Updata Advisors 2008 Information Technology M&A Outlook
TABLE OF CONTENTS:
Overview Putting aside global credit market challenges and a market correction, 2007 was by most measures a very good year for the information technology industry. Aggregate revenue among the industry's largest bellwethers grew... read more>>
Enterprise Application Software 2007 was an interesting year for enterprise application software. Building on the momentum of 2006, trading values and M&A activity got off to a strong start... read more>>
Internet The internet sector -- including e-commerce, new media and web-based services -- experienced record post-bubble deal activity and rapid change in 2007... read more>>
Infrastructure Software Several key trends that have emerged in infrastructure software over the past several years will continue to be the primary M&A market drivers through 2008... read more>>
IT Security/Compliance IT security and compliance pure-plays outperformed the overall technology market by a wide margin in 2007. The share price index of larger public bellwethers rose... read more>>
IT Services Updata tracked 424 IT Services deals in 2007, representing a 13% increase in deal activity from 2006 levels. While the year was strong for IT Services M&A, it was also a year of great contrasts...read more>>
OVERVIEW
Putting aside global credit market challenges and a market correction, 2007 was by most measures a very good year for the information technology industry. Aggregate revenue among the industry's largest bellwethers grew by 11.4%, while many smaller cap IT companies turned in growth results well in excess of this. IT vendors have benefited from a multi-year capital spending cycle as large organizations continue to invest in new technology infrastructures to streamline operations and remain competitive. The big question for information technology companies in 2008 is whether or not IT spending will remain robust in the face of continued credit turbulence, declining real estate values, and high oil prices. Add to that the uncertainty brought about by a U.S. presidential election year.
As a case in point, and as this was going to press, Microsoft announced its intention to acquire Yahoo! for $45 billion. This deal has sparked enough attention, intrigue, speculation and opinions that Updata Advisors will prepare a separate research report devoted entirely to analyzing this deal. Stay tuned.
In this report, our annual outlook for information technology M&A, we focus on prospects for M&A activity in 2008 within Updata's five sectors:
Enterprise Application Software
Internet
Infrastructure Software
IT Security/Compliance, and
IT Services
In each of these sectors, we examine business and valuation trends affecting the M&A environment, broadly and by sector, and offer predictions for 2008. On balance, we believe 2008 will be a strong year for dealmaking, driven by the following factors.
Large Cap Buyers Acquiring Mid-market Companies. Large technology vendors perennially seek smaller and mid-market targets to fill product/services gaps, expand into adjacent markets, and/or add mass and market share. With private equity buyers becoming less aggressive in a tougher borrowing environment, competition for assets and valuations may moderate in certain sub-sectors, which should drive opportunistic acquisition activity.
Adoption of New Internet Technology (Web 2.0). Creative destruction, which by its nature is a recurring theme in technology, is becoming more prevalent due to disruptive web-enabled services, applications, tools and devices that are driving a new spending cycle among consumers and businesses seeking greater productivity and convenience. This in turn will drive acquisitions of promising earlier-stage internet players, and continuing consolidation at the top.
Slowing Economic Growth. Growth is a primary value driver for most technology companies. A slowing economy raises pressures for vendors to increase organic growth, and many are likely to step up M&A activity to maintain growth rates that support their public valuations.
Consolidation Strategies Among Large Cap IT Companies Vying for Global Leadership. The largest technology firms have well-defined roadmaps to leverage their core strengths into broader markets. As these giants jockey for top-spot status in their chosen areas, the impact on M&A activity will continue to be substantial. Since 2005 Google, IBM, Oracle, SAP, Microsoft, and HP have spent over $80 billion on acquisitions.
Falling U.S. Dollar. We expect to see more foreign companies acquiring U.S. firms in 2008, due to the devaluation of the U.S. dollar relative to foreign currencies. According to Bloomberg, historically foreign buyers have accounted for 18% of U.S. deals on average since 1988. In Q4 2007, foreign buyers accounted for 45% of U.S. M&A transactions.
The IPO Option. In the absence of more stable global equity markets, the IPO option for many young and growing IT companies will be even more difficult, and the pre-IPO queue will continue lengthening. If only the very strongest companies have access to the IPO track, more venture-backed companies will focus on the M&A exit path.
In the report that follows, our sector practice leaders provide a deeper look into market conditions and projected M&A activity across the IT industry in 2008.
2007 was an interesting year for enterprise application software. Building on the momentum of 2006, trading values and M&A activity got off to a strong start through the first half of 2007. In the spring, Cisco announced its acquisition of WebEx for $2.9 billion, a startling 7.5x WebEx's trailing annual revenues, in what stands as the largest pure-play SaaS deal to date. Of course, Oracle made the opening gambit in the consolidation of the business intelligence sector by acquiring Hyperion Solutions for $2.8 billion in March, a healthy 3.4x Hyperion's trailing annual sales.
Then came the July-August credit crunch, which continues to this day -- and yet the application software market barely blinked. Yes, the macro environment cooled the volume of deal activity in the second half. But two very large software transactions nonetheless occurred in the Fall: SAP's $5.6 billion acquisition of Business Objects, followed by IBM's $4.9 billion purchase of Cognos. And, application software stocks continued to trade well. For the year, the Updata Enterprise Application Software Index finished up 17.0%, versus 9.8% for the Nasdaq and only 3.5% for the S&P 500. Our takeaway from this is that the software sector is somewhat immune to credit problems that may constrain deal activity for old-line companies that are valued (and financed) primarily on cash flow (EBITDA). 2007 proved yet again that, in the software world, it's more about future growth than current cash flow. Thus, with certain exceptions (discussed below), we remain generally optimistic about the application software sector in 2008 despite increasingly evident macroeconomic malaise.
