Some Thoughts on the Boom in Software Consolidation

What is driving the merger and acquisition boom in the enterprise software industry? (Pricing pressures, industry maturation) Is it good? (Only if acquiring companies learn from earlier problems) Will it work? (Some will, some won’t, with the critical variable being the quality and capabilities of management)

During the past few years the overall pace of mergers and acquisitions in the enterprise software industry has accelerated notably. Clearly Oracle has been a major factor, but many other companies have become more active, including long standing acquirers such as IBM and Computer Associates. In addition to these players there have been a number of others from EMC to Symantec to name some more. What is behind all of these acquisitions? Are they good? Will they work?

As we have written on previous occasions one of the bigger drivers in acquisition activity has been the efforts of customers to reduce the number of vendors they support. Major IT organizations through standardization and rationalization of their IT operations can realize substantial savings in the biggest cost component, IT labor. This has made it much more difficult for smaller software companies to develop or maintain their presence in larger customer organizations and have made them more amenable to being acquired. (Likewise some improvement in valuations but without a corresponding improvement in the IPO market has contributed to making the sale to a larger software company an attractive exit strategy.)

However another major factor behind the recent M&A boom has been ongoing pressures of software pricing. Software pricing is under assault on a variety of fronts such as the internet which has enabled new business models, open-source, and lower development costs through use off-shore development resources. The impact of generally lower prices is the need for increasing economies of scale with respect to leveraging development resources, support and sales.

The internet has lead to the emergence of new business models by the likes of Google and Yahoo. These companies offer many software components on the internet for free, supported by advertising, or where users pay via modest a la carte subscriptions, threatening traditional pc software models. Traditional pc software and applications with substantial up front costs and periodic upgrade costs look comparatively expensive and inflexible. In addition there is greater vulnerability to system crashes.

On demand is another example of software as service that challenges traditional enterprise software vendors. Companies such as Salesforce.com or RightNow, which provide applications on a services based model, represent an alternative to the more traditional license/maintenance support models used historically by applications vendors.

Open source alternatives represent yet another threat to traditional software pricing models. Regardless of the fact that open source vendor pricing for support may often negate the pricing differential vs. traditional software vendors, customers perceive open source as a means of becoming less dependent on their vendors. Less dependence means less pricing flexibility for vendors.

Finally very low cost off-shore development opportunities represent both an opportunity and a risk for software vendors. Those vendors that aggressively take advantage of the dramatically lower wage costs, can pass those savings to their customers, and be better positioned to weather the deflationary trend in software pricing. However, those vendors that ignore the opportunity will be incrementally threatened as other vendors and customers do go off-shore. Arguably, it is easier for larger vs. smaller software companies to take advantage of off-shore resources.

The following trends further complicate the analysis of enterprise software vendors in terms of understanding various growth drivers: products vs. features, processor based capacity definitions, numbers of users, or other metrics used to measure volumes and usage.

The above factors increase the uncertainty of sustainable growth and profitability and thereby serve to generally undermine stock valuations for traditional enterprise software vendors.

There is little question that each of these trends is quite powerful with substantial momentum. Nor is there much doubt that each of these trends is inherently negative with respect to the traditional enterprise software business model -- there is little question it is an extremely difficult one to address.

We believe there is a parallel in the challenges facing the traditional enterprise software vendors to that which IBM has faced for the past 15 years or so in its mainframe hardware business.

While IBM’s mainframe business has seen declining revenues, it has nonetheless remained a highly profitable and strategic business. Large profits have funded IBM’s development of its services business, as well as the build out of its software business. Likewise IBM has been able to leverage its unique relationship with it’s customers who have been dependent on the mainframe as the foundation for many of their mission critical systems. Put another way, IBM has managed to successfully transform itself into a diversified business, while being able to leverage its historical position as provider of mission critical systems to very large companies. A substantial part of that diversification came through acquisitions of companies such as Lotus, Tivoli and PWC.

We believe that traditional enterprise software vendors whether fundamentally systems management or applications vendors are pursuing similar strategic objectives; managing the maturation of their original core business, while attempting to build/acquire complementary products that can be sold into their installed customer bases. Clearly some vendors have had more success than others, as measured by their financial performance (if not their stock performance).

