By Ken Bender, Managing Director, and Allen Cinzori, Vice President - Software Equity Group, LLC
ECONOMY
The economy continued to show signs of recovery in Q3, as stock market indices, public company valuations and economic activity barometers all improved. The S&P 500, NASDAQ and Dow slowed and stumbled a bit, but still closed up 2%, 10% and 3% in Q3. Year-to-date, the S&P 500, NASDAQ and Dow are up 13%, 33% and 11%, respectively (Figure 1). And what a difference a year makes. Relative to October 2002, these indices increased 28%, 60% and 27%, respectively.
Most encouraging was the unexpected growth in Gross Domestic Product (GDP). Rather than the 1.4% GDP increase that was predicted, Q2 GDP came in significantly higher at 3.3%. Economists are now anticipating an even healthier third quarter, with GDP estimated to improve by 5% (Figure 2). Another respected economic barometer, The Conference Board's index of ten leading economic indicators, continued upward in Q3, advancing 0.6% in July and 0.4% in August. The CB index is up 2.5% from its March low - further evidence of a strengthening economy in H2.
Investors and economists were also encouraged by September's employment figures which show businesses adding jobs for the first time in eight months. Nevertheless, only some 57,000 jobs were added and the U.S. unemployment rate remained at 6.1%, after declining from a 2003 high of 6.4% in June 2003.
The software industry generally kept pace with the broader market. The average market value of the SEG-SEVENTY, our index of public software companies, climbed 19% in Q3, on the heels of a 10% increase in Q2 (Figure 5). Other major Q3 market indices for the SEG-SEVENTY:
- Median revenue multiple for the group grew 17% to 2.5 times trailing-twelve-month (TTM) revenue
- Median PE climbed 14% to 33.1x
- Median multiple of EBITDA was 21.0x
- Average operating profit margin before depreciation, interest and taxes was 16.7%
- Average revenue multiple for the SEG-SEVENTY was 3.1x, and the corresponding confidence interval at 80% was 2.8x to 3.5x.
- Measuring enterprise value (adding debt and deducting cash and cash equivalents) the median EV to TTM revenue ratio was 1.7x.
The markets continued to disproportionately reward the industry's largest players - those public software companies with the greatest revenue. For the 21 software companies in the SEG-SEVENTY with revenue between $200 million and $1billion, the Q3 median revenue multiple, a key valuation measure, was 2.6x, but only 2.3x for those with revenue below $200 million. Companies with revenue in excess of $1 billion, however, boasted a median revenue multiple of 4.3x in Q3. The difference is even more startling on a PE basis. Companies with revenue between $200 million and $1 billion were valued at a median PE of 42.3x versus 30.2x for those with revenue less than $200 million.
Investors, buoyed by signs of improvement in the general economy, justified the run-up in public software company stock prices and valuations by claiming public software companies are currently undervalued "if the market fully recovers." Perhaps. But the present reality doesn't support the run-up. Despite an improved economy, software company revenues continue to decline. And despite nearly three years of cost cutting, software company earnings are faring even worse. During the past twelve months, median revenue of the SEG-SEVENTY actually declined 8.3%, and median earnings fell a whopping 40.7% (Figure's 3 and 4).
Looking forward, IT spending, an important barometer for improved tech sector growth, is expected to improve in 2004 according to recent IT spending surveys by Goldman Sachs and Gartner. Goldman forecasts a 2.3% increase over 2003. Merrill Lynch remains slightly less optimistic, predicting improved growth in late 2004, or 2005.
Software sector focus remains a key determinant of public software company valuation, as it has for the past three years. However Q3 showed marked change in certain sector valuations. All sectors, with the exception of Supply Chain Management and Customer Relationship Management, showed improvement over Q2. SEG-SEVENTY median revenue multiples by sector for Q3 were:
- Business Intelligence (BI): 3.4x
- CAD/CAE: 2.2x
- Customer Relationship Management (CRM): 1.5x
- Developer Tools (DT): 3.2x
- Enterprise Application Integration (EAI): 2.5x
- Enterprise Resource Planning (ERP): 2.4x
- Information / Data Management (IM): 2.5x
- Security: 3.6x
- Supply Chain Management (SCM): 1.8x
The ERP sector of the SEG-SEVENTY, comprised of seven companies, saw the largest increase in valuation, growing 53% in Q3. We attribute much of this growth to increasingly successful penetration of the small-medium business market, which eluded most of the major ERP players until recently, as well as sector consolidation. Business intelligence, which has morphed into business performance management and caught the attention of enterprise CEOs and CFOs, grew 32% in Q3. Security software moved up 30%, while info/content management increased 29%.
