This column was originally published on RealMoney on Sept. 5 at 2:01 p.m. EDT. It's being republished as a bonus for TheStreet.com readers.

When I wrote about the six suitors circling

Mercury Interactive

( MERQ) a few weeks ago, a number of readers asked for the names of other likely takeover candidates in the tech sector. While naming names would be pure speculation on my part, we can certainly narrow the list down somewhat.

Essentially, there are two types of acquisitions: strategic and financial. Most of the high-profile acquisitions we've seen of late have been strategic in nature, but I think that tech companies will be targeted for financial reasons by private equity much more often over the next few years.

Strategic Acquisitions

It doesn't take a rocket scientist to understand the whats and whys of a strategic transaction.

EMC

(EMC)

and

Oracle

(ORCL) - Get Report

have been on acquisition binges in recent years in efforts to plug product holes, bolster top-line growth and/or enter into new markets.

In addition to the aforementioned pending acquisition of Mercury by

Hewlett-Packard

(HPQ) - Get Report

,

IBM

(IBM) - Get Report

announced plans to acquire security-software vendor

Internet Security Systems

( ISSX),

MRO Software

( MROI) and

FileNet

( FILE).

Seagate

(STX) - Get Report

bought Maxtor, and EMC is again targeting

RSA Security

( RSAS). There's plenty more, but the tune is the same: Big company plugging a hole with smaller company.

Software companies make attractive acquisitions because of their high-level intellectual property and the fact that there is virtually no cost of goods, which yields very high margins. Software also has three added advantages:

  • It tends to generate an attractive cash-flow stream for extended periods of time.
  • It doesn't break or wear out. Users' needs may change, but on the last day of its life, software still does the same thing it did on day one.
  • It's highly flexible, in that it can improve its performance by updating the underlying hardware. As CA (formerly known as Computer Associates) demonstrated (aside from the some other questionable practices) throughout the 1980s and early 1990s, layering new products onto an existing sales organization can generate significant leverage.

So what are the current likely strategic acquisition targets? There's no way to know for certain, but trends within IT offer clues.

Service-oriented architecture (SOA) looks to be developing into the prevailing approach to application development for years to come. As an increasing number of large hardware and software companies seek to participate in SOA, some will build their own suite of "middleware" products, while others will buy their way in. The obvious targets are

BEA Systems

( BEAS),

Tibco

(TIBX)

and

webMethods

( WEBM), and this is certainly not a secret lost on investors. They have been mentioned for some time. Of the three, I think webMethods may be the most attractive because it also meets the criteria for acquisition by private equity that I outline below.

Financial Acquisitions

I think a far more interesting development on the acquisition front will be the increasing number of buyouts along the lines of the recent deal struck by Texas Pacific Group and Hellman & Friedman LLC to acquire

Intergraph

(INGR) - Get Report

for $1.3 billion.

Over the last five years or so, the rise in private equity funding has been nothing less that meteoric. At the same time, there's been no dramatic increase in the amount of food they like to eat. In general, private equity players have focused on what they consider stable industries with attractive cash flow characteristics and well-defined assets. Transactions are almost always friendly, and the targets are frequently private or units being spun off by a public company. However, when there's too many dollars chasing the same deals, either the prices start to go up, increasing risk, or the buyers start to shop elsewhere. That's exactly what I believe will begin to happen.

In addition to the private equity firms, we've also seen a number of activist hedge funds that are buying controlling interests in public companies, demanding board seats and forcing change to happen. That's long overdue.

So with private equity looking for new land to farm and some hedge funds looking to fix "broken" companies, there are more than a few candidates in the tech sector. The one segment that generally isn't perceived as ripe for acquisitions is semiconductors, but that's actually the one that is filled with the most targets.

Many are what I like to refer to as products masquerading as companies. Despite top-line stagnation, many have strong balance sheets, attractive intellectual property positions, solid customer bases and talented personnel. However, the dream that may have inspired many to join a fledgling firm and help grow it into the next Intel has probably long since expired.

So what would I look for among semiconductor companies as financial acquisition targets?

Products that are unique

-- Companies with a high level of intellectual property will tend to carry substantially higher levels of gross margin than the industry average, and customers are obviously willing to pay for that.

A significant difference between gross margins and operating margins

-- The company is "overspending" on R&D and/or SG&A (selling, general and administrative expenses) with the goal of regaining top-line growth and profitability through "investment." This also becomes a vehicle for boosting cash flow.

Company founders are no longer actively managing the enterprise

-- Professional managers are less likely to be emotionally attached to a company, thereby increasing the odds that they'll be receptive to an acquisition offer.

Fabless manufacturing model

-- This avoids the heavy capital expenditures necessary to deliver competitive products.

Utilization of standard CMOS process technologies

-- This provides flexibility in the selection of foundry partners.

A large net-cash position relative to total value

In the table below are three companies that fit a number of my criteria:

Actel

(ACTL)

,

Exar

(EXAR)

and

Hifn

( HIFN). Over the last five fiscal years, these three have managed to generate an operating profit four times (out of 15 possibilities), yet each is highly profitable at the gross margin line. Their managements are spending them into the red. Each has decent levels of cash that, if their current courses are continued, will be wasted, and each has attractive levels of net operating losses, as well as tax assets. If they can generate sustained profitability, the cash flow would improve quite nicely.

What would make these types of companies far more attractive would be to roll up several into one. If they are incorporated into larger entities, a number of possibilities come into play.

The obvious is the overhead savings from an administrative perspective. Less obvious are the cross-selling opportunities to current customers. The single largest benefit would come on the manufacturing side. These three companies currently use nine different foundries, and with that level of fragmentation, they're likely paying premium prices for all their wafer processing. While consolidation of production at two to three foundries wouldn't be easy or come quickly, there's no doubt that the benefits would be substantial.

I'm not suggesting that these three are going to be acquired within the next month or so, but they all have certain characteristics that make them attractive, and acquirers are facing an environment in which they will likely have to become much more creative.

Investment firms of all types are being paid to put their cash to work, not to sit on it waiting for the perfect opportunity. It only takes one or two success stories to get prospectors digging in a new field. I believe the first of those may have been the controlling interest in

MEMC Electronic Materials

(WFR)

purchased by Texas Pacific Group a few years ago. That was a great example of what can be done by thinking outside the box.

At the time of publication, Faulkner was long MEMC Electronic Materials.

Faulkner has been in the investment business for 18 years with an exclusive focus on technology stocks. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Faulkner appreciates your feedback;

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