BMC consolidated a number of complementary mainframe systems management vendors such as Boole & Babbage, Fourth Dimension, BGS and others. With the benefit of hindsight their most successful acquisitions were Patrol and Remedy, both of which were geared toward entering altogether new, but complimentary markets.

Herein lays the test for managements of the traditional software firms. To help counter the ever growing pressures on revenue growth, these companies must build out their product reach and leverage their existing installed customer base. Market share consolidation may alleviate traditional pricing pressures, but as the acquiring vendor preserves its pricing power in the short-term, it undermines its longer term position as customers seeking greater value look for alternative, substitute solutions which inevitably emerge. (BMC and Compuware are excellent examples of vendors which are contending with a new generation of competitors based on price, and while both of these companies benefited in the short term, few today would look at the deals aimed at market share consolidation in a particularly positive light.)

Arguably a more successful acquisition strategy focuses on adding highly complementary products that can be clearly defined as separate products (and not confused as extensions or added features to existing products) and that further broaden the relevance of the acquiring company’s solution. For the record, the potential problem with product extensions or feature is the difficulty the vendor may have in getting additional value or revenue for them from their customers. However, in fairness, it is often difficult to determine whether additional functionality can truly qualify as a distinct product. The real point is the capability (whether feature or product) has to significantly contribute to the acquiring company’s competitive edge from a product perspective to justify added value.

Of course there is another factor that plays into acquisition strategies and that is the potential for highly financially accretive deals owing to very low valuations for the target companies. When these types of deals are not complementary and are merely financially driven, they are inherently tactical in nature, with the biggest risk being the distraction of management and company resources from the more important task of leveraging the company’s strategic opportunities. Investors should be weary of companies who are making these types of investments.

Do the recent acquisitions by companies such as IBM, Computer Associates and Oracle meet this test? History will ultimately be the judge, but in our view each of these companies are a combination of tactical and strategic deals. Clearly Oracle is the most aggressive in terms of number and size of deals, followed by CA and then by IBM.

We are not going to provide in this forum a detailed evaluation of the pros and con these companies’ recent deals. However, a high level (and admittedly subjective) view of the overall character of these companies’s acquisitions strategy is summarized below.

Our judgments reflect the following parameters:

• Financial risk grades were assigned based on price and scale of acquisitions relative to the overall size of the company;

• Strategic opportunity is our qualitative view regarding the inherent logic and fit with the company’s existing business;

• Market share consolidation is determined by the extent to which the acquisitions overlap with existing product offerings vs. extending product range;

• The overall grade is essentially an average of the ratings for the first two factors. (We decided not to include the market share consolidation or complementary nature of deals done as part of the grade, since we have seen successful deals of both types.)

CA we gave an overall grade of B+. Financial risk is medium given the size and nature of the deals announced to date. Strategic opportunity is high, since the deals are very complementary to CA's existing products. Market share consolidation factor is comparatively low.

IBM we've given an A. Financial risk of their deals is small. Strategic opportunity is typically high. Market share consolidation is medium.

Oracle we've also given a B+, a rating which is probably the most controversial given the pace and scale of the company's acquisitions. Financial risk is medium, despite the magnitude, owing to modest valuations for the acquired companies. Strategic opportunity is high, since despite a lot of market share consolidation, the acquired products typically add a combination of significant additional presence in major verticals as well as significant extensions of functionality. Market share consolidation is high.

In the case of each of these vendors, success will ultimately be determined by the abilities of the respective management's to meet the unique challenges of their specific deals.

Last, but not least, we are a bit behind in posting to our blog, since we have spent the last couple of weeks working to improve our own technology infrastructure.

We recently formed Blue Atlas Management, LLC as our official business entity for consulting related work. For those interested in learning more about our services please visit our website at: www.blueatlasmanagement.com for more information. Please note that we have a new email address, jmendelson@blueatlasmanagement.com. As always we welcome any comments you may have.

Legal Disclaimer
Nothing herein constitutes an offer or solicitation to buy any security. Readers are advised to review their own financial situation, risk tolerance, and investment objectives as to any investment. Information provided here is based, in part, from sources believed to be accurate and reliable, although no representations or guarantees can be provided as to its accuracy or completeness.

