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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 2 | 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 | 3 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. 4 | 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 | 5 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. 6 | 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 | 7 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 About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. About EY’s Global Technology Sector EY’s Global Technology Sector is a global network of 15,000 technology practice professionals from across our member firms, all sharing deep technical and industry knowledge. Our high-performing teams are diverse, inclusive and borderless. Our experience helps clients grow, manage, protect and, when necessary, transform their businesses. We provide assurance, advisory, transaction and tax guidance through a network of experienced and innovative advisors to help clients manage business risk, transform performance and improve operationally. Visit us at ey.com/technology. © 2015 EYGM Limited. All Rights Reserved. EYG no. DC0247 ED None EY-GTC This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice.