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Will the enterprise market spend significant IT budget on Windows Vista in 2007?



M&A: A Look at the Year Ahead
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If IT spending is, indeed, a key bellwether of software M&A activity, 2005 does not promise to be a boom year.

A number of other key indicators, however, suggest otherwise:

Public Software Company Revenue and Earnings
In prior reports, we’ve noted a very high correlation between NASDAQ performances on the one hand, and software M&A deal volumes (Figure 4) and valuations (Figure 3) on the other. NASDAQ performance, in turn, is largely driven by corporate revenue growth and corporate earnings.

From a revenue growth standpoint, public software companies had a rather lackluster year. The median TTM revenue increase for the SEG-100 (Our index of publicly traded software companies) in 2004 was a rather paltry 8.9%. Most, however, succeeded in growing earnings at a considerably higher rate. