We believe the M&A environment for the U.S. technology sector has turned the page from a period of depressed activity since the spring of 2022, shifting when the long-awaited Microsoft/Activision and Broadcom/VMware M&As finally closed late last year. Furthermore, an expectation for growth, albeit moderating, and the likely end of rate hikes replaced concerns of a possible global recession. Pent-up demand for inorganic growth has proved too strong to keep a lid on M&A in U.S. tech as issuers seek to scale efficiencies and expand product offerings and capabilities.

Greenlit Deals Signal More M&A In The Near Term

There was a lull in tech M&A from the second quarter of 2022 until late last year. Supply chain disruptions during the height of COVID-19 lockdowns led to higher inflation and a corresponding interest rate increase in response to combat higher prices. However, the U.S. economy remained resilient. In our view, this could prompt tech M&A over the near term.

Scrutiny from regulators across the globe and the uncertainty of transaction approvals also deterred potential acquirers and targets from pursuing M&As. Antitrust reviews threatened the completion of Microsoft Corp.'s acquisition of Activision Blizzard Inc. and Broadcom Inc.'s acquisition of VMware Inc., and the long and arduous approval process took tremendous financial resources and possibly some operational focus away from those involved. Meanwhile, Adobe Inc. abandoned its proposed acquisition of Figma in December 2023, 15 months after its acquisition announcement.

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When macroeconomic conditions were highly uncertain and interest rates climbed without clear signs of stopping, the valuation gap between buyers and sellers widened. It took more than a year for the valuation gap to narrow between potential targets and suitors, in our view, as the industry gained better clarity on technology spending patterns, business and economic conditions, and the level and path of interest rates from here. Although it is difficult to ascertain the timing of large M&A transactions, recent approvals point toward a more conducive environment.

IBM Corp.'s management team signaled its strong interest in M&A to bolster its hybrid cloud growth strategy, announcing in December 2023 its intent to acquire certain software assets from Software AG for $2.1 billion and, more recently, to acquire HashiCorp Inc. for $6.4 billion. Hewlett-Packard Enterprise Co. (HPE) also announced in January 2024 its acquisition of Juniper Networks Inc. for $14 billion to expand its networking portfolio and pursue potential revenue synergies given HPE's broader go-to-market strategy.

The largest tech deal announced since fall 2023 belongs to Synopsys and ANSYS for $35 billion. In our view, the acquisition of ANSYS will help Synopsys diversify its product portfolio to include simulation and analysis, further its cross-sell opportunities, and lower its customer concentration risk. Meanwhile, those pursuing tech M&A likely breathed a sigh of relief when Cisco Systems Inc.'s sizeable acquisition of Splunk for $28 billion received approval and closed in March 2024, about six months post-acquisition announcement.

Election Uncertainty And Geopolitical Risks Could Be Headwinds

Antitrust regulation

The past three years of President Biden's term, which includes the nomination of Lina Khan for Commissioner of the Federal Trade Commission (FTC), has focused on limiting corporate dominance and aimed to create a more competitive business environment. The administration seemed to place particular emphasis on M&A by large tech companies, which include Alphabet Inc., Amazon.com Inc., Apple Inc., and Meta Platforms Inc.

This extended to smaller deals like Amazon's relatively small acquisition of Roomba-maker iRobot for $1.4 billion. Both Amazon and iRobot agreed to terminate the transaction a year and a half after the announcement in August 2022, as the FTC had yet to approve the deal over concerns that Amazon will give preferential treatment to its own products over competing brands in the online marketplace.

Ongoing lawsuits and investigations are unlikely to resolve anytime soon. This includes the FTC's cases against Amazon (exclusionary conduct in online marketplace) and Alphabet (default search engine), as well as the Department of Justice's lawsuits against Apple (app store) and Meta (accumulated monopoly power via anticompetitive mergers with Instagram and WhatsApp).

The European Commission and U.K. antitrust regulators also uphold stringent approval processes, as evidenced by the lengthy process before approving the Microsoft-Activision transaction, the abandoned Adobe-Figma deal, and, more recently, Qualcomm Inc.'s failed bid to acquire Israel-based communications chips vendor Autotalks Ltd. for $350 million due to lack of timely regulatory approval.

It is unclear if a potential change in U.S. government administration will provide significant relief to the level of tech M&A scrutiny. Former President Trump had expressed his view that social media platforms facilitate misinformation and advocated to repeal Section 230 of the Communications Decency Act of 1996, which gives legal protection to tech companies for third-party content generated by its users. It is also unclear whether former President Trump's view on social media platforms will hurt tech M&A prospects.

Geopolitical risks

Geopolitical risks are rising in today's world and the U.S.-China strategic confrontation will likely persist irrespective of the U.S. presidential election outcome. If tensions worsen any further between the two largest economies or intensifies the technology race, it could impede with supply chains and disrupt investment and capital flows for both countries--and others.

In terms of tech M&A, the most affected subsector is semiconductors because of the industry's presence in China. The country's antitrust authority, the State Administration for Market Regulation (SAMR), requires M&A approval if the two parties have combined revenue of at least 4 billion Chinese yuan ($567 million) in China and exceed 12 billion Chinese yuan ($1.7 billion) globally based on 2023 thresholds. The last sizeable U.S. semiconductor M&A deal that received SAMR approval was Advanced Micro Devices Inc.'s $35 billion all-stock merger with Xilinx in February 2022. Broadcom also closed its $69 billion purchase of VMware after receiving approvals from regulators in China and the European Commission.

As semiconductor chip design and manufacturing, leading edge or not, is increasingly viewed as important to national security interests, the chance of an expedited regulatory approval process has significantly diminished. As such, chip companies have been highly selective when evaluating whether to pursue M&A deals because of their apprehension for an extended regulatory evaluation, business disruptions that may occur during the period, and the potential for incurring M&A termination fees.

Tax policies

The Biden Administration continues to take strong actions on reforms related to corporate tax policies, including the imposition of a 15% corporate minimum tax and a 1% surcharge on share buybacks by certain corporations through the Inflation Reduction Act of 2022. In the President's budget for the fiscal year ending September 2025, submitted in March 2024, he outlined new tax proposals that set the corporate tax rate at 28% (up from 21% currently), raise the corporate minimum tax rate to 21% (from 15%), increase the global intangible low-taxed income (GILTI) tax rate to 21% (from 10.5%), and repeal the reduced tax rate on foreign-derived intangible income (FDII).

A Republican administration's tax policies could be more positive for companies. While in office, the Trump Administration enacted the 2017 Tax Cuts and Jobs Act (TCJA). This brought a major overhaul to U.S. tax code, reducing the corporate tax rate to 21% from 35%. The expiry of the TCJA at the end of 2025 opens the possibility for changes in taxation, but former President Trump has indicated that, if elected, he would be in favor of extending the TCJA legislation he signed in 2017.

Trade and tariffs

The U.S. executive branch--meaning the President's office--has wide latitude to levy tariffs. In our view, restrictive or protectionist trade policies that favor trade restrictions could result in inflationary pressures, especially for sectors exposed to cross-border supply chains, such as technology. The Biden Administration had placed export restrictions on advanced semiconductors to limit China's high-performance computing capabilities, particularly for AI and technology that poses the greatest national security concerns. We view any effective controls imposed by the U.S. to be potentially harmful to U.S. semiconductor and technology firms.

Former President Trump indicated that, if elected, he would be in favor of a universal baseline tariff of 10% on all U.S. imports and a 60% tariff on all U.S. imports from China.

It appears that trade policies by both parties would hamper free trade with China, a major manufacturing hub for the tech global supply chain. Recently, China's Ministry of Industry and Information Technology announced plans to exclude the use of foreign-made chips in China telecommunications networks. The targeted ban will not take effect until 2027 but would impair Intel Corp. and Advanced Micro Devices' sales to the Chinese telecom firms. Last year, the Cyberspace Administration of China launched a cybersecurity probe into Micron Technology Inc. to review products sold in the country and to ensure the security of key information infrastructure supply chains. While these trade restrictions and investigations appear to center on the semiconductor industry, they could spill into other parts of the tech sector.

Pause In Tech LBOs Unlikely To Last

Financial sponsors soured on leveraged-buyout (LBO) transactions as a rapidly rising interest rate environment took hold in 2022 and 2023. Higher interest rates raise any LBO's financing costs, but companies can still make profitable deals if the take-out valuations are attractive.

As the price discovery process continues and potential sellers are more willing to negotiate on price, we anticipate financial sponsors will become more active once again. Permira recently announced a $6.9 billion go-private transaction with Squarespace Inc., a popular platform for building website. Tech-focused private equity firm Vista Equity Partners recently raised over $20 billion for a new fund set to focus on AI. Thoma Bravo is also reportedly planning to raise $20 billion for its next LBO fund, zeroing in on enterprise software.

A more favorable IPO market and growing cash flow generation by strategic buyers will invariably provide competition to financial sponsors seeking suitable takeout targets.

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Software M&A More Likely Than Other Subsectors Despite Higher Valuation

Tech companies have different objectives when evaluating their M&A pipeline. Many invariably seek a broader set of products and capabilities to support growth. Some look for scale efficiencies and consolidation within the industry.

Software

We anticipate software companies, despite their higher valuation, to receive more M&A attention from both strategic buyers and financial sponsors because of their better growth trajectory, sticky recurring revenue base, and higher-margin characteristics.

The software M&A dynamic is different now versus a few years ago. It is more difficult for large tech companies to pursue large-scale acquisitions without heavy antitrust scrutiny. Instead, we've witnessed more investments or smaller-scale "acqu-hires", a transaction in which a company is bought predominantly for the talent and not for the established product or services. Notable ones include Microsoft's $1 billion investment in OpenAI in 2019 and additional subsequent capital infusions in the billions of dollars. This further extended generative AI capabilities across the two companies' products and services, including Microsoft Azure's data center usage.

Amazon and Alphabet also invested $4 billion and $2 billion, respectively, into Anthropic, an AI startup that is a direct competitor of OpenAI.

Furthermore, in March, Microsoft formed a new organization called Microsoft AI, focusing on advancing AI copilots and other consumer AI products and research, and hired Mustafa Suleyman and Karen Simonyan as executives of this new business segment. Both are renowned AI researchers who have helped develop many AI breakthroughs over the years. These deals have attracted the attention of the U.S. regulatory agencies, which said they will scrutinize these transactions for information about partnership agreements and investments, as well as determine the competitive impact these deals will have in the marketplace.

Although many software issuers we rate are in the infrastructure or application-specific space, issuers may pursue M&A to fill the capability gap related to AI. The impact from AI has yet to be seen, but we expect full effects to arrive over the next few years. We believe generative AI, large-language models, and the transition to inferencing in the cloud and at the edge from data center model training will likely collectively bring innovations to enterprise infrastructure, end-user software applications, and exponential data transmission at faster speeds, covering more endpoints.

Hardware

Technology products used to only be viewed as a broad category, instead of broken up into hardware and software capabilities, because they were developed by the same vendors. The decoupling of software from hardware brought more innovation and faster time-to-market for both industries, through competition and a broader set of technology providers.

Large tech hardware vendors, such as Cisco, continue to innovate and offer capabilities like security and wireless access, which are optimized when incorporated into their networking switches and routers products. Dell Technologies Inc. and HPE offer expanded enterprise solutions portfolios that span client computing, servers, storage, and networking products, providing customers comprehensive choices and an opportunity for vendor consolidation.

As hardware products become increasingly commoditized, we expect vendors to increasingly look to software for improved capabilities and higher customer retention. Companies may also find M&A attractive to boost go-to-market scale efficiencies or supply chain negotiating power, if they provide a good value.

Semiconductor

We expect M&A activities in the semiconductor industry to be mainly tuck-ins and portfolio optimizations. We would have to go back many years to find mega M&A deals that closed, such as AMD's $35 billion acquisition of Xilinx Inc. and Analog Devices Inc.'s $21 billion acquisition of Maxim Integrated in 2020. Before that, Avago Technologies' acquired Broadcom Corp. for $37 billion in 2015.

More noteworthy, in our opinion, are scuttled deals, which include NVIDIA's $40 billion acquisition of Arm Ltd. in 2022, Broadcom's $117 billion bid for Qualcomm in 2018, Qualcomm's $44 billion acquisition of NXP Semiconductors N.V. in 2018, and KLA-Tencor Corp. and Lam Research Corp.'s $11 billion merger in 2016. We believe that the semiconductor industry has consolidated considerably over the years, and regulatory scrutiny is intense, making it less attractive for industry players to pursue large targets when weighing the pros and cons. Additionally, the semiconductor industry has a long-term favorable backdrop given more electronic devices and increasing electronic content, which we expect to bode well for growth without the need for a boost from inorganic sources.

Capital Allocation Priorities' Potential Effect On Credit Quality

Secular growth trends, such as cloud computing, have led to a broad increase in IT spending. In turn, many tech companies continue to demonstrate healthy FOCF generation and cash levels that allow for M&A without compromising credit quality. We expect business transformations from technological evolutions in the not-too-distant future, such as AI and autonomous vehicles, to provide further fuel to the IT spending growth trajectory.