One year ago in this space, we predicted that: (1) application software M&A activity would increase moderately in 2007, though not as much as in 2006, and (2) valuations would hold or improve. It turns out that we went one-for-two on our predictions. Application software deal volume fell off in '07 on account of the second half macroeconomic environment. Our internal data show that our prediction for moderate growth in deal volume would have been realized had the 1H'07 pace continued in 2H'07.
But the bigger story, in our view, is the dramatic increase in valuations in 2007. The median application software deal occurred at an enterprise value/revenue multiple of 3.2x, a substantial increase over 2006. The tables below tell the story.
Top 20 Enterprise Application Software Transactions
How do we explain these outsized valuations? We've mentioned some of the following points before, but they bear repeating:
Large strategic software players remain flush with cash. Oracle, IBM, SAP, Microsoft, EMC, Infor, Salesforce.com, Autodesk and many others have been enjoying what business writers have dubbed "the golden age of corporate profitability" over the last few years. They must put their cash balances to work, and in 2007 they demonstrated willingness to spend down their cash balances to fill holes in their product suites.
Private equity firms remain flush with cash. Although the tightening credit markets slowed fund-raising activity in the second half, these firms still raised a record $302 billion in 2007. This money has to be deployed, and tight credit markets make less leverageable "growth equity" investments like software relatively more attractive.
2007 witnessed the acquisition of several major software names, especially in the business intelligence/analytics sub-sector. Indeed, three of the top five and eight of the top twenty application software M&A deals in 2007 were in the BI space. We believe these marquee acquisitions set the M&A tone for the industry as a whole and boosted overall valuations.
Despite several years of robust M&A activity, the software industry remains extremely fragmented. As the cost of infrastructure outsourcing falls and new protocols like SOA and Web Services facilitate application design, development and integration, it is easier and cheaper than ever to write software code that solves a business problem and start a business around it. Enormous inefficiencies can be wrung out of this fragmented landscape, which enables established players to pay for more attractive technologies.
More than twenty-five years into the PC revolution, application software continues to deliver strong ROI to the enterprise. The application software sector posted 17% year-over-year revenue growth in 2007 -- even as the rest of the economy softened. Monied interests both inside and outside the sector are willing to pay handsomely to buy into this proven track record of growth with low capital requirements.
We offer the following predictions for application software in 2008. Application Software M&A Deal Volume and Valuations Will Flatten or Fall Off Slightly. 2008 is shaping up as a recessionary year, and to predict a significant increase in deal activity may be foolish. But for all the reasons mentioned above, we do not foresee a precipitous drop in either application software deal flow or purchase prices. In addition to the factors above, we believe that price competition among software vendors will intensify in 2008 as IT departments are asked to do more with less and scrutinize their resource allocations. Price wars and the desire to purchase from fewer vendors may promote consolidation among smaller vendors that will have difficulty competing with their larger, more established peers.
SMB Is the Next Frontier. In June 2007, Updata Advisors published a comprehensive application software industry survey. We said then, and we say again now, that the SMB sector is the next frontier for application software providers. Enterprise IT budgets will be tight in 2008, and major vendors will need to move "down market" to maintain the growth rates that their shareholders have come to expect. While this may seem somewhat obvious, a glance at the table of M&A deals indicates that the major software players are still focused on gobbling up their competitors to expand market share among large enterprises. We foresee slightly different types of acquisitions in 2008. IDC makes an interesting prediction that SMB leader Intuit will be acquired this year. Other SMB-focused companies to watch include:
UK's Sage Software: Does this mid-sized ERP player break out of the pack by doing larger deals? Does it get acquired?
Microsoft: How aggressively does it promote its "software and services" offering for SMB?
NetSuite: Does it trade up in an otherwise down year for stocks? Does it get acquired?
Salesforce.com: How effectively does it move beyond CRM to become a suite provider? Does it finally make a major acquisition? Does Force.com create a real SaaS ecosystem?
Google Apps for small business: Do they get traction? Does Google make a major acquisition to penetrate the enterprise?
SaaS Adoption Will Accelerate in a Recessionary Environment. Software-as-a-Service adoption will continue to be the most important trend in enterprise software, and its influence will only increase in 2008. As IT budgets tighten, CIOs will seek cheaper, less risky software solutions. This should bode well for SaaS vendors who offer a pay-as-you-go, "try it on for size" option. Struggling SMBs will quickly conclude that SaaS solutions offer their best means of affording enterprise-class functionality. And in a softening economic environment, software vendors themselves will compete more aggressively on price, which will hasten their own roll-out of SaaS options. In short, a recessionary environment creates incentives all around to embrace Software-as-a-Service.
