Download Top of Mind: Hunting for hidden gems

Top of Mind
Issues facing technology companies
Hunting for
hidden gems
Top of Mind discussion series:
Four themes to navigate
unprecedented disruption
Theme #2:
Hunting for hidden gems
Hunting for hidden gems is part of an EY Top of
Mind series addressing four key themes that can
help guide technology executives’ actions
during this time of unprecedented disruption.
Here we explore the benefits associated with
identifying and extracting hidden gems inside
technology companies.
The four-theme series includes:
1. Stack to solution — technology stacks being
displaced by cloud-integrated solutions
2. Hunting for hidden gems — identifying and
exploiting pockets of innovation and troves
of data lying untapped within the company
3. In the crosshairs — challenges proliferating
from upstarts and activist shareholders
4. Multifaceted security — vulnerabilities and
threats multiplying amid technology transitions
To access our collective overview of the four
themes go to: ey.com/technology
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| Top of Mind Hunting for hidden gems
Investors seek growth. So it follows that they bid up the value of high-growth companies. That’s
why technology companies that lead or otherwise benefit from fast-growing mobile-social-cloud
and big data analytics trends are being rewarded with high valuations right now — while everyone
else, not so much. This growing valuation disparity often overlooks what we call hidden gems:
business units or offerings that are benefiting from (or are at least keeping pace with) disruptive
digital transformation trends, but whose growth is not fully valued by the market.
What’s more, activist investors are increasingly focused on the
technology landscape to find the kind of opportunities hidden
gems represent. Consequently, it is becoming more important for
technology executives to identify their own hidden gems first.
Valuation gap is reminiscent of dotcom bubble — but today’s
values are real
Some investors are concerned because a similar valuation gap
emerged shortly before the dotcom bubble burst. In the late
1990s, companies benefitting from the then-disruptive rise of
internet technologies and business models traded at revenue
multiples greater than the EBITDA or even earnings multiples of
those “bricks and mortar” peers. But unlike in the dotcom era, today
the high valuations with which investors reward many hyper-growth
technology companies are justified. These companies have led
(or fast-followed) disruptive technologies that are creating
permanent, structural changes in the technology landscape.
Indeed, widespread adoption of cloud computing, supported by
increases in bandwidth, processing power and storage, has led to a
change in customer behavior. This is the case for consumers (think
cloud-powered mobile apps, crowd sourcing and mobile video)
and enterprises (think enterprise SaaS, mobile business apps and
“bring-your-own-device,” or BYOD). “Cloud-empowered customer
behavior changes have enabled the emergence of several large-cap,
profitable and fast-growth — say, 35%-plus per year — public companies
over the past five years,” says Jeff Liu, EY Global Technology
Industry Leader, Transaction Advisory Services.
But disruptive technologies are not the only technology
value drivers
Despite their headline-grabbing nature, though, the megatrend
leaders are not the only technology companies creating meaningful
value. For example, trillions of dollars in public market value is still
resident in technology companies associated with client-server
computing, on-premise data centers, vertical supply chains,
customer call centers and direct sales forces.
Further, some technologies that are being adopted more slowly
may prove extremely disruptive in the long run, including
virtualization, web services and big data analytics. “The pace of
widespread adoption of these technologies means that some
technology company valuations have not yet caught up, because
the very real fruits of these new enabling technologies are less
visible,” says Liu.
Some opportunities remain hidden gems
Because not all these technology growth opportunities are
obvious, we believe a number of mid-cap and large-cap companies
contain hidden gems — which represent undervalued opportunities
for investors.
“We are witnessing a massively disruptive period for technology, creating
a perfect scenario for companies to erupt in value or be destroyed and
disappear. In this context, many challenged technology companies have
‘hidden gems’ among their operations, whose value they could unlock if
they only looked at them in the right light.”
Jeff Liu
Global Technology Industry Leader
Transaction Advisory Services
EY
Top of Mind Hunting for hidden gems |
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In our global client base we have observed
three types of these hidden gems:
An established defense
technology vendor may
own a hugely disruptive
commercial security
solution — yet trade at
a steep discount to even
first-generation video
analytics companies.
Geodes:
sparkly gems inside dull
exterior stones
Geodes are companies with enabling technologies that suddenly
have much bigger market opportunities as a direct implication of
cloud solutions and the ability to store, manage and analyze much
larger data sets.
Consider a technology supplier with powerful video analytics
software and solutions it traditionally sells to defense and
intelligence agencies. Its military customers might capture and
analyze 20 years’ worth of video data from a small fleet of drones
or satellites. Up until recently, commercial enterprises simply
couldn’t capture enough information to analyze that way. But today
they can, supported by commoditized optical devices, cheap and
virtualized storage and — perhaps most importantly — analytical
horsepower in the cloud to scrutinize vast amounts of unstructured
content. That defense technology vendor may own a hugely
disruptive commercial security solution. Yet, the company may
trade at a steep discount to even first-generation video analytics
companies.
“Similarly, many technology companies, particularly those in the
services subsector, have large amounts of data. That information
may have far more value than before, once monetized through
the lens of emerging big data analytics tools,” Liu explains. “Data
that companies used to ignore can now be monetized in revenueproducing or expense-reducing types of solutions thanks
to cloud services and big data analytics,” Liu adds.
Social information, embodied in social media communications,
financial data captured in online transactions, and location data,
resident in our devices, appliances and autos, are all rich examples
of “geode” producing catalysts.
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| Top of Mind Hunting for hidden gems
Sapphires:
gems made more colorful —
and valuable — by small
elements within the larger
mineral structure
A sapphire may have
enterprise value hidden in
a division whose revenue
is small compared to the
whole — but is growing at
a faster pace.
Sapphires are often found within companies that may not be
proactively transforming fast enough. Activists love sapphires and
can be the bane of strategically well-meaning executive teams. That
said, shareholders may rightly call for breaking out these gems if
parent corporate strategy is inhibiting growth. It is critical to
evaluate your sapphire strategy to determine if overall value can be
enhanced by investing in an integrated fashion or by separating
businesses in order to allocate capital — and value — more
appropriately.
Consider a hardware vendor that has slowly and methodically
executed on a vertical software strategy, creating significant
leverage in its financial model. The new software offerings are
high-growth and higher-margin than the core hardware and services
revenue. But because the high-growth additions still are a small
percentage of overall revenue and profitability, the company trades
in line with pure, untransformed, competitors. “Ironically, if valued
alone, the software division likely would be a more meaningful
amount of overall market value,” says Liu.
Executives should ask themselves:
1. Am I properly positioning the value of my sapphires to
Wall Street?
2. Am I allocating capital in an optimal way to my sapphires?
3. Do I know the differences (in value) between a separated
sapphire strategy versus an embedded sapphire strategy?
4. Do I have a response and plan for activists who wish to mine
my sapphires?
Top of Mind Hunting for hidden gems |
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Rubies:
Separating a ruby’s
business units allows
natural buyers to emerge
for each — potential acquirers
who would not consider the
“unified” business as a target.
gems in the red because of
elemental impurities
Rubies are the most challenged. They are companies that have
been slower to adjust to disruptive technologies and typically
contain diverse business units. One or more divisions were likely
obtained through M&A, for growth, but were too little too late, or
failed to be integrated effectively enough to drive synergies.
Consider a computer peripherals manufacturer simultaneously
combatting steep price erosion in its core hardware markets and
enduring stumbles on the integration path of its large but subscale
services business. “Unless there is real potential for significant
synergies, keeping two suboptimal businesses together always
results in a poorer valuation than separating them so management
of each unit has independent focus,” says Liu.
What’s more, separating the business units allows natural buyers to
emerge for each — potential acquirers who would not consider the
“unified” business as a target. “Rubies present a good return case
for a split or spin,” adds Liu.
Evaluating various separation scenarios in a detailed way, from
operations to tax to finance and capital allocation, is essential for
extracting value from rubies. And, nothing clouds their value from
stranded costs due to a poorly executed separation plan.
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| Top of Mind Hunting for hidden gems
Lead the hunt — or others will!
We believe there are many hidden gems among public technology companies. Far more
complicated than identifying these assets, though, is the process of change and consensus
required for boards and management teams to figure out how to unlock their hidden value.
That requires shifts in strategic mindset, and in some cases validating new commercial markets
and understanding operational leverage and weaknesses.
And while hidden gems often lay uncovered for a long time, we are
now in an age of “disrupt or be disrupted.” Activist shareholders,
with ample debt capacity and private equity capital, have
demonstrated their willingness and ability to make bets on
technology companies.
So we counsel technology executives to act now to identify hidden
gems and choose a course of action to unlock their value — before
someone else does it for you.
“The hidden gem idea is not about divesting
poor assets, but rather about making a star
of an underutilized asset.”
Jeff Liu
Global Technology Industry Leader
Transaction Advisory Services
EY
Top of Mind Hunting for hidden gems |
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Find out more
Hunting for hidden gems is part of a series of top-of-mind
executive briefs providing separate deep-dive analyses of four
disruptive technology transformation themes: stack to solution,
hunting for hidden gems, in the crosshairs and multifaceted
security.
For more information, or to discuss the diagnostic tools EY
has developed to show how these themes might affect your
own organization, contact Jeff Liu at [email protected] or
+1 415 894 8817.
Name
Telephone number
Email
Pat Hyek
Global Technology Industry Leader
+1 408 947 5608
[email protected]
+1 415 894 8817
[email protected]
+1 415 984 7075
[email protected]
+1 408 947 5435
[email protected]
Technology sector contacts
Jeff Liu
Global Technology Industry Leader
Transaction Advisory Services
Winston Chung
Global Technology Sector Team
Channing Flynn
Global Technology Industry Leader
Tax Services
Dave Padmos
Global Technology Industry Leader
Advisory Services
Guy Wanger
Global Technology Industry Leader
Assurance Services
+1 206 654 6314
+1 650 802 4687
Transaction Advisory Services (TAS) technology contacts
Ranjan Biswas
India
[email protected]
[email protected]
+91 806 727 5131
[email protected]
Staffan Ekström
Global Telecoms Leader —
Transactions and
TMT Leader, Nordics
+1 415 264 8442
[email protected]
+46 8 520 593 90
[email protected]
David Hedley
US Technology M&A Leader
Neil Hutt
United Kingdom
+1 415 984 7128
[email protected]
Ben Kwan
TAS and TMT Market Segment Leader
Greater China
+44 1189 281535
[email protected]
+852 2849 9223
[email protected]
Barak Ravid
Co-Leader Technology, Parthenon-EY
+44 20 7951 0418
[email protected]
+1 415 894 8070
[email protected]
Ken Smith
TAS Leader, Japan
+49 30 25471 21426
[email protected]
+81 3 4582 6400
[email protected]
Tim Dutterer
Co-Leader Technology, Parthenon-EY
Simon Pearson
United Kingdom
Dr. Carsten F. Risch
Germany
EY | Assurance | Tax | Transactions | Advisory
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