By almost any measure, 2008 will be remembered in M&A circles as a year best forgotten. Collateral damage from the global financial crisis caused a significant drag on M&A activity, particularly in the final quarter of the year which bore little resemblance to the first. Volatility and lack of visibility led would-be acquirers to exercise great, and perhaps excessive, caution. According to FactSet Mergerstat, in 2008 there was a 17% decline in the number of M&A transactions and a 32% decline in the value of announced M&A transactions in the Computer Software, Supplies, and Services sector (see Figure 1).
Figure 1 M&A Activity In The Computer Software, Supplies And Services Sector
Although the year was troubled and painful, a long-term view provides an interesting perspective: the technology sector did not suffer to the extent it did in 2001 and 2002 when deal activity and aggregate value, along with tech stocks, plunged by a much greater degree. From 2003 to 2007, the technology industry benefited from the liquidity flowing through the US economy, but the credit bubble burst of 2008 was not a technology bubble burst. The table above highlights the cyclical nature of technology sector M&A activity, from the tech bubble high in 2000, to the tech bubble burst, and on to recovery in subsequent years. These cycles and the correlation between tech M&A activity and the performance of the public equity markets, specifically the NASDAQ composite, can be seen in the figure below (see Figure 2).
Figure 2 M&A Activity Over The Past 10 Years
Updata's proprietary M&A technology database both affirms and magnifies the trends covering the past decade that are highlighted by the Mergerstat data (above). Updata has maintained an M&A database since 1997, including over 7,000 transactions that are focused specifically on the IT sectors in which Updata is most active: infrastructure software, enterprise application software, financial technology, IT security, IT services and Internet. Highlights from our M&A database are presented in Figure 3 and Figure 4 below. 1
Figure 3 Yearly M&A Data For All IT Deals Tracked By Updata
Figure 4 2008 Quarterly M&A Data Summary For All IT Deals Tracked By Updata
The quarterly analysis in Figure 4 above confirms what those of us in the M&A industry already knew: 2008 was bifurcated in terms of M&A activity with the first nine months representing over 90% of the total value of 2008 M&A activity. Nevertheless, while 2008 was one of the most difficult years in recent memory, it also had a fair number of large and interesting M&A transactions (see Figure 5). Not surprisingly, nine out of the top 10 deals were announced in the first seven months of 2008 before the financial markets took a sharp turn for the worse. The top 10 deals in 2008 aggregated total enterprise value of $38.7 billion - an impressive figure despite being half the value of the top 10 deals in 2007 (which were inflated by KKR's $27 billion acquisition of First Data Corp). Moreover, the 2008 metrics do not include Carlyle Group's $2.5 billion majority investment in Booz Allen Hamilton's government consulting business since the percentage acquired (and therefore the total enterprise value) of that deal was not disclosed.
It is also noteworthy that buyers came from diverse and impressive groups of private equity (PE) firms (such as Apax Partners, Hellman & Friedman, Carlyle), cash-rich enterprises (such as HP, Oracle, Microsoft), and foreign companies (such as BAE Systems, Finmeccanica, Reed Elsevier). That prestigious organizations such as these stepped up to the M&A plate throughout 2008 suggests that companies that can will continue to take advantage of M&A value opportunities in 2009.
Figure 5 Top 10 Transactions In 2008 By Enterprise Value
2008 also saw a significant increase in premiums paid to publicly-held technology companies which is reflective of the downturn in share prices. The average 1-day premium paid to US companies (acquired for an offer price of greater than $5 per share) was 37.1%, a 57% increase over the average 1-day premium of 23.6% paid in 2007 (see Figure 6).
Figure 6 Premiums Paid Analysis
Revenue Multiples Paid In 2008
Overall, median M&A revenue multiples dropped across all Updata IT subsectors in 2008, to levels that signal an attractive buyer's market from a historical standpoint (see Figure 7). No matter how bearish one may be on the state of the global economy, the ever-innovating and growing technology industry is trading today at valuations historically reserved for mature, if not stagnant, industries. In our view, this will not remain the case for long.
Figure 7 Three-Year Median Revenue Multiples By Sector
Moreover, certain deals in 2008 highlight that top-performing IT companies still command impressive multiples (see Figure 8). BladeLogic, for example, had been a public company for only nine months before it was acquired by BMC for 11.2x trailing 12-months' (TTM) revenue, enabling BMC to enhance capabilities in the data center automation space. eBay's acquisition of Bill Me Later, notably announced in the midst of October's chaos, represented a multiple of 7.9x TTM revenue. Few industries outside of technology post deals with valuations like these, even in the best economic climates.
Figure 8 Top 10 Deals By Revenue Multiple
Private Equity Deal Activity
PE buyers looking for recurring revenue streams actively acquired companies in the transaction processing sector (such as Trizetto, Fiserv, Q9, and Experian's transaction processing unit), the government services sector (such as Booz Allen, Civica) and digital media (such as Getty Images). However, with the exception of the Experian deal announced in October, private equity activity was hampered by the disappearance of credit in the fourth quarter - and almost all the largest deals were struck in the first seven months of 2008 (see Figure 9).
