June 2, 2010: Enterprise Software Giants on the Prowl – Sorting Out M&A Targets
A brief audio review of this research can be found here: http://live.ssrllc.com/wp-content/uploads/2010/06/June-2-2010-Paul-Sagawa-Software-MA.wma
Software has historically been the most acquisitive arena in TMT. SAP’s recent $5.8B acquisition of Sybase and IBM’s public commitment to $20B in future deals suggest that recession-related caution may be giving way to an up-cycle in software M&A. Indeed, the number of deals by serial acquirers Oracle, IBM, Microsoft, HP, and SAP fell from 38 in 2007 to 26 in 2009, while the net cash position of these five players has risen to $46.2 Billion.
Of 71 enterprise software companies in the Russell 2000 in 2007, 12 have since been acquired, at an average premium of over 40%. The acquired companies fell disproportionately into the Business Intelligence, Web Content management, and Computer Aided Design categories, and were generating 20% annual revenue growth and 5% operating margins at the time of acquisition. Prices paid averaged 3.45 times sales and represented a P/E to Growth (PEG ratio) of 1.90%, vs. 3.0 times P/S and 1.79% PEG for non-acquired companies.
Oracle had slowed down its M&A pace from 2007 to 2009, with enterprise infrastructure vendor BEA Systems the main addition, but has nearly equaled its 2009 deal flow just 5 months into 2010. IBM has been steadier, but has publicly pledged to pick up the pace. It recently announced a $1.4B deal to buy business process integration software vendor Sterling Commerce from AT&T. Microsoft has disavowed immediate interest in large M&A, but has done numerous small deals over the years and has a prodigious cash balance to help fund future deals. HP has been aggressive, mixing software deals with hardware acquisitions, its recent acquisitions of 3Com and Palm evidence of its appetite. SAP has been historically quiet, but recently stepped up with its deal for Sybase, possibly signaling further interests. We also note that other IT giants – Google, Cisco, EMC, VMware, et al. – could potentially step up as well.
We believe that the most active M&A areas in software will be business intelligence, virtualization and cloud technologies, security and high-growth industry-specific markets, such as health care and education. Business intelligence (BI), including the closely related field of data integration and quality software, is a particularly likely arena for deals. BI was ranked the number one technology priority by CIOs in Gartner’s annual surveys until this past year, when economic crisis raised forced it to the back burner in favor of cost reduction initiatives for many organizations, but is expected to grow nearly 9%/yr through 2014. Furthermore, the BI market is fragmented – no one player has a complete solution – making M&A more likely as the big vendors (Oracle, IBM, Microsoft and SAP) expand their portfolios.
Virtualization, projected by Gartner as the fastest growing category of software through 2014, allows multiple separate and secure computing environments to be implemented on the same server hardware. This improves hardware cost efficiency and speeds implementation of new applications. The concept, applied more broadly to very large scale servers positioned on the web and implementing separate and secure applications for many different organizations, becomes cloud computing. While it has been hyped for many years, the cloud concept of hosting software centrally on the internet and selling access to the shared resource as a service appears to have gained critical mass, particularly given its potential for dramatic cost savings. Virtualization platforms are dominated by VMware, with Microsoft and Oracle in pursuit. The leading cloud computing platform vendors are Microsoft, Oracle and IBM. Each of these companies may be interested in extending their software platform with applications, security tools, storage management capabilities, etc.
Security has been a hot market for quite a while and should continue to be so, given the increasing risks as enterprise applications and data migrate onto the internet cloud. Microsoft, Oracle, IBM, HP, Google, Cisco, EMC, VMware, et al. have all made acquisitions in this space and can be expected to be active in the future.
The recent Federal Government health care overhaul and its reform agenda for education are expected to spur substantial IT investment in these arenas, suggesting smaller software firms with forward looking solutions for these markets could find themselves targets. Oracle has been particularly active in pursuing industry-specific computing solutions, with Microsoft also active. Given SAP’s roots in industrial automation, it could also be an interested buyer.
In these categories, we believe acquirers will focus on share gainers and profitability leaders, or on early stage, not publicly traded innovators. Screening public BI, virtualization/cloud computing, health care and education software companies by sales growth and margins yields a list of 19 companies with characteristics consistent with eventual acquisition. Given the combination of growth and profitability, these candidates are likely attractive investments in their own right, with the potential of 20-40% premium to current valuations if acquired.
Companies that screen as well positioned for acquisition, and that could see substantial upside to current valuations if acquired include Informatica, OpenText, Tibco, Microstrategy, Citrix, Red Hat, DoubleTake, Quality Systems, Cerner, SkillSoft, and McAfee.