Supportive fiscal and monetary policies over the past two years have been instrumental in helping U.S. companies, including those in the technology sector, navigate COVID-19 pandemic-related business disruptions. While the dip in performance appears shallow compared to other nonfinancial corporate sectors, and policies' direct impact on the tech sector may be viewed as subtle, we expect a longer lasting impact from many tech companies' liability-management exercises taken and opportunistic debt issuance at historically low borrowing costs.

U.S. technology companies set a record for debt issuance at $335 billion in 2021, following its previous record of $280 billion in 2020 (Chart 1). Issuances in 2020 were mostly for liquidity preservation given the uncertain macroeconomic outlook at the onset of the pandemic, whereas those in 2021 were more opportunistic. We found tech companies becoming increasingly confident in the global economic recovery in 2021. Employers' hybrid work arrangements provided a surge to PCs, peripherals, and collaboration software spending that started in 2020 and remains strong. Meanwhile, consumers' mobility and spending on services and experiences were limited by COVID-19 restrictions. More spending was for goods, including electronics.

Chart 1

Investors' relentless search for yield coupled with the strong business fundamentals of the tech sector allowed companies to issue debt at historically low costs. Microsoft Corp. refinanced a sizable portion of its debt at a lower coupon rate. Apple Inc., which generates significant free operating cash flow (FOCF) and has a sizable cash and investment balance, issued $20 billion in 2021 to take advantage of low borrowing costs. Lower-rated tech companies--many financial sponsor-owned, highly indebted, and carrying variable-rate term loans--also benefitted meaningfully. Investors anticipated rising interest rates and drove spreads on term loans to historic lows, allowing them to refinance at low rates and push out debt maturities.

Debt issued by tech companies in 2020 was prudent at the time. But, in hindsight, it was only necessary for some companies to weather negative effects from COVID-19. It only served as an added buffer to most as the dip proved to be short-lived. Liquidation measures, such as tightened working capital uses and suspension of capital spending for growth, helped boost FOCF in 2020. More impressive is the even higher FOCF generation in 2021 (Chart 2) despite working capital reversals and resumption of growth outlays.

Chart 2

As a result, tech sector cash and investment balances are robust (Table 1). After a strong 2021, when tech companies generated significant FOCF, their cash and investment balances are higher than even the peak of the COVID-19 pandemic in the second quarter of 2020. Inflation pressure in the U.S. appears more lasting than temporary, discouraging companies from carrying excessive cash, especially when the debt capital market remains favorable. Factoring in our expectations for another year of strong information technology (IT) spending growth in 2022, we believe tech companies are encouraged to increase research and development and capital spending, pursue opportunistic mergers and acquisitions (M&A), and return excess capital to shareholders.

Table 1

Favorable Business Prospects, Strong Free Cash Flow, Excess Liquidity, Low Debt Costs Are A Recipe For High M&A

In 2021, global IT spending increased 10.5%, almost doubling the estimated global GDP growth of 5.6% (and U.S. GDP growth of 5.5%). Tech M&A reached a historical high, according to 451 Research. We believe another year of strong M&A and transaction sizes could be larger as company valuations remain elevated. Our forecast is for global IT spending growth of 6.3% in 2022, again outpacing global GDP growth of 4.3% (and U.S. GDP growth of 3.9%).

Unlike the flurry of large M&A announced in the second half of 2020 concentrated in the semiconductor industry, we found activity in 2021 to be more balanced across the software, semiconductor, and services subsectors. Significant leveraged buyouts (LBO) of software companies by tech-focused financial sponsors followed rampant fundraising over the past few years. Hardware-focused tech companies were less active last year. In the fourth quarter of 2021, corporate restructuring by International Business Machines Corp. (IBM) led to the spin-off of its managed infrastructure services business (Kyndryl). Balance sheet maneuvers by Dell Technologies Inc. allowed significant debt repayment following its spin-off of VMware Inc., which included a $12 billion dividend to shareholders. Dell received about $9.7 billion as an 81% owner.

Chart 3

While it is difficult to predict the size, timing, and companies involved in M&A, here we provide our thoughts on M&A activity this year in each tech subsegment and the puts and takes.

