Contrary to the overall economy, the software industry showed some encouraging signs over the quarter. For the first time since we began tracking the SEG-SEVENTY, our software industry public company index, the index recorded positive growth. However, M&A activity, which strongly correlates with the economic environment, faced its share of challenges during the quarter, slowing considerably as world affairs put many buyers and sellers on a temporary holding pattern.
Among the various industry groups, software continues to be M&A's crown jewel, and buyers continue to seek small and midcap companies with strong financials, technology/market leadership, solid customer bases and product assortments that the buyer can leverage to obtain immediate incremental revenue and earnings.
Moving into Q2, we continue to forecast a 10% increase in software M&A for the year, as U.S. economic growth, increased competitive pressure and the Software Fortune 50's growing interest in the midmarket serve as catalysts.
ECONOMY
The overall U.S. economy remained lackluster for much of the first quarter, "frozen" by the beating drums of war. Public markets, which showed promise at the start of the quarter, were 15% off their peak by mid-March as uneasy investors reacted to increased geopolitical uncertainty (see Figure 1). By quarter-end, the Nasdaq, Dow and S&P 500 were down 3.0%, 7.1% and 6.7%, but remained above October's lows.
Underlying the market indices, major economic indicators illustrated some of the challenges present in the U.S. economy. Gross domestic product (GDP), the speedometer for the U.S. economy, decelerated slightly from the 2.4% pace it set in 2002 to approximately 1.7%, as rising energy prices, sluggish business expenditures and flat retail sales took their toll. Businesses and consumers cited geopolitical uncertainty as a major factor for their subdued spending. Unemployment remained relatively flat, ending the quarter at 5.8%.
Looking forward, many analysts are conservatively optimistic, forecasting 2.1% GDP growth in Q2 and 3.7% during the second half of the year. Recent economic releases from the consumer sector, which accounts for roughly 2/3rds of U.S. GDP, support their outlook. Retail sales jumped 2.1% in March, the biggest gain in seventeen months, and Consumer Sentiment faired very well late in the quarter, largely due to the coalition's successes. The Central Bank continues to insist that growth will pick up upon resolution of events in Iraq.
Somewhat surprisingly, the software industry showed some very encouraging signs over the quarter (see Figure 2). For the first time since we began tracking the SEG-SEVENTY, our software industry public company index, the index recorded positive growth, adding 16% to its Q4 2002 market value. The index's median revenue multiple increased 15% to 1.8x and the median earnings multiple grew 10.2% to 34.2x. Median revenue multiples for each sector were:
- Business Intelligence (BI), 2.6x
- CAD/CAE, 2.0x
- Customer Relationship Management (CRM), 1.1x
- Developer Tools (DT), 3.1x
- Enterprise Application Integration (EAI), 1.6x
- Enterprise Resource Planning (ERP), 1.6x
- Information / Data Management (IM), 1.9x
- Security, 2.4x
- Supply Chain Management (SCM), 1.7x
The first quarter also reinforced a trend highlighted in our Q3 2002 Report - the larger and/or more profitable the public software company, the higher the valuation as a multiple of revenue (see Table 1).
MERGERS & ACQUISITIONS
M&A activity, which strongly correlates with the current economic climate, slowed considerably in the quarter, as world affairs placed most buyers and sellers in a holding pattern (see Figure 3). Relative to the fourth quarter, the number of transactions fell 21% and aggregate dollar value declined by 25%. Should the economy continue at the current rate, 6,244 deals would close at an aggregated $290B in 2003.
Among the various industry groups, software M&A continues to lead all other sectors. Software accounted for 272 deals, approximately 17% of U.S. M&A activity (see Table 2). Software buyers continue to seek small and midcap companies with strong financials, technology/market leadership, solid customer bases and product assortments which the buyer can leverage to obtain immediate incremental revenue and earnings.
Acquirers spent $4.7B on software businesses during the quarter, at an average purchase price of $17.3M, a 10% reduction from Q4. The cause? Fewer "mega" deals, increased buyer interest in small and midcap niche or vertically focused businesses, and a number of "fire sales" at depressed valuations.