From an M&A Perspective, SaaS Companies Will Remain Locked In The Penthouse -- Until A Breakout Transaction Occurs in Late 2008. Notwithstanding the superior attributes of their business models, the major SaaS players have one problem: their stocks trade too well on a relative basis. The 21 major public SaaS companies tracked by Updata currently trade at a median of 5.2x LTM revenues and 4.1x forward revenues. Many of the leading names in the space (Salesforce.com, Vocus, Red Hat, Concur, etc.) trade at even higher multiples, and the newer entrants still basking in their IPO glow (NetSuite, SuccessFactors) are trading off the charts. The problem created by such lofty multiples is that it is difficult for would-be suitors to justify to shareholders the cost to acquire a SaaS leader. We at Updata have had multiple conversations with top SaaS executives who have asked us if we know anyone who might be interested in acquiring their companies.
Moreover, SaaS companies are having difficulty deploying their inflated currencies to make acquisitions themselves. With a few notable exceptions like Kenexa, which has made a couple of acquisitions in pursuit of a BPO strategy, most SaaS players dare not acquire anything remotely resembling a traditional software company for fear of diluting their pristine SaaS financial models and their trading multiples. The upshot is that despite all the attention the SaaS model has garnered, there has been relatively little SaaS M&A activity. Pure-play SaaS players are effectively locked in an elite penthouse, with no choice but to focus on organic growth. We believe that SaaS valuations may start to erode during 2008, as the SaaS business model becomes mainstream and the scarcity value inherent in SaaS names dwindles with each new IPO. And we predict that a major SaaS company will get acquired in the second half of 2008 (Google/Salesforce.com?). Overall, while the "SaaS valuation gap" may begin to shrink, on-demand models will still enjoy a deserved premium over traditional license models.
Hold the Obituaries for Private Equity. We believe that, to paraphrase Mark Twain, reports of private equity's demise have been greatly exaggerated -- at least when it comes to their appetite for software companies. As we noted above, U.S.-based private equity firms raised a record amount of capital in 2007, despite the turmoil in the credit markets. They will need to deploy this capital, and they will focus relatively more on growth equity investments like software and relatively less on traditional cash-flow-based LBOs. In addition, some established venture capital firms are raising later-stage funds that look more like private equity, e.g., Menlo Ventures, Sequoia Capital and Polaris Venture Partners, each of which is looking to deploy over $1 billion. We believe that private equity investors will continue to provide entrepreneurs with a compelling alternative to selling their companies outright to strategic acquirers.
The chart and table below show the 2007 stock price performances of each of the seven major application software sub-sectors that we follow. We then offer our brief thoughts on what to look for in 2008 in each sub-sector:
More specifically, the trends to watch in the seven major enterprise application software sub-sectors that we follow include:
Business Intelligence (BI). Consolidation in the BI sector was one of the big software stories of 2007. As many of the traditional BI players were consolidated away (Hyperion, Cognos, Business Objects, OutlookSoft, etc.), a host of on-demand and specialty providers emerged to attempt to take their place: LucidEra, LogiXML, Host Analytics, Panorama, Oco, Pentaho, Verix, PivotLink (f.k.a. SeaTab Software), Autometrics, OnDemandIQ, Blink Logic and many more. In 2008, we expect that some of these vendors will gain traction, as enterprises increasingly demand the improved decision-making conferred by robust BI solutions along with the advantages of the SaaS business model. Still, we think there are too many of these players to survive, and we believe that consolidation among the on-demand BI vendors will begin in late 2008.
Customer Relationship Management (CRM). CRM bellwether Salesforce.com first opened up a lead in this sub-sector as the SaaS pioneer in a space that, owing to the light and intuitive nature of the CRM application, was the most amenable to rapid SaaS acceptance. SFDC ran away with the sub-sector through its continual innovation and aggressive marketing prowess. But for all its success, SFDC's market capitalization is only a fraction of the large suite providers', and is roughly on par with the recently acquired leaders in other sectors (Cognos, Business Objects). SFDC is not a software giant -- yet. And so its current mission is to branch out beyond CRM and become an ecosystem and platform for on-demand applications, not only to grow but to ward off threats from upstart suite providers like NetSuite, Workday and Intacct. SFDC has begun and will continue to execute on this mission in 2008, as evidenced by its recent announcement of its Force.com computing and development platform and utility pricing options.
Enterprise Content Management (ECM). We believe ECM is a sector to watch in 2008. Enterprise content is proliferating at an enormous rate. Good business practices and new legal and compliance imperatives make it more important than ever for businesses to manage and organize their exploding content in a comprehensive, efficient manner. Microsoft's recent acquisition of FAST Search and Transfer at a notable valuation of 6.5x trailing revenues suggests that we are not alone in our view that enterprises will increasingly demand well-organized, searchable structured and unstructured data.
Enterprise Resource Planning (ERP). Industry juggernaut Oracle, with its $110 billion market capitalization -- exactly twice that of SAP as of this writing -- dominates the ERP sector with its insatiable appetite for acquisition-driven growth. (We note that Oracle is a full stack and suite provider and can only loosely be called an "ERP provider"). Oracle currently trades at a multiple of 5.6x trailing revenues and 4.5x forward revenues, or more than twice the median multiples for the ERP sector as a whole. Despite the continued "buy" ratings of many Wall Street analysts, we have difficulty seeing how Oracle continues to grow at a similar pace in a softening environment. For this reason, we do not expect either Oracle, or the ERP sector overall, to match its 2007 performance -- but clearly the major ERP providers are more entrenched than ever and will continue to dominate the software landscape for years to come. As the industry consolidates, there are fewer acquirers. Thus, it will also be interesting to see if vendors such as CDC Software and Infor can complete rumored IPOs and continue to be aggressive consolidators.
