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Three Reasons to Expect a Tech Buyout Binge

Talk about a payday!

On Monday, hard-drive manufacturer, Western Digital (WDC) announced that it’s buying sTec (STEC) for $340 million. As a result, sTec shares soared 88% higher.

The news might have surprised some analysts. But not me.

The media is full of articles about the “death of the PC” – and how it will sink hard-drive manufacturers like Western Digital and its main rival, Seagate Technology (STX).

But as I told you in April, the fear-mongering is overdone.

Both Western Digital and Seagate have retooled their product lines to offer solid-state drives (SSDs) – the primary storage devices used in tablets.

Western Digital’s acquisition of sTec – which makes SSDs – merely represents another positive step toward capitalizing on the mobile revolution. (If you’re curious, I still consider Seagate the more attractive investment out of the two. It’s cheaper and yields more.)

But the buyout is significant for another reason…

The Tech Sector’s “Black Friday” Moment

While the sTec purchase is certainly relevant on an industry level – as in, the deal should encourage more consolidation in the data storage market – it carries much more significance on the macro level.

I believe it could signal the start of sector-wide tech buyout binge – the likes of which we haven’t seen in years.

Here are the three most compelling reasons why I think that’s the case…

~ Tech Buyout Catalyst #1: Cash, Cash… and More Cash

Big Tech companies have never been in a better financial position to go on an acquisition spree than right now.

Consider:

Since the end of the Great Recession, the top 1,500 U.S. companies have stockpiled an insane amount of cash. To be exact, they’ve accumulated $500 billion.

But get this: Tech sector companies amassed a whopping 42% ($220 billion) of that total, according to Morgan Stanley’s (MS), Hernando Cortina.

Now, if we look at the total amount of cash in U.S. companies’ coffers, tech firms still lead the way.

Of the roughly $1.5 trillion sitting on non-financial companies’ balance sheets, the tech sector accounts for 33% of it. That’s $507 billion – the most of any sector.

And it makes a pretty tidy war chest for acquisitions.

If we use the sTec purchase as a guideline, there’s enough cash to fund another 1,651 acquisitions of the same size.

If we consider the amount of cash on tech companies’ balance sheets as a ratio to their market cap, it’s never been higher. It currently stands at 16%.

As Cortina sums it up, “The current amount of cash is particularly excessive and inefficient.” Indeed!

Tech companies desperately need to put the money to work. And the next two market conditions all-but guarantee they’re going to start spending it on acquisitions…

~ Tech Buyout Catalyst #2: Build Up by Buying Out

Big companies can’t innovate. At least, not nearly as fast or consistently as smaller companies.

You spot the problem here?

Innovation is the key to creating new products and services – and, in turn, increasing sales and earnings.

So what’s the natural solution for growth-strapped big technology firms? Innovate (and grow) through acquisitions. Let small companies come up with new ideas and then simply buy them.

As it turns out, large technology companies desperately need to start buying growth…

In the last quarter, S&P 500 companies reported earnings growth of 3.3%. But tech companies actually reported a 2.7% decrease in earnings.

If that’s not bad enough, if we strip out the rare 20% profit growth that Microsoft (MSFT) notched up, tech sector profits shrank by 5.3% during the last quarter, according to FactSet Research.

~ Tech Buyout Catalyst #3: Tech on Sale

The timing couldn’t be better for technology companies to go on a shopping spree.

We already know they have the cash to afford it and that they desperately need to buy growth.

But the best part is, they can do it cheaply.

Based on forward price-to-earnings (FPE) ratios, technology companies are trading at a 21% discount to their 10-year average valuation. That’s the biggest discount in a decade.

Bottom line: Look for small cap, undervalued, innovative companies whose profits are growing at impressive rates. Because given the cash mountain and anemic growth rates of their big tech counterparts, I can assure you that these small firms are being hunted.

sTec investors just pocketed 88% from this very scenario – and I believe it’s just the start of a wider tech buyout binge.

Ahead of the tape,

Louis Basenese