Software

Within the tech sector, we anticipate the highest M&A activity in software. Application-specific companies (i.e., Salesforce.com Inc., Adobe Inc., and ServiceNow Inc.) have long enjoyed the secular trend of workload migration to the cloud and their ability to improve customer revenue generation and productivity. We expect a long runway for growth in software-as-a-service, but functionalities such as software development and integration, data analytics, observability/optimization, and cyber security are higher growth areas over the near term. Therefore, these firms are the most likely to conduct M&A. The technology landscape continues to evolve and becomes increasingly complex, with customers demanding software platforms able to process workloads across on-premises, private and public clouds, and even multicloud environments. The need for protection from cyber security threats is increasingly important. The traditional framework of firewall protection within the perimeter of an on-premises data center is now only a small part of the overall protection architecture. As devices proliferate, areas such as identity and access management, end-point protection, application security, cloud workload protection, and disaster recovery will be crucial amid the magnitude of business disruption that could arise from security breaches.

For example, in May 2021, a ransomware attack on the Colonial Pipeline, compromised computerized equipment managing the system that transports gasoline, diesel, and jet fuel. Colonial paid about $2.1 million in ransom (net of recoveries), but more important the pipeline was shut down for days and disrupted motor fuel along the east coast. In 2020, the popular Orion networking management software by SolarWinds Holdings Inc. was hacked and undetected for months, allowing a routine software update to slip malicious code into customers' IT systems and compromising networks of tens of thousands of large corporations and government agencies globally. Cyber security is now one of the most important focus areas of corporations and their boards of directors. We expect correspondingly higher IT spending in this area.

Software platform providers will also look to bolster their integration tools as they seek to ensure workload compatibility across different operating environments. We view the practice that combines software development and IT operations (DevOps) as becoming mainstream because it facilitates faster deployment and enables product quality improvement through close collaboration between the two teams. The marketplace is highly fragmented and the benefit to users so vast that we expect this area to evolve rapidly as developers innovate and large platform companies (i.e., Microsoft, Alphabet Inc., Salesforce, Oracle Corp.) deploy more capital.

Data analytics will be increasingly valuable. Companies across sectors (retail, manufacturing, industrial, health care, etc.) are well on their journey to digitally transform their business processes. Data provide insights for revenue generation, improving productivity, automation, and downtime and data-loss prevention. We believe tech companies will continue to invest heavily, both organically and via M&A, to expand their products and services to include data extraction and analytics and deepen their industry knowledge.

While timing of M&A is difficult to predict, transactions occur when there is significant equity market fluctuation. Microsoft recently announced plans to acquire Activision Blizzard Inc. for $68.6 billion, following Activision Blizzard's stock price decline of almost half in the last 12 months. This is similar to Microsoft's acquisition of LinkedIn Corp. in June 2016, following LinkedIn's stock price decline of over 40% a few months earlier. Software companies with significant intellectual property (IP) become attractive to strategic acquirers during equity market dislocations. The significant market value declines of high-growth software companies recently could present opportunities for heightened M&A in a sector awash in liquidity.

Semiconductors

Larger M&A will be more difficult to come by. Within the semiconductor submarkets, we find memory and semiconductor capital equipment to be the most challenging for transactions. The industry has consolidated considerably over the past six years. The DRAM memory market is the most consolidated with Samsung Electronics Co. Ltd., SK Hynix Inc., and Micron Technology Inc. controlling a significant portion of the output. The NAND market is only slightly more competitive with five major vendors: Samsung, Toshiba Corp., Western Digital Corp., Micron, and SK Hynix. The semiconductor capital equipment landscape is highly concentrated with ASML Holding N.V., Applied Materials Inc., Lam Research Corp., Tokyo Electron Ltd., and KLA Corp. each holding significant market share in their respective product areas. Expectedly, any proposed M&A in these areas would attract extensive regulatory scrutiny and competitor complaints. Applied Materials terminated its plan to acquire Kokusai Electric in March 2021 as it did not receive timely approval from Chinese regulators. While we would not preclude further consolidation, especially when semiconductor design and process manufacturing become increasingly expensive, we find the regulatory hurdle prohibitively high for further market consolidation.

