Completing the Circle: Hardware/Software Deals

I wrote recently about how buying software companies is a common strategy for semiconductor firms to expand quickly into new markets and technologies. It is equally interesting to look at OEM hardware companies buying software companies. That trend has accelerated with the success of Apple Inc. (Nasdaq: AAPL) as it tightly couples hardware and software business models.

A few questions come to mind from this development:

• How is the strategy for hardware companies buying software firms different from that of chip companies buying software firms?
• What kind of valuations are these deals generating?
• What are some of the more interesting deals?

As I mentioned in my previous blog, a chip company typically buys a software company to bundle a piece of software or a suite of tools with a particular chipset. Hardware companies also acquire software firms to achieve vertical integration, pursue new markets quickly, and acquire talent and IP. The main difference is that the hardware companies typically are selling an end product and seek to bring software expertise in-house, whereas a chip vendor sells a chipset to many different hardware OEMs. A classic example would be BlackBerry (Nasdaq: RIMM; Toronto: RIM) buying QNX to bring that technology in-house.

I reviewed data collected by Capital IQ from June 2010 to June 2012 on 189 hardware company acquisitions of software companies. These were the most active buyers.

• Cisco: seven acquisitions
• Hewlett-Packard: seven
• RIM: six
• Dell: five
• EMC: five
• Motorola Mobility: four
• Nokia: four

It's very interesting that several of these companies are facing turmoil and severe market pressure (HP) or even fighting for their existence (RIM and Nokia). Many of these hardware companies are facing extreme competition and often must acquire software companies to offer more compelling products quickly. In addition, Apple's model of full hardware/software integration has accelerated the pace of acquisitions.

It is certainly ironic that Motorola Mobility was a key buyer of software firms, while Google bought Android and then bought Motorola Mobility. You have an Internet company buying a software company and then buying a hardware company, which itself had been buying a bunch of software companies. That is what I call integration!

Looking at the metrics, the deal values over the last two years have been very solid.

• The average deal size was $365 million.
• The average enterprise value/revenue ratio was 3.1.
• The average enterprise value/EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio was an astounding 41.7.

Clearly, hardware companies are paying premiums for software companies. However, the EBITDA ratio may be somewhat misleading. Many of these small and midsized software companies are still growing with low EBITDA, so the denominator is very small, making the ratio look very large. A more reliable ratio would be the enterprise value/revenue one, which is very respectable but more reasonable.

Apple proved that a full integration of hardware and software will work, and its competitors like Google and RIM seem poised to continue that trend. Nokia has been shedding much of its own software like Symbian and Qt, but many believe it is an attractive target for Microsoft. This would complete the circle of integration -- though in this case a software company would be acquiring a hardware company. This month, Microsoft unveiled a tablet line using its own hardware, thereby breaking its own model of separating software and hardware. Could a Nokia acquisition be next?

The good news for owners of software companies is that hardware companies often pay a significant premium. When planning an exit strategy, considering potential buyers from different segments, including software, services, and hardware companies, can dramatically increase your exit value.