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The tech sector is broad and includes companies in the semiconductor, hardware, and software subsectors. Although similar to other sectors where a few large companies represent a significant proportion of their sectors' activities, the tech sector takes it to a different level. The largest tech companies, such as Microsoft, Apple, NVIDIA, and Broadcom, have outsized influence when evaluating the industry's overall revenue, profitability, free cash flow generation, cash, debt, and shareholder return metrics. Therefore, to get a better sense of the business performance and financial policies for S&P Global Ratings' comprehensive tech sector coverage, it is imperative that we analyze the credit health of our rating universe both with and without these large and influential tech issuers.

Credit quality for the technology sector has diverged over the past few years. Larger companies continue to see lower fixed operating costs and improved secular growth trends, such as cloud computing and electronics proliferation, whereas smaller ones, especially those owned by financial sponsors and heavily burdened by their debt loads, face pressure on credit ratings as their operating cash flows are mostly absorbed by higher debt-service costs and some liquidity crunch, outweighing benefits from their growth and cost-cutting initiatives.

As we anticipate a more active tech M&A environment over the near term, tech issuers will need to evaluate whether and how their capital allocation priorities will shift. We do not expect financial policy from our rated issuers to pivot significantly. This is based on our view that shareholder returns, especially buybacks, are discretionary in nature, and most tech issuers have already established financial policies that are consistent with their business strategies.

Companies are unlikely to overhaul their capital structure strategies despite a higher interest rate environment. We believe debt repayment would be less of a priority--with the exception of a few issuers--given the favorable longer-term growth trajectory and stable to improving profitability that we expect will continue to support credit profiles.

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Below are our views on capital allocation priorities on select high profile U.S. tech issuers.

M&A

• IBM Corp.'s (A-/Stable/A-2) CEO expressed his desire to complement the company's organic growth strategy with opportunistic M&A ever since he took the top job in April 2020. Since then, notable acquisitions include Turbonomic (purchase price of over $1.5 billion) in June 2021, Apptio ($4.6 billion) in June 2023, WebOS ($2.1 billion) in December 2023, and HashiCorp ($6.4 billion) in April 2024. Given IBM's focus on hybrid cloud that spans the largest global enterprise customers, we believe there is no shortage of attractive acquisition targets.
• Cadence Design Systems Inc. (BBB+/Positive/--) continues to benefit from strong demand by semiconductor and design systems customers for its mission-critical electronics design automation (EDA) solutions. Although the company has historically exhibited a conservative financial policy and has maintained very low leverage over the past few years, we believe Cadence could more actively seek acquisitions, especially after its direct competitor, Synopsys Inc.'s proposed acquisition of Ansys in January 2024.
• CrowdStrike Holdings Inc.'s (BB+/Stable/--) credit metrics remain strong, with a large net cash position and improving FOCF. However, given the fragmented cybersecurity software landscape, we believe CrowdStrike could engage in a single large-scale acquisition or multiple tuck-in acquisitions to bolster its product breadth. The evolution and prevalence of AI in the digital world will only raise the importance of cybersecurity and encourage the industry to migrate to a consolidated platform approach from its predominantly best-of-breed product offerings.

Shareholder returns

• Apple Inc.'s (AA+/Stable/A-1+) FOCF will likely exceed $100 billion once again in fiscal 2024. If history is any guide, large-sized acquisitions are unlikely for Apple, and we expect shareholder returns to more than exceed FOCF generation given its financial policy to level its net cash of $58 billion to zero over time.
• Dell Technologies Inc.'s (BBB/Stable/--) revenue, profitability and cash flow generation have improved markedly over the past few years, benefitting from a surge in PC sales in 2020 and 2021 and debt reduction from dividend proceeds that accompanied its VMware spinoff in 2011. Dell is near its financial target of 1.5x reported gross leverage, which is roughly equivalent to S&P Global Rating' adjusted leverage near low-1x. While Dell's concentrated ownership and dual-class shareholder structure--with the same board makeup that was comfortable operating at higher leverage--remain risks in our view, its cash and investments balance exceed its stated minimum target of $4 billion-$5 billion and we expect FOCF to exceed $4 billion in fiscal 2025. We believe the company will increase shareholder returns over the coming quarters.

Capex:

The U.S. CHIPS Act, enacted in August 2022, aims to bolster domestic semiconductor manufacturing and research capabilities in the U.S.

