Cash Is King

Why you can’t buy tech companies with stock anymore.

Late-breaking 2002 trend story: In the new New Economy, cash is king!

Today’s Wall Street Journal leads with a dissertation on how Microsoft, Cisco Systems, Intel, Dell, and Oracle are sitting on a combined $87 billion in cash—and only Intel pays a dividend.

Meanwhile, in the past few weeks, three major technology deals have been concluded entirely in cash—even though the buyers all have a comparatively desirable stock. IBM bought Rational Software for $2.1 billion, Yahoo! acquired Inktomi for $235 million, and Level 3 Communications—the survivor of the fiber-optic extinction—grabbed up the remnants of Genuity for $244 million.

In tech-land, stock has for decades been the favored way to pay employees and acquire companies. Options allowed businesses large and small to hire and retain employees without spending much cash. And during the bull market, companies with strong stocks—Tyco, Global Crossing, AOL—could gain market share by swapping their shares for harder assets. Using stock meant you never had to hustle to line up financing. It meant you could pay as much as you wanted to get the deal done. And as long as the market rose, it meant never having to say you’re sorry.

Stock continued to reign even after the bursting of the bubble. May’s blockbuster Hewlett-Packard-Compaq tie-up was an all-stock transaction. So why are recent targets demanding cash on the barrelhead, even when the buyers are solid companies?

One unlikely reason that companies won’t settle for stock is that there is still too much cash in Silicon Valley. There are still way too many companies providing software, hardware, networking services, fiber-optic capacity, you name it, to way too few customers. They have not consolidated quickly because of the stubborn refusal of “zombie” companies to die.

“Zombie” company is a term coined to describe pointless but still operating Japanese companies. U.S. zombies differ from their Japanese counterparts, which are essentially bankrupt but survive only because the banks refuse to call their loans. The gaijin zombies, by contrast, are flush with cash left over from the late-’90s venture-capital and IPO gold rush. And because they cut back swiftly after the bubble burst—and because, unlike manufacturing companies, they don’t have giant fixed costs—they can survive for years without doing much business. Or in some cases without doing any business.

Take Corvis. This fiber-optic company, which once had a market capitalization of $36 billion, notched revenues last quarter of $1.35 million—about what a convenience store does in a good year. Even with virtually no revenues, it managed to run through about $30 million in cash in that period. Still, it has $548 million in cash and short-term investments left to burn!

Add ego to cash, and you have a powerful obstacle to consolidation. Executives like to run businesses—even if they’re failing. It’s better to be a CEO of a public zombie software firm than one of 400 executive vice presidents for strategy at a larger, more viable company—you get better benefits, more perks, and more ink.

As a result, sometimes the buyers need the target more than the target needs the buyer, even if the target is struggling. Yahoo! is perhaps the strongest remaining pure-play Internet company. But to justify its price—about 188 times earnings—it needs to increase revenues and diversify away from online advertising. And pronto. Inktomi, the search-software company Yahoo! bought, was just another broken-down $1 stock. But with $45 million in cash, it could afford to muddle along for a few more years, and since nobody expected anything of it anymore, it didn’t have much incentive to improve. Who needed the deal more? A similar dynamic applied to IBM’s purchase of Rational Software. Rational reported a $32 million operating loss in its most recent quarter but has cash and short-term investments of about $1 billion—enough for seven years of such losses.

Cash also reigns because—deflation fears not withstanding—one can be reasonably sure that a dollar today will be worth a dollar six months from now. The same can’t be said for stocks. When the Hewlett Packard-Compaq deal was announced in September 2001, it was valued at $25 billion. But by the time it closed in May 2002, HP’s stock had lost 24 percent of its value.

Finally, cash offers the cleanest exit strategy. Insiders at acquisition targets are typically prohibited from selling their shares in the buying company for several months. It’s a safe bet that Time Warner executives wasted a huge amount of time in the months after the AOL-Time Warner merger nervously watching the minute-by-minute action in AOL’s stock (ever downward). But when you sell for cash, you can go buy that yacht or second home tomorrow—or, in the case of bankrupt Genuity, pay off your creditors.

The willingness of the buyers to spend cash on other companies can be read as a sign of optimism. Paying cash to buy businesses with growth potential is bolder than letting the dollars languish in a bank garnering paltry interest.

More significantly—and this is the real reason for hope—buyers are far more astute when they use cash than when they use an alternate currency like stock. Indeed, many of the most ill-fated mergers of the boom would never have been consummated had the purchasers been required to use real money. If cash had been king back in 2000, it’s likely that America Online would be like one of today’s sellers—a busted stock with a comfortable cash cushion—and that profitable Time Warner would be heading out to shop with a pocketful of dough.