Unlike, the SEG-SEVENTY, which experienced a 15% increase in value when measured as a multiple of revenue, the median software M&A multiple fell to 1.1x, from 2.0x (see Figure 4). However, we believe this decline is an aberration, as the first quarter saw a significant reduction in the number of strategic acquisitions and a disproportionate number of asset purchases out of bankruptcy - examples include Primavera's acquisition of Evolve and Amdoc's purchase of Exchange Applications. Moving forward, we anticipate that M&A valuations will enjoy a premium over the public markets, as has historically been the case. A closer look at Q1's more strategic acquisitions reveals that healthy valuations still exist for the right opportunities.
- Cisco / Okena; est. revenue multiple: 25.7x
- Microsoft / Placeware; revenue multiple: 5.6x
- Itron / Silicon Energy; revenue multiple: 4.7x
No surprise, cash remains king. Cash continues to be the preferred acquisition currency as many buyers maintain the view that their stock is undervalued (see Figure 5). 70% of buyers used cash - an 8% increase over the previous quarter, 17% stock, and 13% used a combination of the two.
M&A: Most Active Software Sectors
Computer aided engineering, CRM, security and SCM were the most active categories during the first quarter. Representative transactions include:
Computer Aided Design / Engineering - ANSYS / CFX
- Bentley Systems / Infrasoft Corp.
- Intergraph Corp. / Pelican Forge Software Corp.
Customer Relationship Management - Convergys Corp. / Cygent
- Skywire Software / Attenza
- The Cobalt Group / Cowboy Corp.
Supply Chain Management - Click Commerce / Allegis Corp.
- RiverOne / Softchain
- SEEC / Assets of Asera
Security / Firewall - Cisco Systems / Okena
- Network Associates / Deersoft
- Tumbleweed Communications Corp. / Valicert
While there was a heterogeneous mix of active software categories, Energy/Utility and Government/ DoD were certainly the dominating industry verticals, comprising approximately 8% and 10% respectively, of the acquisitions we identified during the quarter.
Energy / Utility - Excelergy / Forwardmarket
- Indus Int'l / SCT's GEUS Business Unit
- Itron / Silicon Energy
- Lodestar Corp. / Advanced Utility Solutions
- SunGard Data Systems / Caminus Corp.
- SunGard Data Systems / HTE
- TRADEPAQ / Lester Associates
Government / Department of Defense (DoD) - Boeing / Conquest
- General Dynamics / Creative Technology
- ManTech Int'l Corp. / Integrated Data Systems
- Perot Systems Corporation / Soza & Company
- SAIC / SCIENTECH
- SAIC / VGS
- SFA / Analysis Corp.
- SRA Int'l / Adroit Systems
- Zanett / Paragon Dynamics
M&A: Most Active Buyers
As the following indicates, Cisco led the quarter with the largest transaction, and was joined by Hummingbird, Microsoft, Open Text and SunGard as one of the more acquisitive companies.
Cisco Systems - Linksys Group, $500M
- SignalWorks, $13.5M
- Okena, $154M
Hummingbird - Key Automation/Dispro, ND
- LegalKEY Technologies, ND
Open Text Corp. - Corechange, $4.2M
- Eloquent, $6.7M
SunGard Data Systems - HTE, $121M
- Caminus Corp, $159M
Overall, it was a challenging quarter for M&A. Moving into Q2, we continue to forecast a 10% increase in software M&A for the year, as U.S. economic growth, increased competitive pressure, and the Software Fortune 50's growing interest in the midmarket serve as catalysts. Further, our experience indicates buyers have begun to transition away from cost cutting initiatives and are showing more receptivity to growth opportunities. This is good news for sellers that may be considering an exit.
CONTACT INFORMATION
Software Equity Group, L.L.C.
12220 El Camino Real, Suite 120
San Diego, CA 92130
www.softwareequity.com
p: (858) 509-2800
f: (858) 509-2818