Figure 9 Top PE Deals In 2008 By Enterprise Value
IPO Activity
The dearth of initial public offering (IPO) activity in 2008 has underscored the importance of M&A as a liquidity track. 2008 saw eight software, services, and Internet IPOs, a substantial decline from the 45 IPOs tracked by Updata in 2007 (see Figure 10).
A dominant theme among 2008's IPOs was recurring and reliable revenue models, including: subscription-based Rackspace's software-as-a-service (SaaS) computing model, ArcSight's "must-have" compliance and security solutions, e-learning and testing providers China-Distance Learning and ATA, and VISA's transaction-based revenue streams.
As shown in Figure 10 below, Visa's IPO in early-2008 was by far the largest offering and is still trading above its offering price. The last IPO in 2008, Grand Canyon Education, is also currently above water, as is the IT healthcare company CardioNet. The rest of the 2008 IPOs are currently trading substantially below their offering price.
Figure 10 2008 IPOs
Another reason for cautious M&A optimism in 2009: many prominent technology companies are sitting on large cash reserves and are looking for investment. They are ready for strategic and tactical deals or to take advantage of low equity prices. These cash-rich companies have also been some of the more prolific buyers in 2008 (see Figure 11).
Figure 11 Cash-Rich Companies
While the economic uncertainty of 2008 is most certainly going to hang over into 2009, we believe that M&A will remain an important corporate strategy for growth and enhanced competitiveness. 2008 has proved that even in the most troubled economic environments, well-considered M&A transactions were still announced and completed.
The remainder of this report discusses in more detail trends and transactions we have witnessed in 2008, and what we expect to see in 2009.
SECTOR ANALYSES
Updata's sectors of focus include: infrastructure software, enterprise application software, financial technology, IT security, IT services, and Internet. The trading metrics shown below imply that we appear to have entered a buyer's market for corporate assets, with valuations at historically low levels, particularly for technology companies (see Figure 12).
Figure 12 Summary Public Company Valuation Metrics
Share price performance of IT sectors tracked by Updata is shown in the chart below (see Figure 13). In 2008, while the NASDAQ fell 40.5%, each of the technology sectors which Updata tracks, with the exception of Internet and financial technology, out-performed the NASDAQ.
Figure 13 2008 Sector Stock Indexes Versus NASDAQ Composite
INFRASTRUCTURE SOFTWARE
As with many other aspects of the economy and capital markets, M&A activity in the infrastructure software sector deteriorated rapidly over the course of 2008 (see Figure 14). Q1 2008 was characterized by decent deal volume of 21 transactions (which is roughly equivalent to the quarterly average deal volume over the previous two years) and a strong median multiple of EV to TTM revenue of 6.5x, driven by a few high-multiple transactions and one blockbuster deal (Oracle/BEA - $7.2 billion). Unfortunately, the subsequent three quarters have trended down sharply in terms of transaction volume and median valuation multiples. By Q4 2008, quarterly transaction volume was roughly half of what it had been on average in 2007 and 2006 and the median EV multiple was an anemic 1.1x. After adjusting out the Oracle/BEA transaction, results for 2008 are substantially lower across the board compared with the previous two years (see Figure 15).
We believe these results reflect several key trends. We note that public equity prices of the large buyers are down sharply during the same period, which, in combination with ongoing uncertainty over the length and depth of the economic downturn, has resulted in a more conservative approach to M&A. There is now an absence of large, blockbuster deals that tend to drive up the aggregate value of transactions as well as the fewer, highly strategic transactions that tend to drive up the median valuation multiples. Representative transactions over the course of the year tell the same story. High valuation multiple transactions such as Novell/PlateSpin (8.2x) and BMC/BladeLogic (11.2x) during Q1 gave way to consolidation and value-oriented transactions such as MicroFocus/NetManage (1.1x), Progress/IONA (1.6x) and IBM/Ilog (1.5x) over the balance of 2008 (see Figure 16). We believe that strategic buyers continued to have interest in certain areas of functionality and placed a high value on growth during 2008. However, we believe the more conservative approach that prevailed for much of 2008 manifested itself in substantially fewer and smaller strategic high-valuation multiple transactions as buyers shifted their focus to transactions that could be completed at lower valuations and with lower risk of achieving targeted returns.
The key question is: Will this negative trend line in infrastructure software M&A continue or have we seen the bottom? While macroeconomic indicators offer little assurance of a recovery any time soon, we do expect transaction volumes to improve over the course of 2009. We expect median transaction valuations to improve also but at a slower rate. We expect that transaction volumes will increase in part due to a growing number of value-oriented, consolidation focused and distressed deals. While this type of activity drives higher transaction volume, such transactions are typically completed at lower valuation multiples resulting in continued downward pressure on valuation multiples in the aggregate. We do believe there could be several bright spots of activity in infrastructure software M&A during 2009 including virtualization, data center automation, storage management, and cloud computing. Despite the general weakness in infrastructure software M&A during 2008, several strategic deals such as Symantec/SwapDrive (Updata advised SwapDrive) and RedHat/Qumranet were completed in these sectors later in 2008.
Figure 14 2008 Infrastructure Software M&A Quarterly Data Summary
Figure 15 Infrastructure Software M&A Yearly Data Summary
Figure 16 Top 10 Infrastructure Software M&A Deals In 2008 By Enterprise Value
In the virtualization, data center automation, storage management, and cloud computing sectors, small vendors have developed strategic functionality and continue to benefit from strong growth opportunities supported by the intersection of two powerful trends. First, virtualization is forcing enterprises to revisit the way they manage and operate their infrastructure, and it is enabling entirely new service delivery models (including cloud computing). Second, the deep and persistent economic downturn is forcing enterprises to seek ways to reduce and better manage IT costs. As a result, we believe these sectors are likely to be the source of several transactions over the course of 2009 as buyers seek to expand their solution sets and drive future growth.
Updata's predictions for the infrastructure software sector in 2009 include:
Automation and virtualization technologies are hot and will remain so. In this economic climate, the dominant theme in IT departments is to cut costs wherever possible. As a result, the strong interest around automation and virtualization technologies over the last two years should continue (and maybe even accelerate) during 2009. Automation and virtualization technologies can lower costs by scaling back labor expenses and improving productivity while reaching higher performance levels. Virtualization is causing significant disruption among incumbent data center system and software vendors rendering this area ripe for continued M&A activity. Representative transactions during 2008 include Novell's $205 million (at 8.2x revenue) acquisition of PlateSpin in February and RedHat's $107 million acquisition of Qumranet in September.
Storage management is a continued focus area. Enterprises are seeking to balance cost containment with explosive growth in demand for data storage and increased demand for networked storage driven by adoption of server virtualization. As a result, storage in the cloud and cost-effective storage management technologies should garner substantial interest during 2009. Representative transactions in this sector during 2008 include HP's $360 million acquisition of storage vendor LeftHand Networks in October and Symantec's $124 million acquisition of SwapDrive (an Updata client) in June.
Opportunities are in the clouds. As of late, venture funding has been difficult to secure, but RightScale, a provider of cloud computing management software, scored $13 million in its second round just last December. 2 Although cloud computing models are still nascent, the promise of a compelling combination of flexibility and cost savings has and will continue to attract substantial attention from enterprises and service providers alike. Incumbent IT management, system, and platform vendors are betting on cloud computing and racing to stake a claim in virtualization management in order to begin developing cloud management/delivery platforms. As enterprises feel pressure to make cost-cutting a primary agenda item, companies specializing in cloud computing technologies could make attractive M&A targets. A 2008 example of a deal of this type includes Rackspace Hosting's acquisitions of Jungle Disk and SliceHost in October.
ENTERPRISE APPLICATION SOFTWARE
The number of transactions and announced enterprise value in the enterprise application software sector fluctuated somewhat throughout 2008 (see Figure 17). Deals and announced enterprise value started the year off strong, but fell off in Q2. Enterprise application software deals did not reach Q1 2008 levels again. Valuations decreased steadily throughout the year.
On a brighter note, the total number of transactions tracked by Updata in the enterprise application software space fell only 3% in 2008 from 2007 (see Figure 18). While this is still a drop, it cannot compare in magnitude to the drops in most of the other sectors; this is evidence of the continuing and inevitable consolidation in each and every sector. In other words, there are still too many applications vendors pursuing too few IT budget dollars. The largest deal tracked by Updata in enterprise application software was Microsoft's $1.1 billion acquisition of Fast Search & Transfer back in January (see Figure 19).
Vertical domain expertise drove significant amounts of M&A activity in the enterprise application software sector in 2008. Particular deals indicative of this trend include I-many's acquisition of Edge Dynamics, which provides channel demand management solutions to the life sciences industry and Autodesk's acquisition of Softimage, which develops 3D technology for the film, television, and games markets. Additionally, vendors that specialize in technology for the legal or government sectors made up a healthy proportion of the enterprise application software transactions tracked by Updata in 2008.
Figure 17 2008 Enterprise Application Software M&A Quarterly Data Summary
Figure 18 Enterprise Application Software M&A Yearly Data Summary
Figure 19 Top 10 Enterprise Application Software M&A Deals In 2008 By Enterprise Value
In general, valuation multiples may continue to suffer in this sector. With the lack of credit available to both strategic and financial buyers, wide gaps in valuation expectations between buyers and more established targets, the high degree of risks of integration in a difficult IT spending environment, and the overall mindset of being internally focused to weather the storm, large deals are unlikely to lead the charge. Consolidation within the application space among the larger players started years ago and is likely to continue, but not until the economy bottoms out.
However, we are optimistic that deal volume will not be down dramatically in 2009. Where M&A deal volume will likely be strong is at the lower end of the market, the sub-$100 million levels. Large, cash-rich participants (such as Oracle, SAP, IBM, Microsoft, HP, EMC, et cetera) will be bargain hunting and will view this as an opportunity not only to buy quality assets and further widen the gap between them and would-be market share challengers, but also to enter new markets with leading edge technologies. However, these established acquirers will be disciplined and will negotiate very hard on price and deal terms while they conduct cautious levels of due diligence. Meanwhile, IPO liquidity alternatives are unlikely, and many venture capitalists may pull the plug on new funding for weaker portfolio companies or for those in sectors that have been largely consolidated.
