04   NetSolve           Remote network & IT       $128.5
                                        monitoring
           10/21/04  Perfigo            Network access control     $74
                                        software
            1/12/05  Airespace          WLAN hardware & software  $450
                                        provider
IBM         4/1/04   Candle Corp.       Data & application        $350
            4/7/04   Daksh eServices    Call center &             $170
                                        outsourcing services
            1/25/05  Corio              Application & system      $182
                                        management services
Microsoft   4/26/04  ActiveViews        Microsoft's .Net & SQL    NA
                                        applications
            7/16/04  Lookout Software   Microsoft Outlook search  NA
                                        tool
           12/16/04  GIANT Company      Anti-spyware software     NA
                     Software
            2/8/05   Sybari Software    Content security & spam   NA
                                        software
            2/22/05  En'tegrate         Microsoft ERP software    NA
                     Software (ERP      tools
                     toolkit)
EMC        10/12/04  Dantz Development  Back-up & recovery        NA
                                        software
           10/28/04  Allocity           Email storage networking   $10
                                        software
           12/21/04  SMARTS (System     Network systems           $260
                     Management Arts)   management software

Source: The 451 Group