The year after the 9/11 tragedy was difficult for both publicly traded and early stage enterprise software companies alike. The following is a complete review and analysis of the software equity markets in 2002, including private equity deals, M&A, and general economic factors.
ECONOMY
A threatened war with Iraq, continuing concerns about domestic security, sharply reduced corporate spending, public company accounting scandals and increased unemployment, all took their toll on the economy in 2002. Businesses largely hunkered down, leaving consumers, who account for roughly 2/3rds of U.S. Gross Domestic Product (GDP), at the helm. Forty-year-low mortgage rates and zero interest rates provided much of the incentive for consumers to push real GDP upward 3%. Recent indications of weakening consumer confidence have raised some concern, but analysts' project continued resilience from consumers as income growth and tax cuts offset increased personal debt and escalating energy prices.
On the business front, capital investment declined precipitously as businesses focused on cutting overhead, shedding excess inventory and eliminating non-core operations. That said, many sectors now appear to have worked through their issues, and year-end reports show improvements in earnings and fewer workers laid off. Other encouraging signs: By the end of 2002 temporary staffing agencies added 14,000 workers to the workforce, and the manufacturing workweek grew by 0.3 hours, measures which are often precursors to stronger employment trends.
Overall, the US economy appears somewhat stronger today than it did a year ago, but remains on fragile ground, vulnerable to a host of economic and geopolitical threats.
CAPITAL MARKETS
U.S. markets ended the year on an upswing, with the Dow, Nasdaq and S&P 500 climbing 7.5%, 8.3% and 5.6%. For the year, these same indices were down 17.2%, 32.5% and 23.8% (see Figure 1).
While the broader market indices showed improvement in the fourth quarter, the software industry remained flat relative to the third quarter. The median price to revenue multiple for the SEG Sixty, our software industry public company index, was 1.5x (see Figure 2). The average was 2.0x, with 80% between 1.8x and 2.3x. When compared to the first quarter, the median revenue multiple declined 54.8%. The fourth quarter median price to earnings ratio was 30.5x.
Figure 1: 2002 Performance of Stock Market Indices
Not surprisingly, providers of security software faired the best during the fourth quarter. The median price to revenue multiple within this sector grew 19.1% to 3.0x. The information/data management sector increased 6.1% to 1.7x. Customer relationship management (CRM) and enterprise application integration (EAI) businesses were hit the hardest, falling 26.9% to 1.1x and 23.8% to 1.2x, respectively. Conservative IT expenditures continued to characterize enterprise spending in the fourth quarter, with CIO's favoring high priority solutions with an identifiable short-term ROI.
Figure 2: Software Industry Median Multiples by Sector
For 2003, Goldman Sachs projects 5% growth in enterprise IT spending with the majority spent on security, wireless LAN connectivity, Windows OS and storage management. EAI, network management software and supply chain management are also expected to increase.
INITIAL PUBLIC OFFERINGS
Initial public offering (IPO) activity declined further in 2002, as would-be candidates eschewed the weak and volatile public markets. IPOs fell to a two decade low to seventy-five, raising an aggregate $22.6B, the lowest dollar amount since the early 90's.
Healthcare led the IPO market with the largest number of offerings, at seventeen. The telecomm sector, which saw one-hundred-eleven in 2000 and five in 2001, had none. Only five software companies went public in 2002, and as a group lost an average 26% of their offering price by year-end.
Figure 3: U.S. Initial Public Offerings
Among the software companies that braved the IPO market, Altiris, a provider of corporate and IT asset management software, and Verint Systems, a provider of analytic software for communications interception, video surveillance and business intelligence, saw their stock prices hold up well. At year-end, Altiris and Verint were up 47% and 27%, respectively, from their offering price. Plumtree and Printcafe were not so fortunate. Corporate portal software provider Plumtree fell 60% and Printcafe, which provides printing industry supply chain software solutions, declined 89%.
Software companies Accpac International, Bentley Systems and Silicon Energy withdrew their planned IPOs in 2002. However, Accpac, a provider of business management software, did reregister late in the year. Accpac joins InterVideo, a provider of digital video and audio software, as a 2003 IPO candidate.
PRIVATE EQUITY
2002 U.S. venture capital investment returned to 1997 levels according to PricewaterhouseCoopers/ Venture Economics/National Venture Capital Association MoneyTreeTM Survey. For the year, the number of companies funded declined by 36% while dollars invested fell 49%, with $21.2B invested in 3,016 companies. This compares to $41.3B invested in 4,712 companies in 2001. The average investment fell 20%, to $7M.
Life sciences, which includes biotech and medical devices, received the lion's share of VC funding, accounting for 22% of the total, or $4.7B. Up 13% from 2001, this was the only growth sector. Of the $4.7B invested, 57% went into biotech and the remainder into medical devices.
Software continued to be the industry sector attracting the most VC equity investment in 2002, with 799 companies funded (26% of the total). Relative to 2001, the number of software industry VC investments declined 20%. In dollar terms, $4.3B was invested in software businesses in 2002, compared to $8.1B in 2001 and $17.3B in 2000 (see Figure 4).
Figure 4: Software Industry VC Investments
2002 saw VC investment focus shift from early stage entities to more stable later stage companies. Thomson Venture Economics indicates that for every dollar invested in new financing in 2002, four dollars were invested in follow-on deals. In 1999, two and one-half dollars were invested in follow-on deals for every dollar of new financing. MoneyTreeTM reports that 19%, or $817M, of all VC dollars invested in 2002 went to early stage companies. 21% of the $817M went to early stage software companies within the software sector.