MERGERS & ACQUISITIONS: THE TRENDS
M&A activity increased in Q3, and valuations notably improved in comparison to Q2. The composition of buyers changed, a predictable by-product of higher stock prices and market valuations. With fewer undervalued, high-potential companies ripe for the picking, private equity buyers, omnipresent in the first half of the year, retreated from the buyer landscape. More public company buyers stepped into the acquisition fray, seeking to leverage their higher priced stock as currency. Most stayed close to home, seeking new customers, enhanced product functionality and access to the small/medium business markets. Still, some interesting new trends began to emerge in Q3. Technology buys, particularly in the mobile and wireless arenas, reappeared after a long hiatus. And a surprising number of buyers signaled their willingness to venture into new markets, product lines and technologies.
Industry Consolidation
Industry consolidation among larger public companies, which some predicted would become the next M&A tsunami, stalled, right along with Oracle's hostile takeover of Peoplesoft/JD Edwards. There were a few rollups, most notably Chinadotcom's acquisitions of Ross Systems and Industri-Matematik; IMSI's purchase of CADKEY, CADalog.com and assets of Upperspace Corp; and SSA Global Technologies' purchase of EXE Technologies.
Private Equity Buyouts
After more than a dozen acquisitions in Q2, private equity firms ended their shopping spree and withdrew from the market. Exceptions were Symphony Technology Group, which added struggling POS vendor GERS Retail Systems, and Thoma Cressey, which bought litigation support services provider Daticon.
Strategic Acquisitions
Most acquisitions in Q3 could be characterized as strategic, yet financial considerations continued to predominate. Buyers sought and bought companies with complementary products and the same target markets. The majority stuck to the now standard formula - the acquisition must be able to yield immediate incremental revenue through cross-selling the installed base of each party, and should be accretive immediately or in the near term. The seller should be a close neighbor, rather than direct competitor, as proximity is comforting to all concerned. Q3 examples of this buy your neighbor acquisition strategy include Business Objects/Crystal Decisions, Secure Computing/N2H2, and Lockheed Martin/Titan.
However, a significant number of buyers pursued a very different acquisition strategy in Q3, signaling a subtle shift in software M&A. Technology was their primary objective, but these were not the "technology buyers" of the bubble era. The quest in Q3 was for highly sophisticated, market proven, immediately deployable technology, often comprising an entirely different product category, which would fundamentally extend and improve the user experience when embedded with the buyer's offering. Buyer motives ranged from dramatically differentiating from the competition, to extending into a new product category (e.g., Ascential/ Mercator, Hyperion/Brio, Informatica/Striva, Pervasive/Data Junction).
And finally, a surprising number of buyers ventured even farther from home in Q3, seeking to acquire a new line of business, enter entirely new markets, or fundamentally alter their current identity (e.g., Symantec/PowerQuest, NTN/Breakaway, Intuit/IMS, Kodak/PracticeWorks).
Vertical Market Software Companies
Vertical software company acquisitions continued to lead all other software sectors in the third quarter. Niche vertical players were in demand by both larger vertical players seeking to extend their offerings, and enterprise players seeking greater penetration into vertical markets. The health care sector saw the largest number of transactions, including Perot/Vision Health, WebMD/Advanced Business, Quovadx/CareScience, and American Healthways/StatusOne. Government, financial services, and legal sectors also saw multiple acquisitions.
MERGERS AND ACQUISITIONS: THE NUMBERS
Relative to the second quarter, total U.S. M&A activity for all industry sectors increased 7%, and dollar value was up 34%. At the current run rate, 2003 will see some 7,728 deals, outpacing 2002, with aggregate transaction value exceeding $412 billion (Figure 6).
The software industry continues to lead all other industry sectors in M&A activity, accounting for 381 deals in Q3, or 17% of the total. Software transactions in the first three quarters aggregated to 953, approximately 16% of all U.S. M&A activity. Acquirers spent $12.1 billion on software businesses in Q3. (Figure's 7 and 8).
Software industry M&A valuations improved considerably in Q3. As a result of the improving economy and the trends cited above, the median software M&A multiple for Q3, at 1.6x, was a substantial improvement over Q1 and Q2 (Figure 9).
Strategic acquisitions, i.e., transactions deemed by the acquirers to be essential to their future, predictably yielded valuations considerably greater than the median. Examples include:
- Pumatech / Synchrologic, 5.1x
- EMC / Legato Systems, 4.6x
- Intuit / Innovative Merchant Solutions, 4.6x
- Kodak / PracticeWorks, 4.2x
- Interwoven / iManage, 4.0x
- Business Objects / Crystal Decisions, 3.0x
Q3 also saw significant changes in the preferred form of deal consideration (Figure 10). With stock prices higher, larger public companies no longer considered their stock too undervalued to use as currency. Smaller public companies, with little cash remaining on their balance sheets, but higher stock prices, also convinced sellers to accept more stock. As a result, 42% of buyers in Q3 used cash - down from 67% in Q1. 23% of buyers in Q3 paid all stock (vs. 18% in Q2), and 35% used a combination of the two (vs.15% in Q2).
M&A: Most Active Software Sectors
M&A activity spread to greater number of sectors in Q3. Supplementing the usual array of security software deals were multiple transactions in systems, application and network management, imaging and content management, wireless and synchronization, ERP and vertical apps.
The most active software sectors in Q3, including representative transactions:
Business Intelligence
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Storage Management
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M&A: Most Active Buyers
An increased number of buyers entered the market in Q3, and several engaged in modest buying sprees. Among the most active buyers:
Chinadotcom
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International Microcomputer Software
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Overall, software industry M&A activity in the third quarter continued to show improvement. The number and type of buyers increased. More strategic buyers entered the market, as financial buyers retreated. While strategic acquirers continued to shop opportunities to bulk up in the short term, many sought longer term investments and technologies which could be leveraged into competitive advantage. Software sectors previously hammered by IT budget cuts began their recovery, with notably increased activity in storage management, ERP, wireless and vertical apps. Valuations also improved markedly. We expect these trends to continue for the remainder of the year and remain comfortable with our prior forecasts of a 10% increase in software M&A for 2003.
SELECT SOFTWARE M&A TRANSACTIONS, Q3 2003
| Buyer | Seller | Price | Revenue | Multiple | Currency |
| Ascential Software (Nasdaq:ASCL) | Mercator Software (Nasdaq:MCTR) | $97,900,000 EV | $111,900,000 | 0.9x | Cash |
| SEG's Insight: Fending off a hostile bid from Strategic Software Holdings, enterprise application/data integration provider Mercator agrees to a $106 million cash offer from Ascential. Since spinning out from Informix, the acquisitive Ascential has bought Vality, Torent Systems and Metagenix to beef up its data warehousing suite. The deal represents a 22% premium to Mercator's shareholders. Ascential has more than $500 million in cash remaining. | |||||
| Buyer | Seller | Price | Revenue | Multiple | Currency |
| Business Objects (Nasdaq:BOJB) | Crystal Decisions | $820,000,000 | $270,000,000 | 3.0x | Cash / stock |
| SEG's Insight: Business intelligence software provider Business Objects picks up the world's leading report writer. BO covets the midmarket and Crystal boasts 14 million licenses as well as 350 OEMs. Incremental revenue through cross-licensing is the short-term goal, but BO will have to sell an awful lot of report writers to justify the multiple it paid. For Crystal Decisions, the sale scotches a planned IPO, but it's doubtful the markets would have been as generous. BO also gets Crystal's $95 million in cash and expects the acquisition to be immediately accretive. | |||||
| Buyer | Seller | Price | Revenue | Multiple | Currency |
| Chinadotcom (Nasdaq:CHINA) | Ross Systems (Nasdaq:ROSS) | $66,110,000 EV | $46,050,000 | 1.4x | Cash / stock |
| SEG's Insight: Hong Kong-based Chinadotcom (CDC), a pan-Asian enterprise software and services provider, acquires Ross Systems, a leading ERP vendor in the process manufacturing space. With a whopping 600 enterprise customers in Asia-Pacific, CDC aspires to dominate the region and preempt Tier 1 players, but lacked a comprehensive ERP offering. Ross was an obvious choice. After seeing revenue decline 50% over the past three years, Ross shareholders saw the writing on the wall and grabbed the 23% premium, but will receive only 26% of the purchase price in cash. | |||||
