By Ken Bender, Managing Director, and Allen Cinzori, Vice President - Software Equity Group, LLC
ECONOMY
The U.S. economy showed continued strength in the second quarter, but not all signs were positive. Gross Domestic Product (GDP), a key economic indicator and broadest measure of economic activity, is projected to grow at a healthy annualized rate of 4.4% in 2Q04. First quarter GDP, however, was revised downward by 0.5% to 3.9% due to weaker exports and a decline in business spending (Figure 1). According to a midyear survey of 55 forecasters by The Wall Street Journal, economists are moderately bullish on the economy's prospects, projecting 4.4% growth in 3Q04 and 4.2% in 4Q04. Personal consumption, exports, equipment and software expenditures, inventory investment and federal government spending are likely to be the key drivers. Industrial sector growth is expected to outweigh consumer-related growth.
The Conference Board's index of leading economic indicators, which gauges the economy's likely performance over the next three to six months, also forecasts a robust economy and continued expansion. The index, which grew 0.1% in April and 0.5% in May, has advanced 13 of the past 14 months. May results reflected an increase in eight of the 10 indicators used to derive the index, with consumer confidence and stock prices the only exceptions. The Board's index of coincident indicators, a gauge of current economic activity, rose 0.3% in May and an equivalent amount in April. The index tracks payrolls, incomes, sales and production. After dropping in May, consumer confidence took a surprising leap in June, reaching the highest level since mid-2002, as consumers became more confident in a sustained economic recovery.
Despite this positive news, rising interest rates, skyrocketing oil prices and fuel costs, the war in Iraq and looming U.S. Presidential elections cast their shadow on the economy and set a sober tone on Wall Street. The Federal Reserve, to no one's surprise, raised the federal funds rate 25 basis points to 1.25% to check inflation and keep the economy from overheating. The funds rate had been at 1% since early 2003 - its lowest level since 1958 - as the Fed fought to stimulate an economy battered by a plunging stock market, a recession, terrorist attacks and war. Most economists expect a series of fund rate increases in the coming months, likely reaching 2% by the end of 2004 and 3% by mid- 2005, according to the Bond Market Association's economic advisory committee. High by today's standards, but a far cry from the 6.5% the Federal Reserve instituted in 2001 to slow an "irrationally exuberant" economy.
Although the economy has continued to expand, generating 1.2 million new jobs this year, June's unemployment numbers generated renewed concerns about the health of the labor force. Employers added 112,000 new payroll jobs, considerably fewer than the 250,000 that economists forecasted. Unemployment remained unchanged at 5.6% for the third month. Still, June's increase was the 10th consecutive monthly improvement.
PUBLIC MARKETS
The combination of continuing economic growth, corporate profits, mixed employment signals, interest rate uncertainty, high oil prices and geopolitical instability was almost more than Wall Street could handle. U.S. Markets ended a volatile first half on a slightly positive note, with the Dow, Nasdaq and S&P 500 up 0.3%, 2.1% and 3.0%, respectively. For the quarter, these same indices were up 0.1%, 1.6% and 0.6%, respectively. Market Caps of the SEG-100, our index of public software companies, lagged for most of the second quarter, but improved in June to close up 7.3% over the first quarter and 0.8% relative to the beginning of the year (Figure 2). Other key 2Q04 measures for the SEG-100, including comparisons with the prior quarter, are enumerated in Figure 3.
On a trailing-twelve-month revenue (TTM) basis, after factoring in 1Q04 (the latest reported quarter as of this writing), overall financial performance of the SEG-100 improved, in large part due to new license revenue. Median TTM revenue increased 3% in 2Q04 compared to 1Q04, while TTM earnings increased 14.6% over the same period (Figures 4 and 5).
The growth in both revenue and earnings typified companies in every software category. On a TTM basis, revenue growth was strongest in storage management (+7.7%) and business intelligence (+7.3%) with customer relationship management (+0.1%) and CAD/CAE (+0.9%) lagging far behind. Enterprise system management providers increased TTM earnings 57.8%, leading all categories, while business intelligence realized the most modest increase (+0.7%) (Figure 6).