Enterprise Software 2006 Outlook -- More of the Same

The enterprise software industry has seen modest growth during the past several years. The benefits of a gradual recovery in IT spending to software vendors, being diluted by ongoing pricing pressures from the increasing use of open source alternatives, consolidation of products, the emergence of third party maintenance providers, as well as growing competition from hosted application providers. We expect 2006 will in many ways be similar to 2004 and 2005, meaning further significant consolidation of vendors, and valuations constrained by uncertainty as to profitability and growth prospects.

The enterprise software industry has shown negligible growth during the past five years or so. Following a sharp decline in the years immediately following 2000, 2004 and 2005 did see a resumption of modest growth.

In contrast to the latter portion of the ‘90s when small software companies dominated the landscape, the power has again shifted back to the largest software franchises, such as Microsoft, Oracle, SAP, Computer Associates and others. However, investors remain concerned about a number of risks to these franchises that has limited the performance of these stocks.

The bubble period of the late ‘90s was a unique and crazy time. Demand for software was feverish, driven by the fear of widespread system failure with Y2K and the greed associated with the opportunities represented by the internet to turn the old “bricks and mortar” world upside down.

In the aftermath of the bubble, the reality that IT spending was out of control struck home. Companies suddenly realized that they had overbought capacity and that their bid to address the opportunities and challenges of the internet was haphazard and not well thought out. A period of severe retrenchment ensued.

The period of retrenchment generally benefited the largest software vendors as large corporations looked to rationalize and standardize their technology infrastructure. The primary goals of these initiatives were to significantly reduce the amount of IT headcount needed, and to be able to utilize less-expensive offshore IT labor.

While IT spending has finally begun to recovery over the past couple of years or so, the reins remain very tight.

Though the prospects for broader IT spending continue to gradually improve, a lengthy list of challenges for software vendors remain. Put in the broadest possible terms, the longstanding business model for enterprise software companies is under assault.

Pricing pressures continue to build.

• Open source alternatives, such as Linux, or other elements of the “technology stack,” is an ongoing threat to major franchises such as Microsoft Windows, or major database products such as Oracle or IBM’s DB2, and application servers as well.

• Third party maintenance providers are another challenge to leading software franchises that threatens to undermine their highly profitable maintenance revenue streams.

• Hosted applications companies like Salesforce.com or RightNow, as well as many others, is another threat to the traditional business model of upfront license revenues complemented by ongoing maintenance and support revenue streams.

As investors readily appreciate, it is extremely difficult to handicap or predict with any accuracy how these various threats to the enterprise software business model plays out in terms of impact on revenue, earnings growth or overall profitability.

If the risks to the business model weren’t enough, the enterprise software industry is at the cusp of a major change in technology architecture. The industry is moving toward web services. We’re not going to try to put forth a substantive definition of what, how and why, but simply note that the move to web services or services oriented architecture will ultimately open the door for smaller software companies to compete again.

Each of these trends has been widely discussed and is arguably well discounted in equity valuations. Nonetheless the associated uncertainty as to the degree of impact, limit the prospective recovery in valuations.

Perhaps the biggest question facing investors as 2006 gets underway is whether the momentum behind any of the aforementioned trends picks up enough speed to create a tipping point in the near-term so as to present a highly disruptive influence to the current industry equilibrium. Our best guess is that this is unlikely to happen within the next twelve months.

Overall, we expect that 2006 will look much like 2005. Meaning, that while IT spending continues to gradually improve, there will be no evidence of a major positive breakout in growth for the larger software companies as any improvement is offset by ongoing pricing challenges.

We do believe that the prospects for smaller software companies will on the margin improve, since much of the consolidation efforts on the part of corporate IT spending have been completed.

Likewise we expect that merger and acquisition activity in the software sector will continue at a rapid pace.

For investors these trends suggest that valuations relative to the broader market averages are not likely to change radically. We also believe that software stocks which generally underperformed the major averages are not likely to be very exciting in 2006. It will continue to be a challenging market environment, where winning stocks may not necessarily be represented by the best companies.




Nothing herein constitutes an offer or solicitation to buy any security. Readers are advised to review their own financial situation, risk tolerance, and investment objectives as to any investment. Information provided here is based, in part, from sources believed to be accurate and reliable, although no representations or guarantees can be provided as to its accuracy or completeness.