Human Capital Management (HCM). Given the softening economic environment, we are slightly bearish on the HCM sub-sector in 2008. Many of the HCM players concentrate heavily on workforce recruiting, which is not likely to be an enterprise priority this year. Our forecast would not apply to HCM companies like SuccessFactors or Salary.com that focus more on employee performance management or compensation management.
Product Lifecycle Management (PLM). In recent years, PLM has been a relatively quiet niche in enterprise software. Will PLM move into the headlines in 2008? We do not foresee any major splashes, though we expect that the leaders in the space such as PTC will opportunistically seek to protect and expand their market shares through selective M&A. We note, however, that unlike its acquisition of BI provider Hyperion, Oracle's 2007 acquisition of PLM leader Agile created no lasting reverberations and spawned no responsive deals. This suggests to us that there is not a lot of pent-up activity in the sector waiting to be unleashed in 2008.
Supply Chain Management (SCM). SCM has performed rather poorly since the bubble era -- but not in 2007. We believe 2007 may have marked a renaissance of sorts for the sub-sector, as businesses renew their focus on removing costs from increasingly complex supply chains. Several new technologies, such as RFID, mobile, and GPS devices, may also significantly improve SCM's value proposition going forward. We note that all of the public companies in the SCM sub-sector are "bite size" for the large ERP players and many private equity firms. We predict that 2008 may witness a significant acquisition or two in SCM, and possibly even a financial investor's sponsorship of a combination like the 2006 Manugistics/JDA merger.
The internet sector -- including e-commerce, new media and web-based services -- experienced record post-bubble deal activity and rapid change in 2007. Updata tracked over 200 M&A deals in the sector last year, with announced values approaching $40 billion. Competition drove mean acquisition values to 5.5x trailing revenues (with premier properties fetching far higher multiples), up from 4.1x in 2006. Share prices for public internet bellwethers rose 30% in the year, handily beating broader indices.
Notwithstanding recent economic uncertainty, we expect at or near record internet M&A activity to continue in 2008, for several reasons: First, growth is the primary value driver for emerging technology/new media companies. In a slower economy, arguably the best way to drive growth is through acquisition. Second, size matters. In 7 of the past 10 years (including 2007), share prices of large-cap internet companies rose more than the overall internet universe. Third, most M&A deal volume is driven by the dozen largest IT and internet vendors, who purchased more than 100 companies last year; these cash-rich buyers need to deploy capital. Lastly, market uncertainty results in greater seller flexibility, helping drive deal activity.
Here are our thoughts on leading internet trends for 2008:
The Mobile Tsunami. Apple's iPhone launch last June unleashed the internet's next phase -- the mobile web. iPhone already accounts for more than one out of every thousand web page views, according to the Wall Street Journal, due to its superior web access UI. Analysts variously predict 30% to 100% annual growth in smart phones and PDAs, which will overtake PCs as the primary human on-ramp to the web over the next few years. This will result in rapidly growing demand for mobile-optimized advertising, applications and development tools in 2008. E-commerce innovators will also benefit as users increasingly make purchases via mobile devices, online and in stores. In this vein, Apple recently filed for a patent covering wireless payments via iPods and iPhones.
Personalization -- It's All You. As predicted by the rule of the 'long tail,' the web is fragmenting. With over 135 million online sites, and the universe growing 5% monthly according to Netcraft, engagement or stickiness is becoming more challenging -- and more valued. Accordingly, in July Nielsen/NetRatings announced that time spent would be a key measure of website popularity, i.e., monetization potential. This is significant given that web searches drive the most web page views but represent only 5% of time spent online, according to the Online Publishers Association, in contrast with 50% for content, 31% for communications and 15% for commerce. The most popular sites -- Facebook, MySpace, Wikipedia, YouTube, etc. -- show that the best way to engage users is to let them create, customize and communicate content. A recent study by Nokia concluded that a quarter of content consumed by 2012 will have been created and shared by peers rather than by traditional media. The continuing shift from Read Web 1.0 to Read/Write Web 2.0 bodes well for sticky sites, and for content creation and customization enablers -- everything from widgets, to "skins" and content feeds/filters -- in 2008.
E-tail, Retail Merge. Is Amazon an internet retailer, or a retailer that uses the internet? The distinction is becoming less relevant. Studies show that about half of shopping is internet-driven; even if you don't buy online, there's a good chance you browse online before walking into the store. This reality may start driving combinations of e-tailers with brick-and-mortar shops, to leverage fixed costs and drive customer and brand synergies. It also will fuel rising demand for technologies related to product visualization, fulfillment and service that improve the quality of experience online.
Social Network Pure-plays Become Hybrids. The days of big standalone social network sites may be numbered. Microsoft-Facebook, News Corp.-MySpace and Disney-Club Penguin highlight the added value derived by linking social network sites with other new media businesses. To that end, Google's OpenSocial platform provides common APIs for social applications across websites, and several private companies offer applications that integrate multiple networks. Actually, most major internet players share characteristics with social networks: eBay may be the world's largest social network, and Yahoo! and Google plan to turn their email services into social networks by letting users exploit their email address books in new ways. While social network sites will continue being snapped-up in 2008, more investment and M&A activity will center around applications that drive social network creation and integration.
