M&A Overview: IT M&A Deals Pick Up, But Uncertain Economy Impacts Valuations
The third quarter of 2008 has seen considerable market turbulence. Conditions were generally rocky throughout July and August, and completely melted down in September. Surprisingly, the number of deals tracked by Updata in Q3 2008 is up slightly from Q2 (see Figure 1). Total announced enterprise value (EV), however, plunged 51% from last quarter and 34% from the prior-year quarter. Enterprise value as a multiple of the trailing 12 months' (TTM) revenue is down 17% from last quarter and 12% from the prior-year quarter. Of course, last quarter's total announced EV was boosted by Hewlett Packard's $13.9 billion bid for IT service provider EDS last May. Excluding that deal, announced EV declined only 10% from Q2 to Q3. Additionally, in Q3 2008 there were very few large deals and only three with announced EV greater than $1 billion, attesting to strength in mid-market M&A (see Figure 2). Clearly, deals are still getting done, but they are taking longer to complete, and valuations are lower as buyers are cautious yet opportunistic in this volatile economic period (see Figure 3).
Figure 1 M&A Quarterly Analysis For Deals Tracked By Updata
Figure 2 Selection Of Announced Deals Greater Than $500 Million
Figure 3 Median M&A Transaction Multiples By IT Subsector - EV/TTM Revenue
IPOs And Private Equity Deals Are Down
The bleak initial public offering (IPO) market continues into Q3 as only five companies went public this quarter, down 87% from one year ago, according to Hoovers.1 Venture-backed companies are facing a similar drought as just $4.57 billion in liquidity was generated through U.S. IPOs and M&A deals involving VC-backed companies, down 66% from the prior-year quarter.2
The technology sector seems to have fared better than other sectors so far. In fact, the sole venture-backed company to complete an IPO in Q3 was an IT company, Rackspace Hosting. Private equity (PE) buyers, who are increasingly having trouble obtaining acquisition financing, have been scarce in Q3 among the deals tracked by Updata with the number of PE deals down 43% this quarter versus last quarter (see Figure 4).
Figure 4 Selected Private Equity Transactions
U.S. Cross-Border Acquisition Activity Cools - Foreign Buyers Shop Here
Last quarter we reported that despite the U.S. economic downturn, American companies were still acquiring abroad with vigor. This quarter, cross-border acquisition activity tracked by Updata tells a different story (see Figure 5). Cross-border deals still made up a healthy proportion of deals overall at 41% compared with 39% last quarter. However, among the cross-border deals that Updata tracked this quarter, 37% were inbound to the U.S. and 37% were outbound from the U.S.3 Last quarter, only 17% of the cross-border deals we tracked involved a U.S. target company.
EMEA (Europe, Middle East, and Africa) barely edged out North America as a target geography. Forty-six percent of cross-border deals involved a seller based in Europe, compared with 45% of sellers located in North America. Only 9% of cross-border deals involved a target based in the Asia Pacific region.
IT services companies comprised the bulk of cross-border IT M&A deal activity (41% of cross-border deals) followed closely by enterprise application software (33%). Among cross-border IT services deals, almost 30% were systems integrators - SAP was in particular demand. Just more than half (52%) of cross-border enterprise application software deals were in the financial technology space.
Figure 5 Selected Cross-Border Transactions
Drop-Off In IT Spend And M&A Activity Varies By Technology
With the troubles that have befallen financial institutions, analysts forecast that IT spending will take a significant hit, with the U.S. and Western Europe experiencing most of the decline. But one spot of good news is that Gartner predicts worldwide IT spending in 2009 will not fall to the levels seen in the dot-com bust when companies cut spending too much, but will grow 2.3% (revised down from 5.8%).4
IT spending cuts will vary greatly depending on industry and technology. According to Forrester, 49% of financial services companies have cut their IT spending budgets.5 In contrast, spending on IT services has held steady for firms in all industries, while IT outsourcing services are gaining traction; 45% of firms state that they plan to increase their use of applications outsourcing and 43% plan to increase infrastructure outsourcing.6
Financial Technology Deals Showed Strength In Q3, But Near-Term Prospects Remain Uncertain
Updata follows M&A activity in the financial technology (Fin-tech) market as a subset of its enterprise application software sector. In Q3 2008, M&A deals involving Fin-tech companies represented a healthy proportion of the overall enterprise application software deals tracked by Updata (see Figure 6). Fin-tech deals comprised $3.5 billion in announced enterprise value, making up 67% of announced transaction value for the enterprise application software sector. Similarly, based on the number of deals announced, Fin-tech deals represented 43% of all enterprise application software deals tracked by Updata in the quarter ended September 30, 2008. While the number of Fin-tech transactions in Q3 2008 outpaced those from Q3 2007, transaction multiples of EV/TTM dropped substantially. On average, Fin-tech transaction multiples were approximately 2.0x revenue in Q3 2008 versus the average multiple of 4.0x revenue observed in Q3 2007. The 2007 multiples were heavily influenced by a few notable deals including Fiserv's acquisition of Checkfree (~4.5x revenue) and Xerox's acquisition of Advectis (~4.4x revenue).
