It's an M&A World

Only a few years ago an Internet pure-play like America Online would have touted its absence of brick-and-mortar operations - magazines, television stations and cable operations - as a sign of its superior value. In those days, a move to merge with a traditional "real-world" company would have meant risking the company's high stock value.

But this morning, when AOL and Time Warner announced their "merger of equals," investors' immediate reaction was enthusiastic. While AOL closed at the end of trading down a modest $2.75 at $71, its price had initially jumped $6.25 to $80.

"This marriage is going to accelerate conversations about mergers and acquisitions across the Net,'' says Todd Carter, director of investment banking at Robertson Stephens, a firm not involved in the deal. "There are going to be board conversations throughout America and the developed world saying, 'My god!

Look at what happened, what are we going to do?"

Investment bankers and analysts are forecasting an M&A feeding frenzy in the year ahead. In the wake of AOL's move, there's now pressure on Yahoo, AltaVista and ExciteAtHome to make similar moves. And beyond the media and portal spaces, the urge to merge has already started to spread.

In online retail, analysts foresee fewer players in crowded areas like pet food and consumer electronics, predicting that megastores will move in and make acquisitions. In the first week of January, Proflowers.com acquired Flowerfarm.com; luxury-goods retailer Ashford.com snapped up Jasmin.com, a perfume site; and shopping-services company Brodia merged with gift registry WishConnect.

Concurrent with the merger trend is a continued drive among the largest Net companies to expand their reach into new sectors. Last year eBay moved into car sales and Amazon.com invested in everything from drugs to groceries. Both are expected to make more strides this year.

In the business-to-business e-commerce sector, big information-services providers like Oracle, the Netscape-Sun Alliance and IBM are also likely to chase deals, as are the new pure-play b-to-b giants, Ariba and Commerce One, which just acquired Mergent Systems.

These mergers "are virtuous, they're offensive in nature and they're synergistic," said Bradford C. Koenig, a Goldman Sachs managing director, in an interview last month. "These are all about strategic positioning to be able to compete better."

For many companies, they're also about primping for Wall Street. By raising sales through acquisitions, firms reassure those investors who value Net stocks by revenue growth rather than profits. "Wall Street expects growth and M&As are a piece of that," says Carter at Robertson Stephens.

In this respect, the AOL deal with Time Warner could be something of a breakthrough. Although investment bankers have used very different methods for valuing the two companies, the market's reaction so far suggests that investors take a positive view of combining a more traditional company with a Net company.

Of course, mergers and acquisitions have not always been considered a good thing. Critics attacked them in the past as little more than financial engineering intended to inflate a company's value and pad revenue growth.

Still, even before the AOL-Time Warner merger, Net deals appeared to be passing muster among investors.

During the past two years, Net companies that have announced large acquisitions have seen their stock prices rise that day an average of nearly 3 percent more than the Standard & Poor's 500 Index, according to Ken Sawyer, managing director at Prudential Volpe Technology Group. In contrast, back at the start of the 1990s such news from tech companies was greeted by an average increase of less than 1 percent.

"Historically an acquirer's stock price has declined on announcement of a merger transaction, but that's not so in the Internet space," Sawyer says.

"It's a Wild, Wild West land grab, and M&As are a key part of the dynamic."

YOUNG COMPANIES WITH NEW CURRENCY

One reason that analysts are forecasting a banner year for Net mergers is that 1999 saw a record number of Net companies go public: more than 200. If 1999 was the year of the Net IPO, expect 2000 to be the year of the Net M&A.

"As spring follows winter, M&A activity follows IPOs," says Koenig of Goldman Sachs.

Take, for instance, IntraLinks, a 3-year-old online financial services company that says it will go public by March. The firm does not plan to use its IPO proceeds to support operations or buttress its already healthy sales. Instead, it wants to buy other companies. "We've completed one acquisition to date and we're actively looking at others," says Mark Adams, chief executive at New York-based IntraLinks. "It could be expanding into new markets or new areas, or acquiring a new technology that's instrumental in improving a product or service for our customers."