Enterprise 2.0 is Here. To date, discussions of E2.0 have focused on 'mash-ups' and importation of consumer web tools, such as blogs and wikis, into the workplace. A major story in 2008 will be movement of the consumer internet behemoths into the enterprise. For example, Google's hosted office applications are already in use at 100,000+ businesses, and the July Postini acquisition adds security services. Google has also articulated a vision for cloud computing that centralizes computing resources. In 2008, internet vendors will step up acquisitions that leverage their presence in the enterprise. Areas include enterprise search (note Microsoft's recent bid for Fast Search), software-as-a-service applications and infrastructure, remote management solutions, and business-oriented web services.
Cross-Media Mergers. Advertisers increasingly seek to reach customers in consistent fashion across different media. As lines begin to blur among broadcast, internet and print, expect more partnerships and acquisitions leveraging the benefits of cross-media viewership, content and advertising. 2008 will see multiple acquisitions of vendors that facilitate unified campaign management across media. While perhaps less likely, the likes of Microsoft or Google could also buy a major 'old media' property like Gannett or the New York Times, thereby adding huge monetizable audiences, while providing advertisers with a compelling cross-media network.
New World Order. The internet's center of gravity is shifting from the U.S. into multiple centers. According to Nielsen/Netrating, China today has almost as many internet users as the U.S. (162 million vs. 211 million), but user growth is much higher in China given its low penetration rate (12% vs. 70% in the U.S.). Internationalization of the net is a meta-growth spending driver touching just about every aspect of the internet sector. In 2008, we expect to see an uptick in international M&A and in tools that improve site localization/globalization.
Online Advertising Consolidation to Continue. Online advertising generates most of the growth in overall ad spending, yet only 7% of total U.S. ad budgets are devoted to the internet, according to the Online Publishers Association. While 2007 saw consolidation of leading online advertising players, notably Microsoft-aQuantive, Yahoo!-Right Media, Google-Doubleclick (pending) and most recently, Microsoft's run at Yahoo!, it is still early innings for the sector, and there will be much investment and deal activity in years to come. Given the increasing importance of internet engagement, expect search giants in 2008 to pursue revenue streams that decrease reliance on paid-search. Attractive areas for partnership and acquisition include contextual search technologies, mobile ad optimization solutions, campaign management tools, and ad-management workflow. Also, technologies that cost-effectively bring ads to the long tail will be in demand.
Gaming Moves Beyond Gamers. After online advertising, video games represent the fastest growing new-media segment, with 2007 spending of $35 billion according to PricewaterhouseCoopers. Online gaming is one of the biggest drivers of VoIP, and casual games are some of the most popular applications/widgets on social networks, making sites stickier. Games will prove a bonanza in 2008 for development studios, networking gear providers, rich media tools vendors and VoIP, not to mention online gaming destinations. Opportunities also lie ahead for non-game applications including military training, education and exercise/rehabilitation (witness Wii's success with seniors). Games are also becoming gateways to broader digital interaction. For example, Electronic Arts offers real-time sports news tickers and social networking features in sports games such as NCAA Football 07. Expect lots of deal activity in gaming this year.
Security Demand to Rise. As the internet weaves deeply into the fabric of life and commerce, greater security risks arise in numerous forms. For example, Gartner predicts that in 2008, almost half of employees will be using non-company-owned equipment on company networks, which presents access and data theft risks. And if "cloud computing" is broadly adopted, extensive controls will be required. Both the challenges and opportunities for security innovators are great. Studies show the greatest barrier to e-commerce adoption is fear of fraud and identity theft, so the stakes are high. Consequently, internet security will continue to be a prime area of transactional activity.
Several key trends that have emerged in infrastructure software over the past several years will continue to be the primary M&A market drivers through 2008. These trends center around: (1) disruptive changes in the way enterprises deploy, use and manage their IT infrastructure, (2) emerging demand from new market segments including small and medium-sized businesses ("SMB") and consumers and (3) continued interest among established vendors in M&A as a technique to drive growth, stake out leadership positions in emerging sectors and enhance both market share and customer "wallet-share."
Interestingly, while deal volumes and median deal values for 2007 remained relatively consistent across the three infrastructure software sectors we track (Application Infrastructure, IT Operations & Management, Storage Solutions) when compared to 2006, median multiples of enterprise value to LTM revenues drifted lower across all three sectors. Despite this decline, many individual deal revenue based multiples exceeded similar multiples of publicly traded companies in the same sectors. In addition, within each sector several high multiple transactions occurred with fast growth, market leaders attaining the highest relative valuations.
We expect these trends to continue through 2008 resulting in generally consistent deal volumes and continued moderate declines in median transaction multiples (due mainly to macroeconomic forces). However, conditions persist to support a fair number of blockbuster transactions and high multiple deals.