Notable transactions during the third quarter of 2008 include Wipro's acquisition of Gallagher Financial Systems (~1.3x revenue), American Processing Company's acquisition of National Default Exchange (~3.2x revenue), and SunGard's acquisition of GL Trade (~2.1x revenue). The largest announced Fin-tech deal in the third quarter was the management buyout of Fiserv's insurance business by Stone Point Capital. Fiserv divested the business in order to concentrate its focus on the banking vertical and to enhance its consolidated operating margins (the insurance unit was a sub-standard contributor). The transaction, which relied on the placement of $385 million of senior debt, fortuitously closed in July, just ahead of the collapse of the global credit markets.
A number of trends continues to drive Fin-tech M&A. For example, offshore service providers are aggressively seeking acquisitions of financial technology processing and lending solutions; HCL and Wipro have each completed such deals so far in 2008. Additionally, acquisitions in consumer protection and identity theft remain healthy. Examples include PayPal's acquisition of Fraud Sciences and London Bay Capital's acquisition of Selling Source. Updata believes renewed M&A activity will arise from the increased demand for compliance and audit solutions in the wake of the credit crisis and also from the continued enthusiasm for mobile banking solutions (which will drive M&A by large Fin-tech players seeking to assemble broader solutions in wireless applications and mobility infrastructure).
While the backdrop for a healthy Fin-tech M&A market remains in place, there is little question that the current state of the global financial services market represents a significant distraction for buyers and sellers. Coupled with the fact that market valuations have dropped significantly in the past 60 days, it is likely that M&A activity in Q4 2008 will be soft by historical measures. However, in the coming quarters, M&A activity will very likely rebound as the unprecedented consolidation activity among banks and broker-dealers creates new opportunities for technology vendors and service providers.
Figure 6 Selected Financial Technology Deals
SECTOR ANALYSES
Updata tracks five core subsets of the technology sector: Infrastructure Software, Enterprise Application Software, Security, IT Services, and Internet. None performed particularly well in the 12 month period ended September 30, 2008, with subsector indices declining an average of 19% (see Figure 7).7 Corresponding valuation metrics of the underlying public companies in these sectors are also shown below (see Figure 8).
There were some interesting shifts between Q2 and Q3 2008 (see Figure 9). Total enterprise value for enterprise application software and security M&A is up from Q2 2008. Median multiples of EV/TTM revenue are up in infrastructure software and security from last quarter.
Figure 7 One Year Relative Stock Price Performance By Sector Versus NASDAQ
Figure 8 Public Company Valuation Metrics
Figure 9 Sector M&A Data
An in-depth look at Q3 2008 M&A activity by sector reveals:
Infrastructure Software
Infrastructure software deals make up 6% of the total number of deals tracked by Updata in Q3 2008 and 4% of the total enterprise value (see Figure 10).8 Deal metrics across the board for the infrastructure software sector in Q3 are roughly on par with last quarter.9 When compared with Q3 2007, however, announced EV for the infrastructure software sector is down 84%. Some trends we have noted in this sector include:
Infrastructure software spend may be better equipped to weather the economic downturn. Although IT spending overall is not expected to grow by much, if at all, in 2009, there are several bright spots within IT infrastructure. One should be emerging geographic markets such as Asia Pacific and another may be infrastructure-as-a-service and emerging "cloud" opportunities as customers seek to better manage costs and defer capital expenditures. IBM, with the largest deal announced in the infrastructure space this quarter, has a broad portfolio of solutions and managed services and has reported that its Q3 2008 earnings outperformed Q3 2007 earnings by 22%.10 Also, the only tech IPO in Q3 was Rackspace, a hosting vendor which recently introduced a high-profile "cloud" offering called Mosso.
