M&A Revs Up in a Mature Software Sector: Today’s software dealmaking has the benefit of wisdom, and a firm hand on the throttle.

Now that the mood swings of the software industry’s m&a activity in its Bubble and post-Bubble adolescence are past, experts see the market entering a more stable phase, albeit one spiced by considerable dealmaking. They sight the rising economy, consolidation linking narrowly focused firms to more diversified entities, and corporate customer demands for one-stop solutions as drivers of dealmaking. “It’s still a tough time to be a small software company, so with the economy improving, I think we’ll see a return to normal levels of m&a activity in the sector,” says Bruce Hadley, editor of Software CEO, a web site that provides software deal and other information. Another take on the distance the industry has traveled from the wild and woolly days of the late 1990s comes from Jim Green, CEO of Composite Software, a San Mateo, Calif.-based, producer of enterprise information integration software. “It used to be that investors were impressed by the number of earrings a software company CEO had. Now, the more gray hair they see, the more reassured they feel.” In describing the doldrums from which he and others think the industry is only now emerging, Green points out that the previous recession in the industry lasted nine months. By contrast, the post-Bubble downturn has lasted about two years and nine months, he says. As a result, there was little pressure to do deals in the past three years, he says, because the industry emphasis was on making sure your company would survive. Of course, a lot of companies did die. “You had a situation where there were 10 companies in niches that could support only two or three,” says Howard Anderson, a management professor at Massachusetts Institute of Technology. But now, improving macroeconomic conditions are giving software executives the chance to scan the horizon for opportunities. As of the third quarter, the S&P 500, Nasdaq, and the Dow are up 13%, 33%, and 11%, respectively. An additional boost may come from a long-awaited hike in corporate information technology spending, which International Business Machine executives forecast at a press briefing in early December. It also doesn’t hurt to have a marquee deal – one that combines a hostile bid with a potential menage a trois – drawing public attention to the sector. Oracle Corp.’s long-pending, $7.3 billion hostile bid for PeopleSoft Inc. in conjunction with PeopleSoft’s $1.8 billion acquisition of J.D. Edwards Inc. amount to public notice that the industry indeed is ready for a new round of consolidation. The Department of Justice was continuing an antitrust review of the Oracle bid in late 2003 while the PeopleSoft buy of J.D. Edwards closed last summer. As a result of all of these factors, deal multiples are inching higher and investment bankers who follow the space say they expect to be pitching to more-receptive prospective clients this year. “The potential is there for a big feast of m&a activity in 2004,” says Ben Howe, a principal at American Century Holdings, a Boston-based investment bank. Some insiders might argue that the deal flow won’t pick up quite this quickly, but most say that a corner has been turned. “The difference in the industry now is that it is at least becoming possible to think about doing a transformative deal is some sectors,” says Nat Burgess, an SVP at Corum Group, a Bellevue, Wash.-based provider of m&a services to software and IT companies. But even with the increase in optimism, some dealmakers caution that the deal merry-go-round isn’t ready to shift into high gear for a while. “You aren’t going to see broad-based consolidation. You’ll see consolidation within sectors,” says Rob Fisher, a partner at PricewaterhouseCoopers LLP in San Jose. Fisher says some corporate CIOs are still skeptical about buying software because of continued cost pressures, among other reasons. And while megadeals like Oracle’s run at PeopleSoft dominate the headlines, experts predict a lot of activity in the middle market. “We’re seeing that mid-tier buyers are showing increased interest in growing their businesses using m&a,” says Ken Bender, a principal at Software Equity Group in San Diego. In a clear reaction to the excesses of the Bubble era, David Weiss, a VP at financial software maker Intuit Inc., says that acquirers are now looking for practical value and acquisitions that are close to their own core competencies. The industry’s new metric is whether an acquisition will offer tangible value to customers, he notes. “In a lot of cases, these are the kinds of companies that maybe haven’t gotten to a critical mass from an operating perspective but which give the buyer a chance to increase its offerings to its own, presumably broader, customer base,” he notes. From Mercy Killings to Buying Value One trend noted by software industry consultant Charles Mills is a movement toward more strategic deals. According to a report by the Software Equity Group, a basic formula for last year’s software deals is that the targets usually have