Updata offers the following predictions for the enterprise application software sector in 2009:
Software-as-a-service (SaaS) offers a compelling cost-saving model. Growth for the emerging SaaS market was robust in 2008, and there is reason to expect that demand for SaaS delivery models will continue to be healthy in 2009. SaaS offers significant advantages over traditional software deployments that must be installed on premise. There are lower upfront costs, no maintenance fees, and due to its typical per-user cost structure, the future costs are easier to assess than those of traditional on-premise software. However, not all SaaS vendors will realize the perceived benefits of the downturn. Many subsectors (such as human capital management, customer relationship management, and soon even business intelligence) have seen such a plethora of SaaS entrants in recent years that the market will be crowded and there will be pressure to cut prices or establish creative new SaaS pricing models, such as per usage or per transaction. Additionally, new capital will be extremely expensive (if available at all), and those vendors without a fully-funded business plan may have to forgo investment in new growth opportunities or, in many cases, not survive on a standalone basis. Finally, ongoing infrastructure costs for SaaS players may result in a liquidity crunch for some vendors and a scramble to find a cloud-computing or platform-as-a-service partner. Clearly, we expect to see ongoing M&A activity in the SaaS space.
Application deployments likely to be less resilient, but vertical expertise is still sought. New application deployments are typically the first to be cut in recessionary environments, and recent CIO comments across the board suggest that this time will be no different. Areas such as security, storage, virtualization, and compliance will likely be less at risk. All of the focus will be on ROI, and most vendors will have to demonstrate a payback in less than 12 months. Of course, this is a general prediction and certain verticals will see more forward-looking IT investments than others. We expect large IT buyers to continue to show interest in leading or "best of breed" vendors within verticals that are large and attractive. While many of these deals are driven by the need to establish a foothold in a certain sector, others will be completed in a defensive manner to take out would-be competitors or to maintain existing market share.
Certain technologies are likely to gain favor as others see slowdown in demand. Companies for which human capital management (HCM) technologies comprise a major source of revenue will likely suffer if the economic downturn becomes more protracted. As the symptoms of a sick economy persist and hiring slows, HCM technologies (especially recruiting tools) will be rendered less of a priority. But again, certain vertical market expertise will be of interest. With the new Obama administration, the make up of Congress, fiscal stimulus plans, and other anticipated initiatives, expect the healthcare, government, energy, and possibly the education verticals to garner much attention from vendors who do not already have a strong presence. Transactions involving vertical specialist targets such as the acquisition of healthcare-focused Zynchros by SXC Health Solutions in December 2008 and the acquisition of government sector-focused Planview MPM Division by Deltek in September will prove resilient in 2009.
Smaller players could join forces to gain critical mass. 2009 may also be a year in which we see smaller vendors consolidating to attack the market with more critical mass. Some of these deals may be of necessity (i.e., survival). One area where this could be a theme is in SaaS where best of breed or pure plays (SFA, HCM, ERP, et cetera) may look to combine to create a suite offering to compete with Salesforce.com, NetSuite, RightNow, Concur, and others. We would also expect to see more on-premise players who are late to the game and do not have SaaS know-how to look to buy up-and-coming vendors as opposed to building out those capabilities in-house.
SMB is still a long-term opportunity. In 2009, the SMB market will be an interesting one to watch. Many established vendors have been targeting the SMB sector for several years, with varying degrees of success. The SMB market is expected to suffer in 2009, as any non-mission critical IT expenditures for small businesses are likely to be delayed in the current environment. However, in the longer term, there is still a huge opportunity in SMB. Vendors who know how to attack this market from pricing, sales channel, and marketing perspectives and who are also well-capitalized and can weather the storm will reap the benefits when these tough economic times finally return. At that point, we may see increased M&A activity involving larger enterprise-focused vendors acquiring firms that specialize in providing application solutions to smaller firms; Citrix Systems' $31 million acquisition of Vapps is an example of a deal of this type.
FINANCIAL TECHNOLOGY
The number of deals and announced enterprise value in the financial technology (Fin-Tech) space dropped off sharply from Q1 to Q2, and then picked up again from Q2 to Q3, but did not reach Q1 levels again in 2008 (see Figure 20). Valuation multiples for Fin-Tech deals, as with most other sectors, fell substantially in 2008. While the median deal multiples varied considerably on a quarter-to-quarter basis, a better indication of Fin-Tech M&A valuations is the annual statistics where the median EV/TTM revenue multiple dropped to 1.3x compared with 3.3x in 2007.