Not long ago, the urge to merge at a firm like IntraLinks would have been seen as precocious at best, and downright foolhardy at worst. A young company that needed new technology or new customers would develop them itself, not go shopping for a startup.

That's likely to change this year. Barring a major shift in the financial markets, IntraLinks and dozens of other firms will follow the lead of heavy hitters like Amazon, eBay and Ariba, all of which boosted their business in 1999 through aggressive acquisitions.

The obvious motivation is money. A record number of Internet IPOs from last year means a lot of companies have stacks of stock market currency to spend.

Also, many of these companies have gone public at a very early stage in their development and still need to add a range of products and services. Their choice is to either develop them internally or buy them. While in the past such young companies wouldn't have the capital to make such acquisitions, the new generation of companies does.

And another factor, aside from all the IPO wealth, is pushing the merger trend.

In the aftermath of the holiday season, online retail's stronger performers will likely see their stocks rise, while those of their weaker rivals will fall. In such an environment, the big companies will naturally turn their hungry eyes to the smaller ones - and the smaller ones will think quickly about joining together to survive.

THE ROARING 2000s

This wave of merger activity actually began as 1999 ended. A lot of bankers toiled long hours in late December. At Robertson Stephens, an adviser on many of 1999's biggest Net M&As, Carter says he was working on six deals, two of which involved mergers between major e-commerce companies. Robertson Stephens is now looking to add more bankers to its M&A team, although the current figure - more than 100 - is five times the number Robertson had a few years ago.

The pace is also accelerating at Deutsche Banc Alex. Brown. On Sept. 22, Broadbase Software, which creates software to help Web sites track customer information, went public. Just days later, Broadbase executives approached their bankers at Deutsche Banc about possible acquisition strategies, says Jeff Liu, a Deutsche Banc VP responsible for business-to-business solutions. By early December, Broadbase had a $330 million deal to buy Rubric, a privately held maker of software that helps businesses conduct Internet marketing campaigns.

"To compress all of that into a couple of months would have been unheard of a few years ago," says Karl Will, a Deutsche Banc managing director in charge of technology M&As. "It's now taking one to two weeks for a deal to happen instead of one to two months."

Indeed, Deutsche Banc expects to do more Net-related M&As in the first quarter of 2000 than it did for all of 1999, says Tony Meneghetti, another managing director there.

ONLINE RETAIL: SITES ON SALE

Perhaps no area of the Internet Economy is riper for M&A activity than online retailing.

One faltering retailer is already a prime candidate for acquisition. Just before the new year, Value America warned that sales would fall below expectations and said it would cut its work force in half. The company announced it would evaluate "strategic refinement," a euphemism often used by firms seeking a buyout.

Some analysts think M&A activity in the retail sector will be slowed because a number of the candidates are struggling; they have few assets worth consolidating. But others say such companies could be good buys for land-based retailers that seek entry to e-commerce. In 1999, for instance, retail chain KB Toys teamed with BrainPlay.com to form KBkids.com.

Mergers in online retailing will undoubtedly take various forms. Some struggling online companies will seek to reshape themselves, while others try to buy their way into new niches. Some categories, such as apparel, should be big enough to sustain multiple players, if each appeals to a specific segment of the market. On the other hand, categories in which products are commodities - such as consumer electronics, pet supplies or gift certificates - are likely to be less forgiving of second-tier companies.

"There should be consolidation but I don't believe all categories will be represented by single brands," says Tod Francis, a general partner at Trinity Ventures, a VC firm in Menlo Park, Calif., that has backed such online retailers as 800.com, iMotors.com, Della.com and Internet Diamonds (which was recently renamed BlueNile.com).

Anthony Noto, an e-commerce analyst at Goldman Sachs, thinks most commerce categories will end up sustaining three or four major players. "In a particular sector you may see players who are Nos. 5 and 6 combining to become a viable No. 3," he says.

Noto expects online retailers in narrow market sectors to reach into adjacent categories to attract customers and revenues. An online grocery store, for instance, might consider acquiring a pet-supply provider or even a Web-based pharmacy.

