Monday, September 25, 2006

GE Fanuc Embedded Systems Continues Full-Out Assault on Military Embedded Market with Plan to Purchase Radstone Technology

GE Fanuc Embedded Systems, a unit of General Electric Company (NYSE: GE), announced on Friday that it has agreed to acquire all of the issued and outstanding shares of Radstone Technology, PLC (London Stock Exchange: RST) for a total consideration worth approximately £130.4 million pounds (approx. US$ 247.8 million). The deal has sixty days from the filing of the paperwork to officially close. This comes after GE Fanuc Embedded’s acquisitions of SBS Technologies and Condor Engineering in March of this year.

1. Why does the timing of this deal make sense for GE Fanuc Embedded Systems & Radstone?
2. How should we evaluate this transaction?
3. What does the deal mean for the competition?

Why Does the Timing of This Deal Make Sense for GE Fanuc Embedded and Radstone?

• Segmentation Growth Through Acquisition – This agreement to purchase Radstone Technology is in line with the strategy that GE Fanuc Embedded Systems has followed in the embedded systems market since the inception of the group with GE Fanuc. This strategy has been to increase the firm’s product portfolio and market share through the aggregation of niche players. The Embedded Systems unit of GE Fanuc was born through the acquisition and merger of three embedded computing companies – VMIC, RAMiX, and Computer Dynamics, with the VMiC Huntsville, AL office becoming the home office. In March of 2006 the business unit continued down this path with the purchases of Condor Engineering and SBS Technologies. Following this round of consolidation the headquarters of the GE Fanuc Embedded Systems business unit moved to the Albuquerque, NM office of SBS, where it currently resides. The plan to purchase Radstone Technology, the high-end conduction cooled VME boards specialist, is just the latest niche player acquisition by GE Fanuc Embedded Systems in a broader effort by the firm to grow the firms product portfolio, particularly focused on growing in the Embedded COTS Military/Aerospace market.

• A Good Time to Sell – Word was widespread that Radstone Technology was in play. A glance at the firm’s financial position makes this pretty obvious. The firm had two years of double digit growth in a row, growing 14% from fiscal 2004 to fiscal 2005 and 10% from fiscal 2005 to fiscal 2006. In 2004 and 2005 the firm showed strong operating margin at 17.8% and 19.0%. The embedded COTS market had averaged roughly 6% growth from 2004 to 2006, so Radstone was beating the market, while also showing strong profits. This made it a great time for Radstone to sell in a hot defense/military market full of potential suitors looking to acquire a new piece of the market.

Given Eurotech’s failed effort to acquire Radstone Technology only a week before GEFE, it would appear that there may have been a mad rush to grab what was an available, sizeable, and desirable niche military COTS embedded company. This market is so fragmented that sometimes the only way to make any order of it and to retain steady market share is to do a tiny piece of the market better than anybody else.

How Should We Evaluate This Transaction?

VDC believes that this deal fits neatly within the GE Fanuc Embedded model: growth through acquisition. With Radstone, GE Fanuc Embedded has filled out its line card in a core product offering, gained access to additional smaller lines, and likely found itself a few dozen additional defense programs to manage and leverage. We think that Radstone and the larger GE Fanuc Embedded business will continue to grow in the near term, throughout the integration transition, and likely beyond.

However, there are a number of questions that remain for us:

1. Assuming (a) certain cost reductions and efficiencies were part of the deal justification, and (b) Radstone’s business is as personality and relationship driven as the rest of the embedded COTs market, how will GEFE meet the productivity goals without eroding some of the most valuable parts of the deal?
2. How will GEFE market, sell and support its growing business of COTs products – as each of the recent acquisitions is built on differing go-to-market strategies?
3. Will GEFE be able to stitch all of these businesses together technically as well as commercially?

VDC believes that the integration of valuable components into higher-value-added subsystems could be an even more significant opportunity – the whole may be a more valuable proposition than the sum of the parts.

Can GEFE position itself as a leading supplier of merchant embedded computing/ communications/control/ countermeasures (EC4) to defense mezzanines? Primes? And what of the larger industrial and commercial market segment opportunities such as IP telephony and instrumentation?

Will software – middleware, utilities, horizontal embedded applications, etc – be part of the GEFE strategy? Our market analysis continues to suggest that higher-level system management, including high availability (HA) support – will be a source of pressure and tension for companies focused on providing discrete hardware platforms.

We like the deal. We are optimistic about the role GEFE might play in the COTs and larger embedded market. We do have questions about where this business ends up.

What Does This Mean for the Competition?

In terms of the overall market for embedded COTS Systems in military applications this is a somewhat small transaction because the market is so broad and wide open. Especially given that there is an increasing amount of participation of the Prime Defense Contractors in this market, weather this be outside sales or just sales to another business unit within the parent company. The market is also flooded with large systems integrators such as HP and Dell as well as large embedded suppliers like Motorola Embedded Communications Computing who do not super actively participate in the military COTS market, but will occasionally supply a custom military product slap a part number on it, put it up on their website, and call it COTS. For these big boys, especially the Primes and the large Systems Integrators this deal may seem somewhat insignificant.

However, this deal does have major implications for the traditional embedded military COTS systems suppliers, these companies often sell to the Prime Defense Contractors Mercury Computer Systems and Curtiss Controls. Theses two companies have in the past been the leaders of this market.

In the recent past, the military embedded market is no stranger to consolidation, as evidenced by the many recent acquisitions by Curtiss Wright Controls and Mercury Computer Systems as well as GEFE’s previous moves into the market.

GE Fanuc Embedded Systems is certainly not buying the market or becoming the first 900 lb gorilla among the niche focused on the embedded military marketplace and selling to the Primes. More to the point, the company has now made itself a more formidable competitor to embedded COTS industry mainstays such as Curtiss Wright Controls and Mercury Computer Systems. Curtiss Wright and Mercury remain the niche leaders for the time being and have set the standard that GEFE is now better positioned to meet. By no means will GEFE now be able to easily win out over the competition; the firm will be in a tough battle with Curtiss Wright and Mercury. We should also not forget that at first anyways, GEFE will be slightly hindered by the integration efforts that it will take for them to combine all of their recent acquisitions into one unit. This should be roughly a one-year effort that will be a slight hindrance and one that will not be faced during the same period by their competitors. There is no reason to believe that at this time the embedded COTS market niche that these three firms compete in can not support all three, along with the many, many other even smaller niche players such as Aitech, Spectrum Signal Processing, and Octagon Systems who are all the experts at what they do.

An interesting development to track as a result of this purchase is the activity of private equity in the market. When Eurotech was not able to acquire Radstone outright, they began a hostile takeover and purchased 15% of Radstone, which means that GEFE will now have to buy back those shares at a gain of a couple million dollars for Eurotech. The embedded market was one where private equity was already ticking up, and when they realize the money Eurotech was able to extract in a very short period of time, it will most likely advance the desires of private equity in the market.

Look for more industry consolidation to occur in the future. With Eurotech losing Radstone to GEFE, look for them to make a move if they really want to bolster their current holdings of Parvus and Arcom in the embedded military market. If the right opportunity appears, Curtiss Wright could go on a buying spree again as well. With involvement of the Prime Defense Contractors in this market and the segmented nature of the embedded COTS military market which has created literally hundreds of firms selling embedded COTS products of some sort, the window of opportunity for acquisitions is never closed.