Early reports of 2Q04 revenue by a dozen leading vendors, however, cast a shadow on an otherwise sunny picture. Veritas projected 2Q04 revenue in the $475 to $485 million range (vs. an expected $480 - $505 million) and Sybase estimated 2Q04 revenue would come in at $188 - $192 million (vs. $199 million consensus). Even bigger shortfalls were signaled by Siebel, which estimated its 2Q04 revenue would be $301 million rather than $353 million, as well as BMC ($318 - $ 328 million vs. $345 - $355 million expected) and Compuware ($286 million vs. $313 million). Conversely, SAP reported software sales rose 15% (to $614 million) in the quarter, exceeding analysts' expectations. Cognos and Lawson, which closed their most recent quarters on May 31 also exceeded Wall Street's expectations.
We do not see the revenue shortfall of some as cause for alarm, or as a portent for the remaining two quarters. First, many companies met or exceeded expectations. Second, 1Q04 was an extraordinary quarter which compelled some to set the bar for the following quarter unrealistically high. Though investors were disappointed, it's important to note 7 of the 11 companies which were hammered for missing their 2Q04 estimates expect to report revenue equal or greater than in 1Q04. Further, 2Q04's revenue hiccup was a function of IT spending patterns, rather than IT budget cuts. Recent surveys continue to indicate IT spending will increase in the coming months (see below). And finally, 2Q04 likely reflects the recent imposition of more stringent revenue recognition policies by many of these vendors.
The markets had fewer concerns about the very largest software vendors (Figure 7). Companies with TTM revenue in excess of $1 billion posted a median 3.7x EV/Revenue ratio compared to a median 2.0x ratio for software companies with revenues less than $1 billion. Investors also remained focused on earnings. The median valuation of SEG 100 companies posting profits in 2Q04 was 3.1x, but only 1.9x for those reporting losses (Figure 8).
IT spending, a precursor of future software industry financial performance, continued to rebound in 2Q04 and appears poised for further gains in the months ahead. CIO Magazine's Tech Poll, which surveys CIOs in a broad cross section of industries, projected an 8.2% increase in IT budgets in the coming 12 months. According to the survey, much of the spending will be focused on security software, computer hardware, storage management systems, data networking, telecom equipment, eBusiness applications and infrastructure software. Security software, computer hardware and storage systems represent the strongest growth areas with 58%, 56% and 53% of respondents indicating increased budget allocations.
Equally encouraging was Goldman Sachs' May IT spending survey, which indicated 55% of CIOs expect tech capital spending to increase in 2004 by 2.4%, up significantly from the 0.9% projection of December 2003. While less optimistic than CIO Magazine's Tech Poll, the survey projects steady growth in IT spending for both software and hardware. Longer-term, CIOs are anticipating a 5.6% increase. Security, storage management and remote connectivity remain top priorities (Figure 9).
The IPO market, spurred by Google, saw more activity than anytime in the past 4 years. A total of 127 companies filed for initial public offerings in 2Q04, up sharply from the 85 registration statements filed in 1Q04. 2Q04 saw 3 software companies begin trading (Salesforce.com, Blackboard, Motive) as well as 12 new software IPO filings. The trend is a welcome improvement over 1Q04 which had 7 filings and no software companies that began trading. Salesforce.com, a customer relationship management software provider, was the story of the quarter closing its first day of trading up 56% from its offering price despite the company's earnings restatement.
MERGERS & ACQUISITIONS: THE TRENDS
Half-way through the year, three overriding trends in software mergers and acquisitions are discernable:
1. Logical, incremental acquisitions. Buyers today are laser focused, more so than ever before. Virtually every public software company, and every venture-backed software company pursuing growth through acquisitions, has a well-defined acquisition strategy and is sticking to it. "Over the transom" deals are few and far between. Potential sellers able to articulate a compelling value proposition to a prospective acquirer will find it falls on deaf ears, unless the buyer has already had the same thought. Conversely, buyers are increasingly frustrated at the inability to find viable candidates that wholly satisfy their acquisition parameters.