complementary products and are in the same markets as the buyers. Most of these “strategic” acquisitions were required to yield immediate incremental revenue through cross selling into the installed base of each party and to be immediately accretive or reach that point in the near-term. While there are still legions of what some call observers “undead” software companies, more of the recent deal activity in software is based on buying assets that have ongoing value, rather than on bottom fishing. “Undead” software companies are those that are sitting on cash hoards and that are, in some cases, profitable, but can’t get traction in the marketplace and, therefore, face uncertain futures. Mills points to the $11 billion acquisition of Practice Works Inc. by Eastman Kodak Co. as an example of a deal based on the ability of the target to help the acquirer achieve strategic goals. This is in contrast to what he called “emergency deals” – designed to salvage some value from companies whose long-term prospects are doubtful. He adds that these “undeads” are healthier than the class of totally distressed companies that represented the worst of the dot-com era’s excesses; those companies have already folded. For some competitors the pruning of the undead or stagnant companies can’t come too soon. According to Anderson, these stagnant companies tend to suck cash out of healthy companies via cutthroat competition. “The living dead companies are out there competing like crazy, cutting prices, and giving buyers amazing leverage,” he says. While the sales of some of these companies show up in the deal flow, Anderson says they usually generate low prices because their valuations have sunk so far. “You can buy them as public shells, and sometimes these deals are little more than glorified employment contracts.'” Mills points to another transaction, Novell Inc.’s $210 million acquisition of SUSE Linux AG, the world’s second-largest vendor of Linux operating system software, as evidence that industry deals have changed to emphasize the pursuit of value. Novell previously bought Ximian Inc., a privately held Boston-based company that makes productivity software for Linux computers, so the SUSE transaction is a follow-on deal that strengthens Novell’s hand in Linux. Hot Sectors, Compelling Strategies Some of the sectors within the software industry that are generating the most deal activity, according to Bender, are security and storage. A bellwether deal in security during 2003 was the $26 million pickup of SafeWeb Inc. by Symantec Corp. The acquisition brings to the buyer, an experienced acquirer of specialized software, SafeWeb’s secure extranet appliance technology designed to reduce the cost and complexity of deploying, managing, and maintaining secure access to remote users. Bender says multiples are higher in security deals, reaching to 8 times trailing earnings, while he notes that there was only a 1.5 multiple for the average software deal in the third quarter of last year. However, the level increased from the 1.2 multiple of the previous quarter. One characteristic that differentiates the security sector is that sales often are driven by a pressing demand to protect assets. “If you’ve been hacked or have other reasons to believe your intellectual property is in danger, you’re going to get some protection right away,” Bender notes. Bender says that storage was another hot sector for deals. EMC Corp.’s $1.3 billion purchase of Legato Systems Inc. and Applied Micro Circuits Corp.’s acquisition of JNI Corp. are examples. Legato brings increased storage capacity to EMC, while JNI enhances Applied Micro’s offerings in storage area networks. But it was storage expert EMC’s second acquisition last year that may have signaled a shift to a more confident mode on the part of software buyers. Its $1.7 billion acquisition of content management provider Documentum Inc. was an attempt to meld the target’s content management software with the EMC’s native storage capacity. In Bender’s view, there are a few main strategic directions that will drive software m&a. One class of deals grows out of companies’ increased confidence that they can justify acquisitions within their own industry segments, although they remain reluctant to leap into new sectors, he notes. A second approach is to do a deal that increases market share by taking out a competitor. Still a third type of deal adds incremental technological capacity to buyers’ existing operations. Other types of deals he expects to see are those that extend the capability of a company’s core software product or that extend the company’s supply chain. Then there are deals that, in effect, hedge a company’s bets by leveraging the firm’s installed base through addition of functionality. Bender says that truly visionary deals have been rare, as more executives show willingness to pursue only one-step expansions but not “bet the farm” projects that leap across a few business categories. Another choice available to corporate strategists on the buy side is to be a consolidator, using acquisitions to gain critical mass and increase profitability. Conversely, there