Tech executives, take note: SCI Systems ( SCI) did the smart thing Monday. It threw in the towel.

By agreeing to sell itself to fellow electronics contract manufacturer Sanmina ( SANM) for a per-share price less than half its 52-week high, SCI signaled that its peak valuation was out of reach, as were the old days of 30% annual earnings growth.

In acknowledging those facts, Sanmina stands out. The bubble that took so many tech shares to great heights popped more than a year ago. Yet big mergers have remained relatively rare, as managers and directors cross their fingers for a rebound. Unfortunately for investors who are hoping for a wave of stock-boosting mergers, this point of view has yet to be fully discredited. That means that plenty of tech companies are going to soldier on alone as fundamentals deteriorate and shareholder value evaporates.


The problems at SCI -- and across the tech sector -- stem from overcapacity and slower growth, courtesy of the turn-of-the-millennium financing bubble. "The real side effect of a huge increase in asset values," notes Trilogy Advisors chief investment officer Bill Sterling, "is overinvestment."

Urge to Merge?
Tech's plunging capacity utilization
Source: Federal Reserve

And overinvestment, whether it is in automobile manufacturing, oil pumping or technology, creates more capacity and more competitors than necessary. It also leads to a quicker maturation of an industry, meaning companies are expanding just as long-term growth prospects begin to fade.

What follows, inevitably, is a wave of consolidation. Leaders recognize that it's suddenly cheaper to expand by buying competitors than by buying plants. Takeover candidates see that the salad days are over. In the early 1980s, for instance, many big energy companies found it was cheaper to take out smaller operators than it was to go dowsing for oil in the Black Warrior Basin.

"Instead of drilling for oil themselves, they went drilling on Wall Street," says Jeff Matthews, president of Ram Partners, a Connecticut-based hedge fund. By buying SCI, he says, Sanmina is doing essentially the same thing. (Matthews has no positions in either company.) SCI inked a lot of deals to take over original equipment manufacturers at steep prices, says Matthews. Thanks to the plunge in SCI stock, Sanmina can now buy it on the cheap.

Ah, Timing

Given that overcapacity and slowing growth aren't limited to the contract manufacturers, more tech mergers are bound to happen, says Merrill Lynch chief quantitative strategist Rich Bernstein. Whether they will come in short order, however, is another matter. Many companies may be slow to admit that the good old days are good and gone, that aspects of the current slowdown aren't just cyclical. There may not be many mergers in the tech sector until after the economy recovers and companies find that their growth has not.

And even when consolidation comes, it may not necessarily take care of tech's capacity problems. Not too long ago there was a wave of mergers in the basic materials sector, but because there was little cutting done, the overcapacity remained. Japan has seen many mergers over the past decade, but little work with the saw: Instead, one sees boards of directors that have doubled in size, bank branches in shouting distance of one another. If tech companies can't cut out excesses when they begin to merge, says Bernstein, they will be no better off than before.