Dow Jones Software Composite consists of 91 U.S based mid to large cap companies drawn from all across the software sector
Several key drivers for Infrastructure Software M&A during 2008 will include:
Macro Conditions Considerably Weaker. With public equity markets in decline and a softening economic environment, macro level support for M&A is much weaker going into 2008 than it was at the beginning of 2007. This, in combination with weaker overall levels of IT spending and ongoing turmoil in the credit markets, will have the effect of pushing some potential M&A buyers to the sidelines and putting downward pressure on median valuations and deal multiples. However, we expect deal volume to continue apace thanks to several factors. Struggling vendors that could survive in strong economic conditions may be forced to consider a sale or merger in a weaker environment. Some acquisition targets that may have been too expensive for potential buyers may become more affordable particularly for buyers with ample cash. Established vendors could be forced to move more aggressively via M&A into markets and sectors that are experiencing faster growth. In addition, a weak dollar increases the likelihood of higher volumes of transactions involving US targets and overseas buyers.
A Virtual Tide Lifting Many Boats. Virtualization software has emerged as a $1 billion market in 2007. Server virtualization is real and on track to become pervasive in the next 3 to 5 years. While this is a relatively narrow slice of the whole IT market, the impact already being felt by IT organizations and the disruptive opportunities that are emerging illustrate market opportunities that are substantially larger. For example, the high server densities deployed in virtualized environments is driving strong demand for services associated with reconfiguring and rebuilding data centers and for greater quantities of networked storage (iSCSI systems in particular). Higher density is also forcing enterprises to deal with rapidly increasing costs and complexities associated with growing demand for power and cooling. Furthermore, increasing populations of virtual systems will drive rapid growth in demand for solutions to monitor, manage and troubleshoot them effectively. In addition to creating opportunities related to the server market, virtualization is being extended across other elements of the infrastructure environment including storage, network, applications and desktops. Each of these markets is as big as or bigger than the server market. As adoption extends across these elements, spending on virtualization technologies and virtualized systems will increase exponentially. We expect to begin to see these multiplier effects in 2008 drive heightened M&A interest in vendors focused on enabling virtualization in other components infrastructure, managing virtualized environments, and deriving more value from them (i.e., automation and utility computing). In addition, as an interesting side note, virtualization spending is a potentially contrarian play in a weak IT spending environment. Much of the server virtualization spending that is being done now is to reduce or avoid capital expenditures on less utilized non-virtualized servers. As a result, we expect virtualization software spending to be somewhat insulated from external economic conditions.
The New Enterprise Software "Stack". The traditional "stack" of enterprise software is being upended by broadening adoption of new service oriented architectures (SOA). SOA results in increasingly complex, componentized and distributed applications that span multiple languages, computing environments and even geographies. When taken in the context of the increasingly complex and distributed networks over which these applications are deployed, we expect demand will grow rapidly for emerging solutions in application development, QA and test and ongoing application management focused specifically on SOA. Another key development in the enterprise "stack" is continued penetration of open source solutions across many areas of the enterprise. One important result is that lower cost of open source software has opened up markets for technology enablement involving business processes and models that previously could not cost effectively leverage the benefits of software. This, in turn, expands the market for infrastructure solutions.
SMB and Consumers in Vogue. As enterprise and data center markets reach saturation for many technologies, established vendors are eagerly chasing SMB and even consumer markets as new growth markets. SMB users will increasingly adopt more sophisticated technology in their businesses and face many of the same challenges (with fewer resources) that large enterprises have been addressing for some time. In addition, consumer adoption of technology that is then brought into the enterprise has begun to shape enterprise approaches to technology development, purchase and deployment (think of Instant Messaging). These trends will accelerate M&A activity in 2008 as vendors look to gain access to products, sales and delivery channels, market presence and branding to penetrate these markets. We believe much of the focus in this area will involve online/on-demand service-oriented solutions; low cost, highly scalable and sales distribution models; and simple, appliance-like devices.
IT security and compliance pure-plays outperformed the overall technology market by a wide margin in 2007. The share price index of larger public bellwethers rose 18% last year, vs. 10% for NASDAQ. Mean announced enterprise value to LTM revenue M&A multiples in the sector of 4.8x (including security services) represents a premium to the overall tech M&A universe and a slight increase over 2006.
Dow Jones Software Composite consists of 91 U.S based mid to large cap companies drawn from all across the software sector
Updata tracked 85 M&A deals in the sector last year, with announced values exceeding $4 billion. While declining slightly, venture investment volumes also remained robust -- Updata tracked 138 fundings exceeding $800 million in the sector. Updata had a strong year in IT Security/Compliance, closing six transactions in 2007; this includes advising filtering vendor, SurfControl on its merger with Websense, representing EXP Labs, an innovative Security 2.0/web exploit firm, on its sale to Grisoft, and selling web application firewall company NetContinuum to Barracuda Networks.
Top 20 IT Security Transactions
Over the past four years, security represented roughly 8% of total IT spending, according to Forrester research. We expect this proportion to remain steady and perhaps grow in 2008 because security and compliance spending represent the highest IT priorities in business customer surveys and thus are more resilient to cost-cutting.
Updata projects an increase in sector M&A volumes in 2008, as a potentially slower economy adds consolidation pressure and buy-side opportunities in a fragmented industry. The top 10 vendors in each of content, traffic and identity/access management constituted only about half of spending in these security sectors, which totaled $15 billion in 2007 according to IDC. Another key M&A driver will be innovation, which continues to be led by smaller, private pure-plays. Updata research found that 88% of acquired security companies had revenues of less than $25 million at deal close.