MERGERS & ACQUISITIONS
Figure 5: U.S. Merger & Acquisition Activity
2002 was a difficult year overall for M&A. MergerStat reported a total of 7,387 U.S. transactions for $441B, down from 8,545 deals for $683B in 2001. Transaction volume approximated 1997/1998 levels, while aggregate transaction value returned to 1993 levels (see Figure 5).
Weakness in the M&A market was largely attributable to declining equity markets, cautious debt markets and global uncertainty. Additionally, M&A was not a strategic priority in 2002, with many potential buyers focused on reducing costs and growing earnings in order to shore up declining stock prices. Public buyers were also increasingly conservative in the face of greater scrutiny from their shareholders. Many prospective sellers, in turn, have chosen to sit on the sidelines until the economy, capital markets and seller valuations improve.
Software was the most active M&A category in 2002 with 1,347 deals, or 18% of the total (see Figure 6). In dollar volume, life sciences was the dominant sector at $72B, which was comprised primarily of Pfizer's $60B stock purchase of Pharmacia. The aggregate transaction value within the software sector was $29B, which equates to an average purchase price of $21.5M. Venture Reporter indicates that 22% of all software M&A transactions were in the range of $10M to $24M, with 26% below this range. "Mega-deals" were limited, with only 18% over $100M.
Figure 6: U.S. Sector Specific M&A Activity
Software company M&A valuations, as a multiple of revenue, remained fairly constant throughout 2002. We analyzed three-hundred-sixty-two acquisitions and determined revenue multiples for more than one hundred. For the group, the median purchase price was 2.0 times the sellers' trailing twelve-month revenue. On a quarterly basis, revenue multiples ranged from a low of 1.9x during the first quarter to a high of 2.2x during the second. The median multiple was 2.0x for the third and fourth quarters. Private sellers received a median revenue multiple of 2.2x, while their public counterparts came in at 2.0x. Though this may seem counterintuitive, as private companies typically sell for a discount due to their lack of liquidity, it reflects the large number of struggling public companies which sold at "fire sale" prices in 2002. Multiples are based on the equity purchase price and therefore do not factor in the buyers' assumption of the acquired companies' cash or interest bearing liabilities. Median revenue multiples by software industry sector for M&A transactions were as follows (see Figure 7):
- Accounting/finance, 2.7x
- Customer relationship management, 1.4x
- Data/information management, 2.6x
- Developer tools, 3.4x
- Education/training, 2.2x
- Enterprise systems management, 3.4x
- Enterprise resource planning, 1.4x
- Security, 4.5x
- Storage management, 3.3x
- Supply chain management, 0.8x
Figure 7: Software Industry Median M&A Multiples*
Cash remained king during the fourth quarter, particularly among buyers with strong balance sheets who refused to use deflated stock as currency. 65% of buyers used cash, 14% used stock, and 21% a combination of cash and stock. For the year, 53% of acquisitions were funded with cash, 24% with stock and 24% with cash and stock. Unsurprisingly, this is a substantial change from 2001, when stock was the prevalent currency (see Figure 8).
Figure 8: Software M&A - Form of Payment
Buyers were cautious and more narrowly focused in 2002. Few relied upon acquisitions to fundamentally alter their business models or markets. Rather, acquirers were much more tactical, targeting small and midcap companies which complemented their core businesses by filling product, technology and market gaps. The vast majority of those companies which were acquired boasted significant numbers of customers, recurring revenue and positive EBITDA. Representative transactions included Cognos/ Adaytum, John Harland/ SPARAK and BARRA/ Financial Engineering Associates.
Entering 2003, we anticipate a modest 10% increase in M&A activity as more buyers re-enter the market following successful efforts to shore up revenues and reduce costs. Complementary small and midcap software companies which provide short-term incremental revenue and accretion will continue to be the preferred choice for acquirers.
Sellers that spent 2001 and 2002 on the sidelines, waiting for the financial markets to improve, will begin to emerge as they become more comfortable with the economy and current valuations. The ongoing need for R&D investment, capital constraints and increased competition will also drive some sellers to seek strategic leverage through merger.
The venture capital community will also spur M&A activity in 2003. After spending the better part of two years divesting poor performers, investing in stable later stage businesses and shoring up their healthier portfolio companies, VCs are more receptive today to exit, despite lower valuations. Many have concluded that a modest exit can have a positive impact on a fund's battered IRR. VCs are also coming to grips with the extraordinary difficulty of achieving rapidly accelerated growth in the current market. We believe the IPO market will remain closed in 2003 to all but the strongest performers, which also favors M&A as a preferred exit path for many VCs.
Finally, we expect to see a continued trend of public companies going private, a common theme in the second half of 2002. Examples include Industri-Matematik, Prophet 21 and Riverdeep. Factors driving this trend include the extensive reporting requirements and liabilities imposed by the Sarbanes-Oxley Act, the significant expense of being a small or midcap public company and lower valuations which afford opportunities for management-led buyouts.
Reports from the Wall Street Journal, RBC Capital Markets and U.S. Bancorp Piper Jaffray support our assessment of increased M&A activity in 2003. The Wall Street Journal projects a 5% to 10% increase in the broader M&A market, driven by flat technology spending and a nonexistent IPO market. Security, storage management and systems/application management will continue as hot categories within the software sector.
Ken Bender is founder and Managing Director of Software Equity Group. He is a frequent guest speaker at industry conferences such as Comdex, SoftExpo, Culpepper, VAR Conference, and many others. Software Success called him the nation's 'leading expert in small and madcap M&A'. He can be reached via email at: kbender@softwareequity.com.
Allen Cinzori is an Associate with Software Equity Group and holds an MBA from the University of Southern California. He has held previous positions with Yride.com and Verizon. He can be reached via email at: acinzori@softwareequity.com.