Year over year, Fin-Tech metrics are down across the board, although not to the extent of some other sectors. Other than enterprise applications, Fin-Tech experienced the smallest drop in the number of transactions in 2008 over 2007 (see Figure 21). It is also worth noting that 2007 data includes the $27.6 billion acquisition of First Data Corp by KKR announced in April; this helps to explain the significant drop in total announced EV in 2008 from 2007. Significant Fin-tech deals in 2008 include the $4.1 billion acquisition of ChoicePoint by Reed Elsevier Group and the roughly $1 billion acquisition of Fiserv Insurance Solutions by Stone Point Capital announced in February and July, respectively (see Figure 22).
Figure 20 2008 Financial Technology M&A Quarterly Data Summary
Figure 21 Financial Technology M&A Yearly Data Summary
Figure 22 Top 10 Financial Technology M&A Deals In 2008 By Enterprise Value
We expect overall Fin-Tech M&A activity to proceed cautiously in 2009 given the ongoing challenges in the financial services customer base. Fin-Tech vendors are more inwardly-focused on their operating performance as they navigate a very difficult business environment characterized by delayed IT projects, extreme pricing pressure by their customers, and elimination of all but the strongest ROI projects. Furthermore, with overall market valuations at deeply depressed levels (and Fin-Tech valuations are no exception), Fin-Tech companies that are performing well are unlikely to consider selling unless the buyer can offer a substantial premium to the market. Historically, these conditions have muted M&A activity which we believe may be the case in 2009. The difficult market environment notwithstanding, we expect to see selected M&A activity in the Fin-Tech space in 2009, and we offer the following predictions for the Fin-Tech space in 2009:
New banking regulations will present opportunities, but not before H2 2009. In the wake of the 2008 financial market meltdown, it is no surprise that the Obama administration (and Congress) is already pressing for large scale regulatory changes to the financial services market. This coming wave of "re-regulation" will generate significant new IT spending by the broadly-defined financial services community (banks, brokerages, fund managers, investment advisors, et cetera). In the same way Sarbanes-Oxley regulation created tremendous opportunities for compliance software and consulting services after its enactment in July 2002, new regulatory requirements in the financial services community will create significant opportunities for Fin-Tech vendors. This opportunity, however, is unlikely to have a meaningful impact on the Fin-Tech market until the second half of 2009 when new regulations may finally be enacted and new spending plans can be developed by the financial community. Ultimately, this regulatory compliance opportunity will generate a three- to five-year spending cycle depending on both the magnitude of the regulatory changes and the number of new organizations falling within regulatory reach (i.e., hedge funds, private equity funds, and newly-chartered bank holding companies such as American Express and GMAC). New technology companies will be formed to address the new regulatory needs and predictably, consolidation through M&A opportunities will flourish.
Risk management and anti-fraud will continue to take center stage. Fraud continues to be a critical issue within the banking industry and while precise estimates are difficult to obtain, many industry experts believe bank fraud costs the industry more than $10 billion annually. Since fraud losses typically flow right to a bank's bottom line, detecting and preventing fraud has significant ROI potential and very short-term payback. The dramatic growth of online banking and brokerage capabilities has increased the prevalence and changed the nature of financial fraud. We expect the financial services sector to continue spending aggressively in anti-fraud areas where technology can help to minimize real dollar losses and theft of confidential customer information. There are many small software and services companies providing anti-fraud technology to financial institutions. This sector has attracted a significant amount of venture funding in the past five years and appears to be ideally situated for consolidation. We expect to see certain large Fin-Tech vendors acquire smaller anti-fraud software companies in 2009, and we may see selected "private-to-private" mergers among anti-fraud vendors as they seek to broaden their overall offerings. In the broader risk management space, we look for continued demand by financial institutions to deploy solutions for improving underwriting decisions. Given the banking industry's heightened focus on underwriting standards, we believe banks will continue spending on risk management technology that helps them improve their credit process.
Payment processing growth slows providing consolidation opportunities. Slowing consumer spending has already had a negative impact on transaction volume growth, a trend that will persist into 2009. Relative growth trends across different transaction types (i.e., credit, debit, ACH, Money Transfer, et cetera) will remain in place although at lower overall levels. Credit transaction volumes may fare worst among payment volumes because in addition to recessionary forces reducing the number and dollar value of point-of-sale transactions, new card issuance has slowed significantly as bankcard issuers tightened underwriting standards and struggled to finance card receivables in the asset-backed securities market. However, because of the recurring revenue model of payment processors, the ongoing secular trend of paper payments to electronic payments and the largely untapped international market opportunity, this sector should fare reasonably well in the current recession and rebound early in a recovery. Consolidation opportunities among processors should increase as overall growth slows because operating scale becomes a more important competitive strength in a slowing market. We expect the larger processors to acquire scale and to broaden their offerings via M&A in this environment. Smaller, innovative payment processing companies (i.e., health savings account credit/debit products or specialized loyalty programs) will represent attractive add-ons to large processors and will be more affordable than in recent years.
IT SECURITY
Unlike most other sectors tracked by Updata, total announced enterprise value of M&A deals in security did not peak in Q1 2008 but in Q3 (see Figure 23). Total EV of M&A activity see-sawed in 2008, starting high in Q1, falling in Q2, skyrocketing in Q3, and then falling in Q4. Security deal valuations increased 38% from Q3 to Q4, the second consecutive quarter of valuation multiple increases, suggesting a bottoming of valuations. However, it is important to note that the number of deals with announced valuations is relatively small so the statistical trend may not be truly indicative of a recovery.