is a sell-side strategy in which a player in effect becomes a target by sprucing up the company to make it a desirable candidate for a larger concern. Either path can be pursued and, in fact, they aren’t mutually exclusive, experts say. Thus, a buyer can be taking a beautification route toward an eventual sale. A trickier option is to eschew external growth strategies and concentrate on being the best niche player possible. “If your specialty is parking lot management software, you’ve got to stick to your knitting and make sure you’re the best parking lot management vendor out there,” Hadley says. Valuations – Reality Sets In Any surge in software deals inevitably will be linked to what some experts are calling a return to realistic valuations on the part of sellers. “More people are coming to grips with the fact that the high multiples of the Bubble were an aberration. I think we’re going to see multiples in the next year or so that will resemble where they were in 93, maybe an average of three times revenue,” Green says. Private equity expert, Sandy Miller, a Managing Director at 3i Inc., says he is seeing buyers that are willing to take advantage of low valuations to make a move fairly early in the cycle in order to lock in a lower price. In describing the sentiment on the seller’s side of the table, Anderson says that software company owners are coming around to the fact that they have to live in the real world. “It’s a tough thing to realize that just because you put $50 million into the company, it’s worth a lot less now.” Anderson says he senses that investment bankers are now having to spend less time explaining to owners why their companies are worth only half as much as the founders think. From his perspective, the important thing about the increased acceptance of lowered valuations is that buyers now are appearing on the scene. “It used to be you would have these $50 million or less market-cap companies that were running out of cash, so the boards would start to consider a sale. But the question is, Where are the buyers?'” Anderson says. Conversely, in the current environment, buyers are starting to surface for more companies on the block. But Hadley notes that even as most players are beginning to accept the reality of more-modest pricing, there are still deals – if they are in the sweet spot of a hot sector like technology – that will fetch higher prices. He points to the sale of security services provider Cybershare that sold for just over 10 times revenue. Looking at private equity, Miller says he expects to see an increased rate of sales of portfolio companies in the next few years. Most of these companies had enough going for them to survive the downturn and are now ready to be sold, he says. Miller expects m&a to be the exit vehicle of choice for these companies. He says that while his firm expects to see what perhaps will be a six-month surge of IPO activity sometime in the next few years, m&a will be the predominant way that portfolio companies reach the market. The most likely buyers, he says, will be larger public companies that will be seeking bolt-on growth by acquiring companies that will allow them to leverage their customer relationships and expand their product offerings. Any analysis of private equity firms’ sales strategies, as well as their reinvestment plans, should include a point made by Green, which is that when there is a collapse in valuations in the public markets, there will be a corresponding decline in the values of private companies. This leaves them in the same boat as public companies when it comes to selling. However, financial buyers have one advantage over strategic buyers, which is that they can fund their purchases with cash rather than depressed stock. Dealmaking in a Smaller Sector While some software executives may miss the heady days of the Bubble, others see the period and the recession that followed it as a healthy part of the business cycle. “Larry Ellison (Oracle CEO) is wrong when he says software is dead. Nor is it going to be a total commodity going forward,” Mills says. While software experts agree that consolidation will occur, few think it will come to the point of the one- or two-company future prophesied by Ellison. The software industry is a much better place to work in than it was during the Bubble, Green says. It is just a smaller industry than people thought it was in 1999. But if there is a continuing thread from the Bubble era, it is a concern voiced by Mills. “If you take a cynical view of industry dealmaking, it would be that it is all designed to keep Wall Street interested in your company.” Even granting Mills’ worry that there is still a place for spin masters in the industry, the likelihood is that the companies that have survived the downturn will emerge as tougher and savvier competitors. And despite the software industry’s new maturity, the drive and innovations of the Bubble won’t be lost altogether. Bender says that because end users will always demand optimum functionality and ease of use, there will always be a place for innovative products generated by small vendors.