• Intel Corp. (A-/Negative/A-2) plans to spend over $100 billion for new state-of-the-art fabs and research and development facilities in Arizona, Ohio, New Mexico, and Oregon, qualifying for $8.5 billion in grants through the U.S. CHIPS Act. Intel also plans to spend about €30 billion for new wafer fabs in Germany and up to $4.6 billion for new assembly and test facilities in Poland, and we expect the builds to qualify for foreign government subsidies.
• Micron Technology Inc. (BBB-/Stable/--) plans to invest up to $125 billion over the next 20 years, with $50 billion by 2030 for two wafer fabs in New York and one in Idaho for dynamic random access memory (DRAM) production. The company has secured $6.1 billion in grants through the U.S. CHIPS Act to subsidize the build and operation of these new fabs.
• Texas Instruments Inc. (A+/Stable/A-1) is pursuing a multiyear capital investment plan that will substantially increase its gross capex (before U.S. CHIPS Act benefits) to about $5 billion annually through 2026, up from about $2.7 billion in 2022. The U.S. CHIPS Office has not made any announcements regarding grants approved to Texas Instruments, and the timing of these potential incentives is uncertain. The U.S. CHIPS Act provides a 25% investment tax credit for chip manufacturing equipment and facilities, for which we believe Texas Instrument, as well as other U.S. chip manufacturers, will quality for.
• Oracle Corp.'s (BBB/Stable/A-2) share buybacks remained subdued in the latest quarter ended February 2024, the ninth quarter of curtailed buybacks since the Cerner acquisition announcement. Now that the company has achieved its mid-3x leverage target, share buybacks could increase, but investment priorities may limit its capacity to do so. We believe Oracle will prioritize capex increases to support expanding cloud and AI capacity.
• Microsoft Corp. (AAA/Stable/A-1+) will likely generate over $60 billion in FOCF in fiscal 2024 (ending June 2024) and over $75 billion in fiscal 2025, all while bumping its capital spending to over $40 billion and $47 billion, respectively, up from capex of $28 billion in fiscal 2023. In our view, Microsoft has a long-term track record of increasing share in the growing IT market, occupying a solid No. 2 position in the public cloud services market (behind Amazon Web Services) and one of the leaders in the nascent generative AI market that will likely represent a rapidly growing proportion of the overall global IT spending. Although we anticipate Microsoft will continue to return capital to shareholders through both regular dividends and share buybacks, we believe the company will prioritize spending on data center expansion and associated power and energy infrastructure initiatives. This will ensure it can meet the demands of the growing needs in both the secular growth public cloud and generative AI markets.

Supplier Prepayment

• NVIDIA Corp. (AA-/Stable/A-1+), Qualcomm Inc. (A/Stable/A-1), and Advanced Micro Devices Inc. (A-/Positive/A-2) all have conservative balance sheets and will likely eye tuck-in acquisitions rather than transformative ones. We view their capital allocation priority, first and foremost, will be to ensure their foundry chip manufacturer TSMC will have sufficient wafer fab capacity to meet insatiable customer demand in advanced graphics processing units (GPUs), AI accelerators, and application processors. Strong liquidity and FOCF generation allow large shareholder returns for all three.

Debt repayment:

• Following Broadcom Inc.'s (BBB/Stable/--) $61 billion acquisition of VMware and Cisco Systems Inc.'s (AA-/Stable/--) $28 billion acquisition of Splunk (both closed in the fall of 2023), we anticipate their capital allocation priorities will lean toward debt repayment over the near term.
• Similarly, we expect Hewlett Packard Enterprise Co.'s (BBB/Negative/--) proposed $14 billion acquisition of Juniper Networks to close towards the end of 2024 and we believe the company will prioritize cash preservation ahead of the transaction and debt repayment post-close to avoid a rating downgrade.
• Corning Inc. (BBB/Negative/A-2) finished 2023 with S&P Global Ratings-adjusted net leverage of about 3x (high-2x when adjusted for undesignated hedges), well above our 2x downgrade threshold. With revenue growth and free cash flow in 2024 likely to be subdued as the inventory digestion phase lingers, we expect Corning to continue curtailing share buybacks, which it has done since the second quarter of 2022 in favor of repairing its balance sheet.
• Western Digital Corp. (BB/Watch Negative/--) announced in October 2023 that it plans to separate its hard disk drive and flash businesses, creating two independent, public companies with market-specific, strategic focuses. The separation will better position each business to innovate, execute product development, and operate more efficiently with distinct capital structures. Western Digital's total debt outstanding has been elevated ever since its $19 billion acquisition of SanDisk in May 2016. While it hasn't yet revealed details of the post-spin capital structure, we expect the company to remain resolute in its aggressive debt repayment efforts to provide maximum financial flexibility to facilitate the spin-off.

Here are our views on capital allocation priorities across select U.S. rated tech issuers.

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