The total number of deals in the sector was down 28% in 2008 versus 2007 (see Figure 24). Total announced EV fell 43% over the same time period. The most marked contrast was the steep drop in median multiple of EV to TTM revenues, which fell 65% from 6.0x revenue in 2007 to 2.1x in 2008. Significant security deals in 2008 include Symantec's $695 million acquisition of MessageLabs in February and McAfee's $465 million of Secure Computing in September (see Figure 25).
The year included an above-average (six) announced acquisitions of public security vendors - Secure Computing by McAfee, Utimaco by Sophos, Tumbleweed by Sopra, Certicom by RIM (terminated), and Sourcefire by Barracuda (terminated). Active acquisition areas include identity and access management, managed security and data loss prevention.
Figure 23 2008 Security Software M&A Quarterly Data Summary
Figure 24 Security Software M&A Yearly Data Summary
Figure 25 Top 10 Security Software M&A Deals In 2008 By Enterprise Value
While enterprises have generally cut IT budgets, security remains a high priority and is therefore less amenable to reductions. Recently, Forrester Research reported findings from a survey of IT decision-makers that indicated only 6% of respondents planned to cut spending on IT security.3 Spending drivers include the desire to be compliant and reduce risk of theft, loss, damage and downtime.
Updata's predictions for the IT security sector include:
Although 2008 challenged security sector valuations, the recovery may be steep. Barring worsening macro developments, IT security M&A valuations and volumes should improve in 2009, for several reasons. First, 2008 saw an uptick in unsolicited and private-to-public acquisition activity, possibly reflecting a perceived bottoming of valuations. Second, M&A valuations are far below the multi-year historical average for the sector, suggesting an overreaction to broader gloomy news. Third, much of the forecasted decline in 2009 enterprise IT spending represents deferred rather than eliminated budgets; consequently, a spending "backlog" may come through more or less all at once when market conditions improve, causing a spike in spending, perhaps near the end of 2009 into early 2010. Fourth, in the long term, the government sector will pick up a good portion of the IT spending slack that the financial sector is giving up; in other words the spending pie is not shrinking but reallocating. Fifth, reduction in venture-fueled over-competition in certain subsectors and a culling of the herd will improve prospects for survivors. Finally, underlying technology trends such as virtualization and mobilization create new security needs that will drive spending growth and, in turn, M&A activity.
Non-traditional M&A is on the rise. 2008 saw a rise in unsolicited, private-to-public, and private-to-private deal activity. This phenomenon was driven by several factors. First, with an essentially closed IPO market, larger private vendors have seen an opportunity to boost their scale and attractiveness ahead of better times by acquiring a public vendor. Examples in IT security during 2008 are Sophos' acquisition of public company Utimaco and Barracuda's attempted acquisition of public company Sourcefire. Second, compelling values in the marketplace create opportunities to build critical mass and add technology inexpensively. Third, more companies are willing to exchange stock rather than raise money at less than optimal values - this creates opportunities for private-to-private deals and other deals that are difficult to complete in flush times. Such creative, "non-traditional" M&A activity will likely continue in 2009, offsetting the drop-off in private-equity financed deals.
Underlying sector spending trends remain positive. We remain bullish on prospects for IT security spending. Unlike other technology sectors, security is a perennially unsolved challenge where needs change alongside technology and usage. Collaboration, computing, and communication advances improve productivity but also heighten the threat and damage that breaches and thefts can cause. Consequently, businesses and individuals alike should be willing to spend more to stay safe. Additionally, as previously noted, security is more of a mission-critical area than other technology sectors. Areas of high-growth and M&A potential in 2009 and beyond include: online fraud reduction; identity-based threat management; in-the-cloud vulnerability management; next-gen network monitoring; and data theft prevention.
Best-of-breed players are regaining the upper-hand over best-of-need vendors. When Art Coviello, CEO of RSA, famously said the "security industry is dead" two years ago, he was referring to the rapid acquisition and integration of pure-play IT security firms into large, broad vendors - acquisitions of RSA by EMC, and of ISS by IBM are prime examples of this. Two years later, the pendulum has swung back a degree toward specialization and best of breed. This can be seen in several notable 2008 market exits by big vendors, such as HP and BMC which essentially quit identity and access management. This is also evident in the rise of large pure-plays (such as Barracuda, Safenet, Sophos) that have been taking share from large generalists like IBM and Symantec over the last two years. A recent survey by Security Channel found that 80% of respondents prefer to work with best-of-breed vendors when it comes to IT security. 4 While industry consolidation continues to occur at a rapid pace, the market seems to remain open to innovators - even among larger competitors in established sectors.