Large IT vendors dominate the infrastructure space. About 90% of the Q3 2008 enterprise value for infrastructure software deals came from the biggest public players including Cisco, IBM, Microsoft, Oracle, and Red Hat. This is up significantly from last quarter when only 28% of announced EV in this sector came from the major players.11 Significant deals include IBM's acquisition of business rule management systems provider Ilog SA and Cisco's acquisition of networking management solutions provider Pure Networks. We believe large vendors will remain active in M&A despite broader market conditions. In fact, deal pace by some large vendors may pick up as valuations come down.
Cost advantages of virtualization and automation technologies spur acquisitions. The credit crunch has enterprises focused on cutting costs, which is exactly what these technologies do by improving productivity and lowering labor costs. Red Hat's acquisition of Qumranet and the acquisition of Computers in Motion by Kace Networks are examples of deals involving targets that specialize in automation and virtualization technologies.
Enterprise application software deals make up 31% of total deals tracked by Updata in Q3 2008 and 34% of total enterprise value (see Figure 11).12 Despite a 25% drop in median EV/TTM revenue multiples from last quarter, 34% of total enterprise value for Q3 2008 comes from enterprise application software deals - up from just 8% last quarter. This represents healthy activity in any economic environment. Below are several sector observations of note:
Human capital management (HCM) likely to see a slowdown. As hiring slows, focus on recruiting, talent management, and other HCM technologies will likely lessen and players such as Kenexa, Successfactors, and Taleo may be hit especially hard. Updata tracked only two HCM deals in Q3: Bedford Funding's $71 million acquisition of Authoria and Salary.com's $5 million acquisition of InfoBasis.
PE buyers cannot maintain the acquisition pace of the past few years. PE buyers are being affected more than strategic buyers. Only five out of the 63 enterprise application software deals tracked by Updata in Q3 were private equity deals, well below the recent pace of PE deals in the enterprise application software space over the last couple years. With the heightened restriction on access to credit plaguing financial institutions in recent months, PE buyers are struggling to obtain financing for their purchases. PE deals in enterprise application software for Q3 include: Marlin Equity Partners' acquisition of Financial Consulting and Trading International and StonePoint Capital's acquisition of Fiserv Insurance Solutions for over $1 billion.
Software-as-a-service (SaaS) companies may benefit from economic turmoil. In a difficult economic environment, perpetual license model software companies may suffer as IT departments hesitate to pay large upfront costs for a software deployment, favoring subscription/SaaS-based expenses. Still, SaaS companies face the challenge of revenue collected over time, and thus move slowly to positive cash flow. If the financial crisis is long and spread across industries, SaaS companies - especially those that have not yet reached cash flow profitability - may have more difficulty weathering the storm.
Security software deals comprise 7% of both deal volume and of total enterprise value tracked by Updata in Q3 2008 (see Figure 12).13 Security deals are up remarkably from last quarter when they made up just 1% of total enterprise value for all sectors tracked by Updata. Below are several noteworthy trends we have observed:
Continuing opportunities for innovators. IT security demand arguably does not mature as it does in other technology sectors; rather, it gets reallocated among sub-sectors while overall spending continues to grow, driven by the ever-evolving threat and technology landscape. For example, spending declines on firewalls will likely be offset by spending increases in data loss prevention, compliance management, and other new technologies. Private vendors remain the primary driver of innovation in security's higher-growth areas, resulting in M&A activity and valuations levels that generally remain above the overall tech market in good times and bad. In fact, according to a September press release from Forrester Research, IT security spending will not suffer the serious declines facing other IT sectors; only 6% of IT security decision-makers indicated that they will cut their spending on IT security.14
Rise of the super pure-plays. Conventional wisdom views security as a feature set that ultimately gets dissolved into offerings by Google, IBM, Microsoft, Oracle, and other major integrated vendors. While partly true, it is equally accurate to say that security is a specialty best handled by specialists. As proof, big private pure-plays have become more influential in the past two years, taking share from the publics by emphasizing focus and depth rather than breadth. Examples include Sophos, which recently acquired publicly-traded Utimaco; Barracuda, which recently tried to acquire publicly-traded Sourcefire; and SafeNet, taken private in 2006. In 2009, we expect such larger pure-plays, working with financial investors, to continue taking share and driving an increasing portion of sector M&A activity.
Breakout markets of the future. Security incorporates multiple sub-sectors with disparate solutions. As new growth areas emerge and ripen, tremendous value accrues to perceived early leaders - high multiples paid in data loss prevention acquisitions is a case in point. In the future, breakout opportunities, and false starts, will remain an integral part of the security market. Although difficult to predict, markets poised for tremendous growth in 2009 include: IT governance and compliance management, internet fraud and identity management, and mid-market security-in-the-cloud. While different, each of these spaces benefits from several strongly favorable underlying trends: customers want to save money, reduce risk, and open up further to the Internet.