What, precisely, are these acquisition parameters? Are there certain themes buyers today share in common? Indeed. Approximately 2 out of 3 (63%) of the 187 software transactions we analyzed in 2Q04 were deemed "Product Extensions", meaning the buyer sought an almost perfect strategic fit with its current offering and target market (Figure 10). In virtually every case, the acquired company offered highly synergistic products and compatible, incremental, value-added technology. Examples include Symantec's acquisition of high flying anti-spam software developer Brightmail; BMC's purchase of Marimba, a leader in change and configuration management; and workforce management provider WorkStream's acquisition of Kadiri, a compensation management software company. Interestingly, these Product Extension acquisitions comprised precisely the same percentage of all transactions in 2Q04 as they did in 1Q04, with most buyers simply refusing to venture far from home.
Only one in ten buyers proved more adventurous in 2Q04, with just a handful of buyers willing to acquire their way into a new vertical market (3%), new geography (2%), or a new software product category (6%). Examples include Cyberguard's acquisition of German security solutions provider Webwasher; Compuware's acquisition of IT governance software developer Changepoint; and Fair Isaac's acquisition if UK-based banking software provider London Bridge. The current dearth of new market/new category deals represents a significant retrenchment in buyer thinking. In 4Q03, these new market / new category buyers comprised almost 20% of all acquisitions.
2. Heightened activity. The number of software transactions has increased quarter-over-quarter for the past nine months and the software M&A market is gaining momentum. Software company buyers, buoyed by increased IT spending, solid revenue growth and improved profitability, are once again acquisition minded. We reaffirm our January forecast of a 10% year-over-year increase in transactions for 2004, but the number could go considerably higher. Gating factors include concerns about the economy enumerated earlier and the current refusal of most buyers to acquire outside their comfort zone. Consider, also, there are simply fewer buyers today than four years ago as a result of continuing industry consolidation, the demise of many Bubble Era public software companies and far fewer software IPOs. For the first time in a long time, demand has outstripped supply, but only for companies with technologies, products and markets deemed highly strategic by acquirers.
3. For the chosen, high valuations. When buyers do fall in love, however, money is no object. The median software company M&A valuation (based on equity purchase price), reached 2.9 times trailing-twelve-months (TTM) revenue in 2Q04, more than double the median M&A valuation one year ago, and a noteworthy improvement over 1Q04's 2.3x (Figure 11). In a move reminiscent of the Bubble Era, Symantec acquired Brightmail, which had filed an initial public offering registration statement, for an amount roughly equivalent to (some believe greater than) the anticipated IPO net proceeds. Though few transactions could match the 14.2x multiple Symantec paid for Brightmail, Mercury Interactive came close in acquiring Appilog for $49 million, which we estimate represents a 12x multiple. Other transactions apparently deemed truly strategic by the buyer included Compuware's acquisition of Changepoint (5x); BMC's acquisition of Marimba (4.6x); and SteelCloud's acquisition of V-One (4x).
There were fewer industry consolidation plays in 2Q04 than the previous quarter, but that may change shortly. The Oracle vs. Justice Department trial in San Francisco is providing a unique opportunity to observe the world's largest software providers as they formulate backroom strategy. Each seeks to increase the control it exercises over enterprise customers by aggressively expanding its platform to broadly encompass both applications and infrastructure. Microsoft, fearful that rival IBM would acquire SAP if Oracle was successful in taking over Peoplesoft, a key IBM's business partner, is apparently considering a possible run at Peoplesoft itself, after giving some thought to acquiring SAP. Undaunted by the backlash from its Peoplesoft takeover attempt, Oracle also appears interested in such "potential targets" as BEA Systems, Business Objects, Siebel and Lawson. In response, IBM has expressed interest in gaining more control over the software sector, either by direct investment in the likes of Peoplesoft or through outright acquisitions. It's beginning to sound like a Tom Clancy novel.