IT SERVICES
While certainly not immune to the effects of the market, M&A activity in IT services proved relatively resilient compared with other sectors tracked by Updata. IT services deals comprised the bulk of the announced enterprise value for 2008 IT M&A, peaking in Q2 with just over $23 billion (see Figure 26). Deal values were not down substantially from 2007 (mainly as a result of HP's giant $13.9 billion bid for services-centric EDS), but the number of IT services M&A transactions fell 23% year-over-year (see Figure 27). The EDS deal re-aligned the top players and propelled HP dramatically into the top echelons of global IT services vendors (see Figure 28). Also indicative of resilience in this sector is that median revenue multiples have stayed roughly consistent since 2006.
Setting aside EDS's broad horizontal offerings, specialists were especially attractive targets in 2008. Companies that provided services focused on specific technologies, such as SAP, Oracle, Microsoft, and salesforce.com, were in high demand. Specialization extends to verticals as well, and in 2008 we saw activity around several sectors, most notably government, healthcare, legal, and compliance/risk management. Not surprisingly, there were very few deals focused on financial services sector technologies.
Figure 26 2008 IT Services M&A Quarterly Data Summary
Figure 27 IT Services M&A Yearly Data Summary
Figure 28 Top 10 IT Services M&A Deals in 2008
Relative stability is relative strength in the current environment, and we expect such stability to drive ongoing services M&A activity in 2009. Valuations in the services sector have hardly been inflated in recent years, particularly relative to the talent and high-value propositions of many IT services organizations. Some themes which may underpin services M&A in 2009 include:
Cloud computing and SaaS technologies deepening enterprise penetration. Most enterprises are moving one way or another toward cloud computing and SaaS technology delivery models given the lower costs compared with running traditional in-house software. That said, enterprise managers are not overlooking the need to quantify and measure IT and business benefits claimed by cloud computing and SaaS. This need has spurred the creation of consultancies focused on evaluation, procurement, deployment, and integration of cloud computing technologies. While growing fast, this segment is still dominated by a peer group of smaller, well-funded firms who mostly hitched their original coattails to salesforce.com technology. Today most are quickly evolving their expertise holistically into value-added strategic consulting focused on interoperability and integration issues key to successful SaaS deployment. We foresee that as technology is increasingly delivered in the cloud, IT vendors of all stripes (software, hardware, consulting) will seek out the talent and methodologies - sometimes through M&A - to transform and deliver their offerings into managed services on recurring-revenue, hosted bases.
IT infrastructure, best practices, and cost savings drive the green initiative. "Green" technology does not just encompass new, clean energy sources; it goes directly to the heart of the enterprise - specifically to cost management, power efficiency, and IT energy consumption. Updata has closed two prominent transactions in this area in the last 12 months, focused entirely on energy efficient operations of the data center - Aperture's acquisition by Emerson Network Power and EYP Mission Critical Facilities' acquisition by HP (both in February 2008). Consulting firms which offer expertise focused on logical and physical IT operations - from virtualization to power and capacity management - will continue to be attractive M&A candidates in 2009.
Enterprises will swiftly hijack Web 2.0 technologies. Just 12 months ago, these technologies were anathema to most enterprise executives, but this is rapidly changing. Smart organizations are embracing Enterprise 2.0 communities across a whole host of constituencies - enabling controlled but fluid interactions among stakeholders like employees, customers, vendors, suppliers, and many others. By its very nature, Enterprise 2.0 incorporates multiple technology needs, ranging from sophisticated web development to e-commerce, content management, security, and beyond. As this matures, we are likely to see practices evolve (and combine) to optimize Enterprise 2.0 at each level of the value chain.
INTERNET
After a buoyant 2007, Internet M&A experienced declines in both the number of transactions (down 25%) and total announced enterprise value (down 58%) in 2008. Valuations dropped precipitously over the course of 2008 from 4.0x TTM revenue in Q1 to just 0.8x TTM revenue in Q4 - an 80% decline (see Figure 29). Median multiples of EV to TTM revenue fell 23% from 3.0x revenue to 2.3x revenue from 2007 to 2008 (see Figure 30).
Overall sector data hides significant differences among sub-sectors, and a net increase in deal activity among many large acquirers. The uptick in large buyer activity is partly attributable to companies seeking to leverage strong balance sheets for competitive advantage. Additionally, there is a growing view that target valuations may not get more attractive than they are now. Areas that have seen significant deal activity in 2008 include online video, specialty social networking, and travel services (see Figure 31).
Virtual worlds, user-generated video and widgets saw an explosion of analyst and popular interest from 2006 to early 2008, driving overinvestment, flocks of start-ups, and some eye-popping deals, beginning with Google's acquisition of YouTube for just under $1.7 billion in October 2006. As user growth flattened in these subsectors, and as advertisers failed (at least so far) to embrace these models, market participants could not generate meaningful revenues, and a culling of the herd has begun that will continue into 2009. In contrast, such adjacent areas as professionally produced Internet video content, massive multi-parallel gaming, and in-the-clouds applications have registered strong growth in 2008, and are likely to see continuing interest in 2009.
Irrespective of the economy and capital markets, the Internet population and time spent online will continue growing at a healthy clip for the foreseeable future. The number of Internet users globally rose 25% in 2008 over 2007, while time online increased 7.7% between May and October 2008 alone. 5 6 This expansion is driving ongoing IP enablement of content, applications, and services - in turn pulling more people and activities online in a virtual cycle. The megatrend of everyone and everything going online puts a floor on potential sector spending declines, and trading and deal valuations.