Chart 4

Table 2

Meanwhile, we expect more M&A in the logic and analog area as it's relatively fragmented, even after significant M&A over several years. To be sure, the M&A path will be more challenging and the rationale for business combination different. We anticipate scale efficiencies will be a factor justifying higher purchase prices, but expansion into adjacent end markets to be the main reason for M&A in these areas. Examples include Renesas Electronics Corp.'s acquisition of Dialog Semiconductors PLC for €4.8 billion, adding battery and power management and connectivity to its embedded solutions portfolio, Qualcomm Inc.'s acquisition of Nuvia Inc. for $1.4 billion, adding high-performance central processing unit capabilities to its mobile-centric product portfolio, and Marvell Technology Group Ltd.'s acquisition of Inphi for $10 billion to boost its optical networking chip products in 5G infrastructure and cloud data center networks.

Deal sizes will likely be smaller but growth potential higher, especially in data center, connectivity, auto, and industrial. Smaller deals may be less attractive to Broadcom Corp., a serial acquirer of sizable semiconductor firms until its pivot to target software companies beginning with CA Technologies in 2018. But we believe the benefit of IP, shortened time-to-market, and customer acquisition will be attractive to others.

Hardware

We believe cloud migration hurdles remain challenging for many hardware vendors, deemphasizing large M&A for scale benefits. Instead, hardware vendors are focusing more on adding software and services capabilities to improve their product value proposition to customers. Cisco Systems Inc., for example, added security, artificial intelligence (AI)-enabled automation, and analytics features to its Catalyst 9000 switches. Also, instead of selling server and storage point products for on-premises use, Hewlett Packard Enterprise Co. through acquisitions now offers this hardware infrastructure paired with AI, machine learning, and data-management capabilities that are cloud-enabled and in a consumption-based pricing model. This offers reasons for customers to keep workloads from migration to the public cloud. Meanwhile, IBM made clear its focus on the hybrid cloud and will continue to evaluate acquisitions that complement its software and services.

We believe this strategy will continue. Enterprises' digital transformation journey will lead to exponentially more data that should add to both cloud and on-premises workloads. As such, we expect on-premises workloads to remain a significant proportion of overall enterprise workloads for years to come. Enterprise customers should continue to value the product reliability and customer service provided by branded equipment manufacturers. However, if workload migration to the cloud accelerates such that enterprise customers significantly reduce their on-premises and private cloud data center presence, the business prospects of branded hardware manufacturers could be significantly diminished.

Among the tech subsegments, it should not be a surprise that the highest business risks reside within enterprise hardware. Facing negative industry trends from cloud migration and disaggregation of software from hardware, hardware vendors that pursue significant changes to their business models face the largest event risks. Disruptive acquisitions to better meet future demands, while sensible, are fraught with execution risks. Thus far, we saw mostly tuck-in, rather than large-scale, acquisitions focus on growth areas such as security, connectivity, edge, internet of things, and software by hardware vendors. This is not a bad approach, in our view, and certainly preferred over shareholder returns from a credit perspective.

Higher Shareholder Returns Likely In 2022

Still, we expect total shareholder distributions to increase in 2022 and remain higher than before the pandemic, a result of the built-up cash and investments and a favorable business outlook. This should especially be the case for tech companies unable to find attractive M&A targets, whether due to high valuations or increasing regulatory hurdles. Again, rising inflation pressure and low yields should deter companies from carrying excessive liquidity on their balance sheets.

There was a clear pivot--starting from the end of 2020--such that publicly held tech companies with broad participation began ramping up their share repurchases and announcing noticeable dividend increases. We attribute this partly to certain semiconductor companies such as Micron, Applied Materials, Qualcomm, and NXP Semiconductors N.V. resuming share repurchases suspended at the onset of the COVID-19 pandemic. However, it is increasingly obvious that tech companies felt more confident in the near-term surge in IT spending, as well as the acceleration in secular growth trends. If we're correct, the trend of higher shareholder returns that began in the third quarter of 2020 should continue in 2022.

Tech companies' FOCF generation was exceptional in 2021. Still, shareholder returns through September were lower than FOCF, providing more flexibility to meet 2022 shareholder return initiatives. (This is especially true when excluding the outsize shareholder returns from Apple, Microsoft, and Oracle; see the bottom of Table 3). Several public issuers have already announced their intentions to scale up share repurchases in 2022. Broadcom announced in December that it had received authorization from its board of directors to repurchase up to $10 billion of shares. The company is also continuing a dividend policy of about 50% of prior-year FOCF (about $13.3 billion in the most recent fiscal year). Therefore, Broadcom's total shareholder distributions this fiscal year could more than double to about $16.7 billion from about $7.5 billion in fiscal 2021. Also, after significant debt repayments and healthy FOCF generation, we expect Dell to start paying dividends or returning funds through share buybacks in 2022. Companies such as Keysight Technologies Inc. and Flex Acquisition Holdings Inc. have also indicated a desire to return more capital to shareholders.