Industry consolidation is practically a law of nature. However our somewhat contrarian view is that consolidation among the industry's largest players will not occur on the scale many predict. The largest enterprise, government and institutional customers, still smarting from huge ERP and CRM investments which did not yield the anticipated ROI, will vigorously resist being dominated by a few players that control both applications and infrastructure. Other negating factors include clashing egos, reluctant Boards, relatively high current valuations, the prospect of massive layoffs and a historically poor track record for industry mega-mergers.
Always interesting is the ebb and flow of M&A activity among different software product categories. There was a flurry of activity in enterprise resource planning. Customer relationship management software companies were also popular targets, accounting for 9% of all 2Q04 software M&A activity (Figure 12). Business technology optimization (a subcategory of enterprise system management) was a "must have" for many of the leading tools and infrastructure players, with 5 deals this quarter. IBM bought BMC competitor Candle Corp. for an estimated $475 million prompting BMC to respond by acquiring Marimba, not a month later, for $186 million. Business process management (a/k/a business activity monitoring or business performance measurement), is also attracting attention from buyout firms and business intelligence software providers. We counted 2 deals in this space during the quarter (Onyx/Visuale and Tibco/Staffware).
Expectedly, security software remains one of the most active acquisition arenas. An array of security software vendors were targeted and acquired in 2Q04, including Brightmail/Symantec, Webwasher/Cyberguard, V-One/SteelCloud, Magnifire/F5 Networks and Trio Security/Symbol Technologies.
MERGERS AND ACQUISITIONS: THE NUMBERS
U.S. merger and acquisition activity in the second quarter of 2004 showed improvement over the equivalent quarter a year ago, and exit valuations continued to ramp. Domestic M&A activity in 2Q04 across all industry sectors totaled 2,517 deals aggregating $153 billion (Figure 13). Relative to 2Q03, the number of deals increased by 18%, while total dollars spent increased 39% over the same period. At the current run rate, 9,980 deals aggregating $769 billion will close in 2004.
Software continued to lead all other industries with 425 transactions, representing approximately 17% of all U.S. M&A activity this quarter (Figure 14). Acquirers spent $8 billion on software businesses in 2Q04, seemingly a precipitous decline in M&A dollar volume when compared to the $15.4 billion recorded in 2Q03. But with no mega-deals (> $1 billion) in 2Q04 and 3 mega-deals in 2Q03 totaling $12.7 billion, it's clear substantially more dollars are being spread across a significantly greater number of transactions. Median software company exit valuations have now increased quarter-over-quarter for six consecutive quarters. The median software company M&A valuation (based on equity purchase price), reached 2.9 times trailing-twelve-months (TTM) revenue in 2Q04, more than double the median M&A valuation of one year ago, and a noteworthy improvement over 1Q04's 2.3x (Figure 11).
With stock prices giving up little of their 2003 gains, stock continued to be a popular form of deal currency. Public companies appeared eager to use their higher priced stock to finance acquisitions, and sellers saw sufficient upside to gamble. As a result, stock comprised all or part of the deal consideration in 58% of 2Q04 transactions, as contrasted with 33% of buyers who took stock in 2Q03. Stock-only deals comprised 26% of 2Q04 transactions, compared to 22% in 1Q04 and 18% in 2Q03 (Figure 15).
MERGERS AND ACQUISITIONS: MOST ACTIVE BUYERS Multi-transaction buyers proliferated in the first quarter, but decreased in the second quarter of 2004. Some of the quarter's most active buyers:
Autobytel.com
- iDriveonline
- Stoneage
- Alopa Networks
- Stargus
- newGov
- RedHand
- Candle
- Schlumberger (Business Unit)
- 0-In Design Automation
- Atair GmbH
- EZ2
- Ezyte
- Dejima
- XcelleNet
- Kadiri
- PeopleView (HCM Tools division)
This report was prepared by Software Equity Group, L.L.C. (SEG), a mergers and acquisitions advisory firm serving the software, life science and technology sectors. SEG is solely responsible for its content. This material is based on data obtained from sources we deem to be reliable; it is not guaranteed as to its accuracy and does not purport to be complete. This information is not to be used as the primary basis of investment decisions. For more, please visit www.softwareequity.com, or phone (858) 509-2800.