MyPoints and Netcentives, two companies that offer one piece of Internet marketing, will likely be targeted by larger online advertising and marketing firms that want to broaden their platforms, expects one venture capitalist, who spoke on condition of anonymity.

Analysts do not anticipate that the heavyweights will rest on their laurels in the year to come. They expect Amazon and eBay to invest in companies to spread their franchises into new categories, technologies and regions.

That was the strategy behind a number of Amazon's big buys last year, most notably a string of three deals involving $645 million in stock, which were announced in April. Primarily a seller of books and music at the time, Amazon gobbled up Exchange.com to expand into rare books. It also acquired Alexa Internet and Accept.com to get some tools that could improve navigation on its site. The company also made sizable investments in online retailers that complement its core business, including Della.com, Drugstore.com and HomeGrocer.com.

EBay, meanwhile, has bought its way into businesses that fit its emphasis on online auctions: international operations in Germany, Butterfield & Butterfield for high-end auctions and Kruse International for auto auctions. Recently eBay absorbed Blackthorne Software, a company that makes it easier for active sellers to manage their auctions. Some analysts have suggested that eBay might now move into the business-to-business space; indeed, it has already made an equity investment in Tradeout.com, a site for surplus corporate materials.

B2B: SURVIVAL OF THE BIGGEST

The business-to-business side of e-commerce is expected to see heavy M&A activity in the future, although the sector is generally thought to be a year or so behind online retailing in that department. Only a few b-to-b companies have made their public debut but dozens more are expected to list their shares in the coming months - thereupon pursuing the same M&A strategy that was followed by firms that went public in the past couple of years.

Want a glimpse of what's to come? Consider the skyrocketing valuation of Tradex Brokerage Services, a Houston-based company that sells infrastructure software for setting up Internet exchanges. Tradex, which Ariba plans to acquire, saw its value jump from $100 million earlier in the year to nearly $2 billion in December, when the deal was announced.

"Some [investors] think they left some money on the table, because it could have been a $4 billion to $5 billion IPO," says Daniel Aegerter, Tradex's chief executive. "We were ready, locked and loaded to take this out."

So why didn't he? Aegerter says that route would have brought the company money, but argues that it would also have isolated Tradex from the large networks that are emerging in the b-to-b marketplace. Aegerter calls Ariba one of the "gorillas" in that market, and he thinks it's better to be on Ariba's good side, even if that means a little less cash in the short run.

Tradex wasn't the only company to be bought by Ariba, which went public in 1999 and quickly reached a stock market valuation greater than $10 billion. In November it scooped up Trading Dynamics, an auction-based marketplace for suppliers, for more than $400 million in stock. Meanwhile, Ariba rival Commerce One swapped cash and shares worth about $230 million to acquire CommerceBid.com.

Now other b-to-b procurement companies are looking to take similar steps. Firms like Intelisys Electronic Commerce, a second-tier provider of infrastructure for online marketplaces, know that if they want to compete with Ariba and Commerce One they'll need auction services. Intelisys board member Ray Fattell says his company "absolutely" will have auction capability, and that it will consider making acquisitions to meet that need.

A possible target for Intelisys - and for other companies seeking to develop b-to-b exchanges - is Moai Technologies, which makes auction software for just such exchanges.

(Ann Perlman, Moai's chief executive, said in an interview in December that the company was raising another round of venture funding and was not involved in any merger talks.) The motor behind all this merger movement is the trend toward b-to-b trading exchanges. While there are about 200 such marketplaces in various niches - from office supplies to truck parts - only a few have gained critical mass.

Kenneth Fox, managing director of Internet Capital Group, a holding company with stakes in 28 online marketplaces, predicts that leading b-to-b companies will consolidate their hold on their marketplace niches, then seek to expand. A plastics company, for example, might look to move into chemicals. "There are going to be consolidation opportunities across process industries," Fox says.

"These [online marketplaces] tend to be winner-take-all. You're going to see No. 1 buy No. 2 and 3."

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