| Buyer | Seller | Price | Revenue | Multiple | Currency |
| Chinadotcom (Nasdaq:CHINA) | Industri-Matematik | $25,000,000 | $45,000,000(estimate) | 0.6x | ND |
| SEG's Insight: Five days after its Ross buy, Chinadotcom (CDC) acquired 51% of IMI from Symphony Technology Group, a financial investor that bought IMI in 4Q02 for $11 million, yielding a $14 million profit after just nine months. CDC needed a supply chain solution company to round out its enterprise suite - which now includes Ross. Look for CDC to cut costs by funneling IMI development to its China R&D center. This rollup should enable CDC to lengthen its lead in China and the Pac Rim. Symphony retains 49% of IMI. | |||||
| Buyer | Seller | Price | Revenue | Multiple | Currency |
| EMC (NYSE:EMC) | Legato Systems (Nasdaq:LGTO) | $1,239,420,000 EV | $280,300,000 | 4.4x | Stock |
| SEG's Insight: Information and storage leader EMC, hammered by IT budget cuts and resistance to its proprietary offering, continues its foray into open systems through acquisition. Its fourth software acquisition in the last 12 months, EMC acquires Legato, the number three seller of backup and recovery software. Expect EMC to also capitalize on Legato's 500 strong sales force and customer base of some 31,000 businesses. Legato shareholders received a 16% premium, a nice outcome given the firm's rocky road since its revenue recognition debacle in 2000. | |||||
| Buyer | Seller | Price | Revenue | Multiple | Currency |
| Epicor Software (Nasdaq:EPIC) | ROI Systems | $20,700,000 | $20,000,000 | 1.0x | Cash |
| SEG's Insight: A provider of enterprise software to the mid-market, Epicor picks up ROI Systems, a privately held ERP vendor to multiple vertical sectors in manufacturing. This deal is typical of the current M&A market; Epicor looks to add immediate revenue and earnings by leveraging ROI's complementary products and 6,500 customers. This is an all-cash deal of a business that has sustained 20 years of profitability for a price equivalent to one-time trailing 12 month revenue. | |||||
| Buyer | Seller | Price | Revenue | Multiple | Currency |
| Hyperion Solutions (Nasdaq:HYSL) | Brio Software (Nasdaq:BRIO) | $116,500,000 EV | $101,800,000 | 1.1x | Cash / stock |
| SEG's Insight: Just days after the Business Objects-Crystal Decisions deal, Hyperion, a leader in business performance management, acquires Brio after former partner Crystal Decisions sells to Business Objects. Brio's strong query and reporting tools are an excellent entre to Hyperion's dynamic enterprise performance monitoring. Brio's declining revenues and ongoing operating losses starkly contrast with Crystal Decisions' growth and profitability and help explain the lower multiple. Hyperion adds Brio's 3,000 customers, while beefing up its query and reporting offering. Brio shareholders get a 39% premium. | |||||
| Buyer | Seller | Price | Revenue | Multiple | Currency |
| Interwoven (Nasdaq:IWVN) | iManage (Nasdaq:IMAN) | $135,918,000 EV | $42,700,000 | 3.2x | Cash / stock |
| SEG's Insight: After six months of partnering, Web content management leader Interwoven acquires iManage, a provider of content collaboration and document management solutions. Interwoven can now tout an end-to-end knowledge management suite to better compete against Documentum. iManage shareholders receive a 23.6% premium, but only about 18% in cash and the balance in stock. Could be risky. Interwoven lost $14.6 million on flat revenue of $52 million in 1H03. Its $2.40 market price fell on the announcement, but rebounded to $2.85. | |||||
| Buyer | Seller | Price | Revenue | Multiple | Currency |
| Intuit (Nasdaq:INTU) | Income Dynamics | $10,000,000 | $3,500,000 (estimate) | 2.9x | Stock |
| SEG's Insight: Financial software behemoth Intuit reenters the acquisition fray, this time buying Income Dynamics, a maker of taxpayer tools that will strengthen market-leading TurboTax by giving it the power to easily estimate the value of items donated to charities. This is Intuit's first acquisition since it bought IT resource and tracking firm Blue Ocean Software for $170 million in August 2002. Income Dynamics revenues are estimated to be $3.5 million. | |||||
| Buyer | Seller | Price | Revenue | Multiple | Currency |
| Intuit (Nasdaq:INTU) | Innovative Merchant Solutions | $116,000,000 | $25,000,000 | 4.6x | Cash |