Following are our thoughts on leading IT security-related trends this year:
New Technologies Open New Vulnerabilities. Rapid business adoption of SaaS, VoIP, Web 2.0-type tools and other emerging technologies open up new access points into the enterprise network and create more security vulnerability management needs. Awareness of these new attack vectors will drive stronger investment and dealmaking in internet security in 2008.
Information Loss Prevention is Paramount. According to Gartner research, almost half of employees will be using personal laptops, pda's and other non company-owned equipment to access company networks in 2008. As remote network use and insider access rights increase, and as data misappropriations keep making news -- e.g., GE's recent announcement that they lost a backup tape with credit card information for over 650,000 consumers; and the theft of a laptop with personal data on thousands of UK military personnel -- demand for ILP will continue growing fast. This includes solutions that prevent information from leaving the network, encrypt data, and enforce access policies. Seven pure-play ILP vendors were acquired since late 2006, including five in second-half 2007, at mean deal value-to-trailing revenue multiples greater than 20x. These deals presage further integration of ILP into broader infrastructure management functions in 2008.
On-demand Security on the Rise. Updata tracked 19 SaaS and managed security acquisitions in 2007, at mean announced deal value-to-trailing revenue multiples of 4.1x. Most notable were Google's acquisition of hosted email security vendor Postini in July, Verizon's acquisition of Cybertrust (which had a significant managed service component), and the merger of SaaS 'supermarket' Perimeter with hosted email provider USA.Net. 2008 will see continued robust investment and M&A activity in this sector, which continues to take share from premise-based security.
Deals Going Global. In 2007, almost one quarter of security acquisitions were cross-border. 2008 is likely to see acceleration of international M&A activity. Inbound deals will be driven by valuation opportunities created by the weak U.S. dollar, plus the rise of sizeable overseas vendors seeking to go global. Outbound deal activity will continue as U.S. companies pursue higher growth markets abroad. A Forrester study found that security is the leading IT priority for European businesses. Further, internet usage is a key security spending driver, and the internet's center of gravity is shifting from the U.S. into multiple centers. For example, according to Nielsen/Netrating, China today has about as many internet users as the U.S. but much lower adoption and security deployment penetration rates.
The NAC Gap Closes. Network access control is an evolving framework for protecting IT assets by ensuring conformity of PC's, PDA's, flash drives and other devices to compliance and security policies prior to network attachment. Currently, dozens of vendors provide one or more elements of NAC, including endpoint control, vulnerability discovery, remediation, and content scanning. As NAC adoption evolves, 2008 will see closer integration of silo'ed NAC products into suites through acquisitions by large infrastructure players, or onto platforms through partnerships with lead framework vendors such as Cisco and Microsoft.
Consolidation of Standalone Security to Continue. Multiple surveys show that large, multi-line IT vendors continue taking spend share from pure-play security companies. As a result, smaller and medium-sized security companies are doing deals to extend their offerings and achieve scale, while larger companies are adding growth businesses and best-of-breed technology. Examples of smaller/mid-sized deals include Grisoft's acquisition of EXP Labs and Webroot's purchase of Email Systems. Examples of larger company activity include Symantec's acquisition of data loss vendor Vontu, Oracle's integration of identity and access management into middleware and database offerings, Microsoft's threat and vulnerability management build-ins to its OS, and EMC's incorporation of security into Information Lifecycle Management. Not surprisingly, large IT vendors represent a growing portion of M&A acquisition volume each year since 2004, accounting for a majority of deal volume. These trends will likely continue in 2008 -- we anticipate several sizeable acquisitions of public pure-plays and best-of-breed privates across market sub-segments anticipated.
Complexity and Compliance Drive Services. As the saying goes, security is a process not a product. This is increasingly so for several reasons. First, regulations impose privacy and data protection practices that require workplace training. Second, social engineering has become the primary hacking threat and is best countered by raising employee awareness of such attempts through education. Also, product functions are becoming increasingly complex, tying into more systems and applications. 2007 saw at least 15 security consulting deals and we expect the number to grow in 2008.
Mobile Management Takes Center Stage. Mobile devices present particular security risks to organizations: 1) they're more apt to get lost or stolen; 2) there are multiple major OS's (BlackBerry, Palm, Symbian, Windows); 3) procurement tends to be decentralized so configuration tends to be inconsistent; 4) mobile devices introduce new entry points such as Bluetooth and SMS; and 5) they create multiple new endpoints requiring management. Mobile security spending is growing 35% annually according to IDC, and will be one of the highest growth sub-sectors for the foreseeable future. This will drive a significant rise in mobile-related investment and deal activity this coming year and beyond.
IT-Physical Convergence. IT security overlaps with physical security. Despite organizational challenges in the past to integrate the two, there will begin to be meaningful convergence-related investment and acquisition activity in 2008. Two prime areas where this will occur are in operations and access management. In operations, conversion of electronic systems -- such as SCADA and premises alarm systems -- to IP-based platforms creates new hacking risks. As an example, a recent train collision in Poland was caused by a teenager who hacked the track management system. In access management, particularly in government installations, facility and network authentication approaches increasingly overlap.
