Datalink’s M&a: Growth By Design

Over the past four years, Minneapolis-based Datalink Corp., a provider of data center infrastructure and services, has made four acquisitions. Together with organic growth, the deals have helped give it a major jolt in size. Revenues jumped from $177 million in 2007 to $294 million in 2010, while net income after taxes just about doubled, to $2.3 million from $1.2 million.

The latest purchase occurred in October, when Datalink spent $17.6 million for the assets of Midwave Corp., a $65 million IT services firm.

It’s a fairly common story in industries like value-added reselling, which is characterized by low margins. And Greg Barnum, Datalink’s vice president and chief financial officer, explains it well.

“Getting the most from our fixed expenses requires growing the top line as fast as we can,” says Barnum. So purchasing a company, he adds, often is a quicker path to bottom-line growth than hiring new sales engineers to open another office — a strategy that can require several years to turn a profit.

Datalink’s recent string of acquisitions began in 2007, when it paid $14 million for Chicago-based Midrange Computer Solution Inc., a storage solutions provider with annual revenues of about $47 million.

Two years later, Datalink paid $8.8 million for Incentra LLC, a data center infrastructure services provider located in Broomfield, Colo., gaining a revenue stream of about $70 million, Barnum says. Also in 2009, Datalink purchased a networking solutions team from Minneapolis-based Cross Telecom for less than $2 million.

The Cost of Displacing Rivals

Analysts in the industries where consolidation is taking place agree on the potential benefits of deal-based growth, rather than by pure competition.

“There’s definitely a heavy cost to displace an incumbent (reseller) who has a good relationship with a customer,” says Eric Martinuzzi, a senior research analyst who follows Datalink and other companies for investment banking firm Craig-Hallum Capital Group LLC. Many mid-sized businesses rely on established relationships with outside experts when embarking on IT projects.

That’s why, when considering potential acquisition targets, Datalink’s executive team appears to have concentrated on resellers that either operate in other geographic markets, or that possess an expertise the company lacks, Martinuzzi says.

“They are buying the service engineers; the relationships with the customers,” he says. “Datalink is very smart. When they look at prospects, they’re looking for a new geography, or a VAR with expertise in an area that Datalink isn’t competing in.”

Moreover, the acquisitions effectively move the cost of acquiring new customers off the income statement. “We’re using our balance sheet to grow,” Barnum says. Rather than boost sales expenses, Datalink — a public company since 1999 — can use its cash to make an acquisitions. Even after its recent deals, as of Sept. 30 it had more than $30 million in cash and equivalents available.

Datalink’s formula seems to have worked. “There’s evidence that it drives future earnings,” Martinuzzi says. For instance, after Datalink’s acquisition of Incentra, many clients were retained and spending a greater portion of their IT budgets with Datalink.

Keys to Success

While acquisitions offer one way that companies can grow, numerous studies have established that the strategy often fails to succeed in creating value succeed. For one, KPMG’s 2008 study, “All to Play For,” found that over the preceding decade the percentage of deals actually enhancing value never topped 34%.

Of course, as with any average, the variances can be significant. “Some companies do M&A very well; they understand the important pieces that need to be executed,” says George Geis, adjunct professor at UCLA’s Anderson School of Management.

And when companies like Datalink succeed with their dealmaking, it can be traced to the way they avoid certain typical pitfalls.

One obvious one is setting too high a price for the target. “If you overpay,” Geis notes, “you get the winner’s curse” — winding up with the target, but with little chance of recouping a too-high purchase price.

Datalink believes it does a good job of setting competitive, but not lavish, acquisition offers.

Another cause of value destruction can be poor integration, which can lead to personnel disruptions. And here, Datalink seems to do very well.

Because most of Datalink’s acquisitions are a means of gaining clients, it’s critical that they retain the sales engineers that attracted the customers in the first place.

“The integration doesn’t have room for error,” Barnum says. To make it work, Datalink integrates the acquired employees immediately when the deal is signed, he explains.

The ‘Earnout’ Tyranny

In addition, Datalink avoids earnouts — those contracts, written into the acquisition agreement, that allow the sellers to gain additional compensation in the future, as long as the business meets certain financial goals. Earnouts could limit Datalink’s ability to make changes to the business — they’re “a recipe for disaster,” Barnum says — as the seller might balk, saying the change will hamper his or her ability to meet the goal.

To be sure, not every potential target is going to agree to these terms. And finding the right candidate takes time. Datalink typically spends several years researching potential deals before one comes to fruition, Barnum says. But that has a benefit, too: It provides the company time to integrate its previous acquisitions.

Savvy acquirers have a strategic rationale, and plan for the deal that’s in sync with the company’s core competencies and strategy, Geis says. The deals aren’t undertaken simply to expand the empire.

The used of a strategy like Barnum’s seems another plus for the Datalink approach.

Some acquirers — Warren Buffett comes to mind — have been successful with a largely hands-off approach. Others have done well by tightly integrating their purchases. “There’s really an art to this. It’s not one size fits all,” Geis says.

So far, Datalink appears to have found the right fit, and investors have noticed. Datalink’s stock has more than doubled over the past four years, rising from $3.71 to $8.84 as of mid-November.