| SEG's Insight: Intuit's buying spree continues, driven by its "beyond accounting" growth strategy. The latest addition is Innovative Merchant Solutions, a provider of merchant account services to small businesses. Intuit, which already has a modest merchant services operation, gains access to 85,000 IMS merchants and a much stronger presence in the highly profitable bankcard processor sector. Note the all cash purchase price has contingencies, most likely an earnout. | |||||
| Buyer | Seller | Price | Revenue | Multiple | Currency |
| Plato Learning (Nasdaq:TUTR) | Lightspan (Nasdaq:LSPND) | $32,970,000 EV | $50,000,000 | 0.7x | Stock |
| SEG's Insight: After racking up substantial losses, ($33.5 million on $50 million revenue in fiscal year '03) and with only enough cash to fund two more quarters, education software vendor Lightspan sells to Plato Learning, a financially challenged provider of e-courseware to community colleges. Plato, which lost $5.7 million of operating income on $78 million in revenue during the last twelve months, hopes to beef up its presence in Lightspan's K-12 market. | |||||
| Buyer | Seller | Price | Revenue | Multiple | Currency |
| SCO Group (Nasdaq:SCOX) | Vultus | $2,700,000 | $1,250,000 (estimate) | 2.2x | Stock |
| SEG's Insight: SCO Group, a provider of tools and services for Linux developers that has seen its stock price rocket upward six fold since filing a $1billion IP infringement suit against IBM, appears to be taking advantage of its new found wealth, with its all stock asset purchase of Vultus Technology, a developer of tools used to design Web app interfaces. This is the first of what SCO identifies as a string of $4 to $10 million strategic acquisitions. Sellers beware. | |||||
| Buyer | Seller | Price | Revenue | Multiple | Currency |
| Secure Computing (Nasdaq:SCUR) | N2H2 (NTWO.OB) | $15,813,000 EV | $11,100,000 | 1.4x | Stock |
| SEG's Insight: Network security provider Secure Computing acquires content-filtering competitor N2H2, seeking to boost its number-three position in content filtering. Secure also picks up 2, 000 new customers. Secure paid 1.4 times TTM revenue after factoring in N2H2's cash and debt. The deal gives N2H2's shareholders a 38% return based on a five-day preceding average, not bad considering the quarter ended June 2003 was the first time N2H2 recorded a profit…of $48,000. | |||||
| Buyer | Seller | Price | Revenue | Multiple | Currency |
| SSA Global Technologies | EXE Technologies (Nasdaq:EXEE) | $16,026,000 EV | $73,656,000 | 0.2x | Cash |
| SEG's Insight: Enterprise software provider SSA Global Technologies nabs struggling EXE, the latest in its series of acquisitions. EXE's highly regarded warehouse management/supply chain execution software will extend SSA's ERP offerings to the mid-market. While EXE's revenues have been flat, it reigned in expenses to near breakeven and had $32 million in cash, making the .22x purchase price appear curiously low. SSA, which earlier acquired Baan, Infinium and interBiz, has a record of picking up deals on the cheap. | |||||
| Buyer | Seller | Price | Revenue | Multiple | Currency |
| Stellent (Nasdaq:STEL) | Ancept | $2,770,000 | $4,500,000 (estimate) | 0.6x | Cash / stock |
| SEG's Insight: The content management sector consolidated further as Stellent picked up small, privately-held digital asset management vendor Ancept, an IBM partner. After Stellent competitors Documentum and Interwoven recently acquired digital asset management developers (Bulldog and MediaBin), Stellent had little choice but to embed the technology in its offering. Ancept shareholders receive $2 million in cash and 100,000 shares of Stellent stock. | |||||
| Buyer | Seller | Price | Revenue | Multiple | Currency |
| The Sage Group (Nyse:HEW) | Timberline Software (Nasdaq:TMBS) | $91,850,000 EV | $63,100,000 | 1.5x | Cash |
| SEG's Insight: The Sage Group follows through on its promise to add vertical business tools for the midmarket with its acquisition of Timberline. Looks like Sage may be mimicking the vertical acquisition strategy Intuit began nearly two years ago. Sage paid Timberline shareholders a 33% premium to get the company's integrated operations/financial tools for medium-sized construction and real estate outfits. The buy gives U.K-based Sage and U.S. subsidiary Best Software a shot at holding onto its current customers as they outgrow the pair's entry-level offerings. | |||||
EV: Enterprise value = Purchase price, plus debt, minus cash & equivalents
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.