Mix & Match Security. UTM appliances and on-demand offerings are taking share from traditional security software, especially among SMBs, due to cost and simplicity advantages achieved by combining multiple products onto one platform. Today, most UTM and SaaS vendors offer a pre-selected, narrow menu of proprietary and third-party products. Over time, such vendors will differentiate themselves by offering a larger array of choices, including incorporating customer vendor preferences. The result will be a highly customized box or set of remote services for each customer. This will place a premium on box, blade and hosting vendors offering superior product choice and management features. Product vendors with strong partner networks and integration-friendly applications also stand to benefit.
Updata tracked 424 IT Services deals in 2007, representing a 13% increase in deal activity from 2006 levels. While the year was strong for IT Services M&A, it was also a year of great contrasts, not least of which was the extraordinary level of M&A activity driven by private equity buyers prior to the emergence of the macroeconomic credit crunch last summer. Bullish sentiment and easy credit in the first half of the year drove valuations, including a 71% rise in average deal value to $264 million.
Top 20 IT Services Transactions
From a multiple perspective, median revenue multiples rose for the Digital Marketing Services firms and the IT Outsourcers, but remained flat or fell slightly for all other sectors. The table below highlights M&A transactions by acquisition target sub-sector.
Our traditional strategic buyers are breathing a sigh of relief at the exit of private equity players and the return of strategic fit and corresponding rationality in the IT Services M&A equation. In 2008, while we expect to see the tempering impact of slow economic growth across several Services sub-sectors, we also predict that M&A activity will remain reasonably strong based on meaningful strategic drivers of market consolidation. Some of these are:
Demand for Specialized Technology Expertise. We continue to receive strong buyer demand for acquisition candidates offering aggregations of talent in particular technology or vertical areas. SAP services firms are most prominent in this group for consistent response, but we also have noted fairly high buyer interest in companies delivering enterprise-class services around Oracle and Microsoft application suites.
Vertical Specialization and Domain Knowledge. Certain verticals will experience robust Services M&A demand, including businesses focused on IT and related outsourcing for life sciences, healthcare, data center infrastructure, government, and to a lesser extent financial services and transaction processing. Specialized domain knowledge in these spaces related to technology and business processes drives M&A activity and valuations.
Growth in Services Practices of Traditional "Product" Vendors. We have been impressed by the huge strides that the traditional technology "product" vendors have been making in building out large, compelling and competitive IT Services offerings, often through M&A activities which are still young, if sizeable. These product companies are pushing toward material business model transformations through the addition of solutions to their corporate offerings and mindsets. Seeking to deliver holistic IT offerings to their clients, encompassing upfront consulting, product sales, and sophisticated integration services, they are scouring the landscape for targets which elevate their customer value propositions and relationships. HP, EMC and Dell were among the most prominent buyers of services companies in 2007 and remain in the hunt in 2008, although even hyper-growth virtualization software vendor VMware bought consulting talent recently.
Digital Marketing Services Sector Consolidation. We expect to see ongoing, exciting consolidation in the Digital Marketing Services (or Interactive Agency) space in 2008. This is a sector where true talent is in short supply and firms that have aggregated it are instantly compelling. It is also a sector enjoying increasing online advertising spending, to the detriment of traditional marketing media such as print, television and radio. Consultancies in this sector often weave together technology, branding, and corporate strategy expertise toward marketing solutions which are cutting-edge, sophisticated, and designed to drive the right traffic through a compelling experience leading to a desired action. Interestingly, these firms are often surprisingly regional in their scope, spurring geographic consolidation as well.
Repeat Services Acquirers. Certain Services companies have been extremely active buyers in recent years and we believe they will continue to be so in 2008. The top 10 Services buyers -- ACS, Perficient, CACI, SAIC, EDB, IBM, Fujitsu, Accenture, BT, and Tietoenator -- have accounted for 105 Services M&A transactions since the beginning of 2005. They represent a cross-section of sub-sectors tracked by Updata. Notably missing from this group, however, are the Offshore Outsourcers. Among this sub-sector, Wipro led in number of M&A transactions, having announced 7 since 2005. But Wipro's relatively large acquisition of publicly-traded Infocrossing, coupled with rumors circulating about its management's desires to do a very large deal, indicate to us that we may see more pronounced M&A activity emanating from Wipro and from India in 2008.
We welcome the opportunity to dialogue on a more detailed level within IT sub-sectors about drivers of value and strategic alternatives for financial growth or liquidity.
Updata Advisors, Inc. Disclaimer
The information and opinions in this report were prepared by Updata
Advisors, Inc. ("Updata"). The information herein is believed by Updata to be reliable and has been obtained from and based upon public sources believed to be reliable, but Updata makes no representation as to the accuracy or completeness of such information. Updata may provide, may have provided or may seek to provide M&A advisory services to one or more companies mentioned herein. In addition, employees of Updata may have purchased or may purchase securities in one or more companies mentioned in this report. Opinions, estimates and analyses in this report constitute the current judgment of the author as of the date of this report. They do not necessarily reflect the opinions of Updata and are subject to change without notice. Updata has no obligation to update, modify or amend this report or to otherwise notify a reader thereof in the event that any matter stated herein, or any opinion, estimate, forecast or analysis set forth herein, changes or subsequently becomes inaccurate. This report is provided for informational purposes only. It is not to be construed as an offer to buy or sell or a solicitation of an offer to buy or sell any financial instruments or to participate in any particular trading strategy in any jurisdiction.
Data cited herein is sourced from Updata’s database and derived from publicly available sources – additional information is available on request.
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