Figure 12 Noteworthy IT Security M&A Transactions Q3 2008
IT Services
Compared with other sectors tracked by Updata, IT services shows the most marked change from Q2 to Q3 (see Figure 13).15 This quarter, IT services deals comprise 37% of the total number of deals, down from 41% last quarter and 47% in the prior-year quarter. In Q2 2008, IT services deals comprised 74% of the total enterprise value; this quarter they make up only 30%. When compared with Q3 2007, however, deals in the IT services sector make up a greater percentage of total EV, up from 25% last year. Trends in IT services that we have seen are:
Certain verticals, including government, pharmaceuticals, and healthcare, show relative strength. Although the technology as a whole has not gone unaffected by the economic downturn, there is reason to remain positive about the IT services sector. If history repeats itself, the federal government will continue to be a prime customer to IT services companies. Deals involving targets that specialize in providing IT services to the government include Raytheon's acquisition of Telemus Solutions and Lockheed Martin's acquisition of Nantero's government business unit.
Competition heats up over specialist consultancies. Last quarter we reported on the rise of Oracle implementation providers as M&A targets in the services sector. This remains the case as Updata has tracked several deals in Q3 involving Oracle specialists (including TITAN Technology Partners' acquisition of Pinnacle Group Worldwide and PricewaterhouseCoopers' acquisition of Entology). But SAP specialists still dominate in Q3 as Indian IT service outsourcing powerhouses Infosys and HCL Technologies duke it out for Axon Group. At the time of this publication, HCL has announced the most recent bid at $780 million in enterprise value. This deal highlights the continued demand for front-end consulting capabilities to support IT services work sent offshore, albeit on a larger-than-usual scale.
Cloud computing evolution is carrying over to services. Cloud computing is a strengthening phenomenon in infrastructure software, and it is making its way into the services space as well. According to research by IDC, spending on cloud computing services is expected to reach $42 billion by 2012, with the economic downturn playing a contributing role in increased spend.16 We are beginning to see proliferation of IT consulting firms building out software-as-a-service (SaaS) offerings, with meaningful venture dollars being poured into these specialists, and nascent M&A discussions are underway to aggregate capabilities.
Figure 13 Noteworthy IT Services M&A Transactions Q3 2008
Internet
Internet deals make up 14% of the deal volume tracked by Updata in Q3 2008 (see Figure 14).17 Internet M&A shows resiliency; at 24% of total enterprise value, deals in the Internet sector comprise twice as much as they did last quarter.18 Several large publics (including Microsoft, Time Warner, and Disney) have actually increased acquisition activity in this sector in the past year. Although overall median EV/TTM revenue multiples have declined since Q2 2008, it is difficult to make a meaningful assessment of the decline on a quarterly basis since most deal valuations are not announced (more so in the Internet sector than in others). Annually, for the year ended September 30, 2008 multiples are up in the Internet sector 20% from 2007 to 3.6x. Several ongoing trends that will drive Internet market strength and investment opportunities include:
Continuing improvements to Internet infrastructure drive engagement. Improvements in internet infrastructure will help drive spending online and venture investment. For example, Internet security technologies such as intelligent anti-fraud technology and transparent identity management enable more secure transaction processing, and increasing Internet bandwidth and better web services drive growth in rich media, specifically in gaming and video. Gaming and video continue to prove their staying power by raising money even in the down economy. Gaming companies such as Trion World Network, Challenge Games, and Big Fish Games have all received venture funding in Q3 2008 and video vendors have raised $500 million in the past year.
Convergence of old and new media aims to increase engagement, drive monetization. Old media is discovering that it needs to keep up with the times in order to keep its audience engaged. The suffering New York Times is attempting to do just that with its recently-launched TimesPeople, a social sharing tool. MTV Networks has begun an initiative to post every music video in its archive online in a move that both connects with today's always-online demographic and goes back to its roots as a music destination. Expect to see more old-new media hybrid models emerge.
Online advertising spend will not disappear. Although dire predictions abound, according to the Interactive Advertising Bureau and PricewaterhouseCoopers, U.S. online advertising revenues for the first half of 2008 grew 15% from the first half of 2007.19 Search related advertising spend experienced the most dramatic growth, up 24% since H1 2007. According to a survey conducted by Epsilon, 63% of senior marketing executives reported that they actually plan to increase spend on interactive/online marketing.20 Q3 online advertising deals include Google's acquisition of Russian search advertising company Begun and Blinkx's acquisition of MIVA.21
Figure 14 Noteworthy Internet M&A Transactions Q3 2008
7 Updata's enterprise application software index is comprised of the following companies: ACTU, BOBJ, CHRD, COGN, DMAN, FIC, INFA, MSTR, OMTR, OTEX, PRO, SPSS, UNCA, ARTG, BVSN, CRM, CTCT, FPND, IMNY, KANA, RNOW, UNCA, EMC, IWOV, OTEX, VOGN, Sage, BasWare, EPIC, INTU, LWSN, ORCL, PROJ, QADI, SAP, SBN, CALD, CNQR, KNXA, SABA, SFSF, SLRT, SUMT, TLEO, ULTI, WSTM, Delcam, ADSK, ANSYS, ANST, CIMT, DASTY, MFLO, MSCS, PMTC, Kewill, ARBA, AZPN, DSGX, GSOL, ITWO, JDAS, LGTY, and MANH. Updata's Internet index is comprised of the following companies: ADBL, CHINA, CNET, GIGM, GOOG, IACI, ICGE, JUPM, KNOT, LNUX, NAPS, NTES, SNDA, SINA, SOHU, TTGT, YHOO, IIG, MIVA, PUB, WSPI, AMZN, DSCM, EBAY, EXPE, FLWS, GSOL, LOOP, LQDT, OSTK, PCLN, SFLY, AKAM, CCOI, CMGI, DRIV, ELNK, GSIC, INAP, KEYN, RNWK, SNCR, UNTD, VRSN, MCHX, VCLK, VWPT, ARTG, CRM, LPSN, RNOW, ULTI, VIGN, VOCS, ABTL, BIDU, INSP, LOCM, LOOK, MOVE, RATE, SOLD, and TZOO. Updata's infrastructure software index is comprised of the following companies: Software AG, CTXS, INFA, JAVA, MSFT, ORCL, PEGA, PRGS, RHT, TIBX, InfoVista SA, Opsware, AVCT, BLOG, BMC, CA, CPWR, HPQ, IBM, KEYN, MOTV, NOVL, CVLT, DBTK, DDUP, EMC, FALC, ISLN, NTAP, RVBD, and SYMC. Updata's IT security index is comprised of the following companies: Trend Micro, CHKP, CTXS, JNPR, MFE, MVSN, SFNT, SYMC, VRSN, WBSN, Certicom, F-Secure, nCipher, ACTI, ALDN, BCSI, COGT, DMRC, ENTU, FIRE, HIFN, ID, INTZ, SCUR, SNWL, TMWD, VDSI, and ZIXI. Updata's IT services index is comprised of the following companies: CRAI, DTPI, FCN, HURN, XPRT, MMC.L, NCI, RECN, SAPE, AXO.L, ANSR, BE, CAP.PA, GIB, CBR, EDGW, ELOY, INFT, KEA, MPS, PRFT, ANLY, CDI, CFS, CTG, CITP, KFRC, NTSC, RCMT, TSRI, CAI, DRCO, ICFI, MANT, MMS, MTCT, NCIT, SAI, SINT, SRX, ACN, ACS, CSC, EDS, IBM, NSTC, PER, UIS, TEAM, CTSH, HCLT, INFY, PTI, SAY, SYNT, VRTU, WIT, ADP, APAC, CVG, CSGS, EXLS, G, HSII, HEW, ICTG, INFY, IRM, PAYX, PSPT, PTI, SYKE, TTEC, WIT, WNS, and WW.
8 Updata defines the infrastructure software sector to include: network and systems management, IT asset management, storage software, networking software, application development tools, enterprise application integration, application infrastructure, and business process management.
11 Major players in Q2 included: BMC Software, IBM, Symantec, and VMware.
12 Updata defines the enterprise application software sector to include: software-as-a-service (SaaS); business analytics; customer relationship management; enterprise content management; enterprise resource planning; human capital management; supply chain management; product lifecycle management; and vertical applications.
13 Updata defines the IT security sector to include: identity and access management, traffic security, content security, vulnerability, and managed security service providers.
15 Updata defines the IT services sector to include: IT outsourcing, business process outsourcing, offshore outsourcing, IT consulting, systems integration, IT staffing, network and systems infrastructure services, and government IT consulting and integration.
21 At the time of this publication, it has been announced that Google's intended acquisition of Russian search company Begun would be in violation of Russia's competition laws and has been canceled as a result. http://www.iht.com/articles/2008/10/23/technology/google.php