Figure 29 2008 Internet M&A Quarterly Data Summary
Figure 30 Internet M&A Yearly Data Summary
Figure 31 Top 10 Internet M&A Deals In 2008 By Enterprise Value
The Internet sector may yet stand to reap benefits in a down market. Disruptive web sites and services, such as those offering a material cost or time advantage over traditional competitors, stand to increase their market share expansion in a down market. Notable areas include in-the-cloud enterprise applications and travel and shopping sites. Expedia (and its subsidiary TripAdvisor), for example, made eight acquisitions in 2008. Deals in the latter half of 2008, including Sonic Solutions' acquisition of CinemaNow in November and Harmonic's December acquisition of Scopus Video Networks highlight ongoing interest in the Internet as a potential countercyclical area for investment and M&A. Updata offers the following additional predictions for the Internet sector in 2009:
Online advertising will weather the storm. Despite a bleak outlook for overall ad spending in 2009, eMarketer recently forecast Internet advertising spending to increase 14.5% in 2009 as online spending takes market share from traditional broadcasting and print media. 7 As late as December 2008, online advertising networks GoFish Corporation and LucidMedia raised $31 million of financing. 8 Online advertising, which accounted for the highest multiple deals in 2007 and 2008, will continue to be an active subsector as Google and Microsoft lead the charge to build, buy, and partner to drive traffic, optimize revenues, and gain a growing share of cross-media advertising dollars.
Social networking will continue expanding in the downturn. Immensely popular online social networks led by MySpace and Facebook will continue to seek ways to increase growth, stickiness, and to improve monetization. This will drive significant M&A activity in 2009. In addition, social networking is tightly linked to such other services as email, video content, and recruiting; acquirers will aim to exploit these linkages by combining services.
Innovations in Internet infrastructure enable Internet video to thrive. Companies specializing in some aspect of Internet video production or sharing were hot in 2008 and will continue to be so in 2009. According to a recent comScore survey, total online videos viewed by U.S. internet users rose 34% year-over-year in November to 12.7 billion, and 77% of the U.S. internet audience viewed online videos. 9 Improvements in, and lowering costs of, bandwidth and access coupled with immense proliferation of content is feeding this hunger for online video consumption. 2008 deals in this space included eBay's acquisition of VUVOX in June and Google's acquisition of Omnisio in July.
The mobile web arena is a fertile space for deals. Handset makers (such as Nokia, HTC, Research-in-Motion), mobile content providers (such as Apple), and OS vendors (such as Nokia, Microsoft, Google) have begun jockeying to control the mobile web content and services market. Juniper Research projects that the global markets for mobile Web 2.0 will be worth $22.4 billion and $11.2 billion for mobile social networking in 2013. 10 The market for mobile advertising is expected to reach $19 billion by 2012, according to eMarketer. 11 In December, Google's mobile ads team announced the capability of AdWords advertisers to show desktop text and image ads on mobile devices with HTML Internet browsers such as Apple's iPhone and T-Mobile's G1. 12 2008 mobile deals such as Zandan's acquisition by Keynote Systems and LiveWire Mobile's acquisition of Groove Mobile provide a glimpse of more to come in 2009.
CONCLUSION: 2009 Presents Trials And Opportunities
While the veil of uncertainty which cloaked 2008 has not yet been lifted, we continue to see M&A used as an important corporate strategy as we enter 2009. Transactions may take longer to execute, and due diligence will be performed more thoroughly than ever, but buyers with available cash will continue to look for M&A opportunities. Flexible sellers, relatively attractive valuations, numerous quality opportunities, and significant cash balances at large public IT vendors will also drive M&A in 2009.
Non-traditional M&A transactions will play an important role in 2009. Private companies with few liquidity options and increasing costs of capital will seek out merger opportunities (mergers of equals, joint ventures, et cetera) to obtain operational synergies, cut costs, gain critical mass, and stay afloat. Increased divestiture activity will be driven by companies looking to raise cash through the sale of non-core assets, product lines, or business units. Private equity capital may also be used to facilitate such transactions, as was the case with Marshal's merger with 8e6 Technologies and ClinPro's combination with Pacific Data Designs (Updata advised Marshal and ClinPro).
The economic turmoil of 2008 certainly presented challenges to the M&A landscape and it is unlikely that 2009 will see a dramatic recovery. M&A thrives in a stable and buoyant market environment that is devoid of uncertainty. As we expect both buyers and sellers to continue to be risk-averse, we do not expect M&A in 2009 to be driven by large and risky transactions; rather, we expect continued activity in the sub-$200 million mid-market range. As discussed throughout this report, the development of new technologies (such as cloud computing, virtualization, software-as-a-service) coupled with increased spending in selected sectors (government, healthcare, energy, security) will be a source of stability, growth, and probable M&A activity.
For these reasons, we at Updata look forward to 2009 as a year of opportunity for thoughtful and creative combinations.