Table 3

Barring significant M&A, we believe tech companies' shareholder distributions will exceed FOCF in 2022, reducing their cash and investment balances. As the debt capital market remains favorable, they could become more aggressive than we anticipate, but we do not expect it to dramatically alter our view of the overall tech sector credit profile. For financial sponsor-owned companies, especially those in the software subsector, we believe many have opportunistically engaged in dividend recapitalizations over the past few years. There could be more in 2022, but we expect less activity than in 2021.

Excess Cash To Be Lower, But EBITDA Growth Keeps Credit Profiles Intact

With expectations of another year of growth, we believe companies will be emboldened to increase investments and pursue acquisition targets to improve their market positions, broaden their product portfolios, and return excess capital to shareholders. Generally, publicly owned tech companies tend to carry lower leverage than those in other nonfinancial corporate sectors because of their inherent technological risk. However, while technological advancements continue, we believe this risk to the overall tech sector will be increasingly offset by broadening end markets for tech products beyond PC and enterprise infrastructure and into diverse end markets serving more consumers, small to midsize businesses, and large enterprises globally. Enterprise tech products continue to be viewed as mission-critical in business operations. Consumer electronics have been integrated into end users' everyday life such that purchases, while not contractually recurring, have become habitual. Correspondingly, we expect tech companies to, over time, adjust their capital allocation policies, including target leverage, to reflect the lower variability in business performance and improved cash flow.

The omicron variant is a stark reminder that the COVID-19 pandemic is far from over. Uncertainty still surrounds its transmissibility, severity, and the effectiveness of vaccines. However, based on how effectively tech companies have managed business disruptions, including supply chain constraints and higher input costs, we believe tech companies will be incrementally comfortable to reduce cash and investment balances and count more on their access to the debt capital markets for significant funding needs.

We believe debt issuance will be linked to earnings growth and attractive funding costs rather than cash or refinancing needs. We anticipate large tech companies will continue to return significant sums to shareholders. Apple, for example, in early 2018 announced its goal to bring its net cash position of about $163 billion to zero over time. Since then, it's still a hefty $66 billion. The company has returned $341 billion to its shareholder return since December 2017. But because of its ability to generate significant FOCF, it appears Apple's goal will not be achieved for another two to three years. We expect highly rated tech companies to issue debt in the still favorable capital markets for opportunistic M&A or shareholder returns without significantly deviating from their financial profiles.

In the speculative-grade area, we caution that a rapid and volatile market repricing or inflation shock could affect companies' debt-servicing costs and funding access. We believe many tech companies have opportunistically refinanced debt maturities and secured low-cost, long-term financing over the past few years. With the favorable IT spending backdrop and investors' continued search for yield, we expect the debt capital market should continue to allow speculative-grade companies to opportunistically issue debt for M&A and, in some cases, redeem preferred equity tranches established as part of their LBOs.

Of course, there will be dispersions in capital allocation policies among tech companies as their business prospects, cash amounts, and overall credit profile vary. Downgrade pressure is highest with legacy hardware and software vendors. We believe IBM and Western Digital will closely manage debt and seek to prioritize debt repayment rather than pursue large-scale acquisitions. Although we count Dell, HP Inc., and Xerox Corp. as legacy hardware vendors, Dell's spinoff of VMware resulted in a significant one-time dividend, allowed material leverage reduction, and provided capacity within the rating to pursue opportunistic M&A or shareholder returns. HP and Xerox both have operations in the secular declining printing business and showed interest in a business tie-up in the past. They could revisit this, but we view shareholder returns to be more likely.

Some issuers have less defined financial policies around capital allocation, leverage, or target credit ratings. For example, Oracle engaged in aggressive shareholder returns over the past few years that led to multiple downgrades to 'BBB+' from 'AA-' in 2018. The rating on the company is further pressured by its recent announcement to acquire Cerner, a health IT provider. We placed the rating on CreditWatch with negative implications. We believe Oracle will likely retain an investment-grade rating, though that will probably require it to curtail share buybacks.

Table 4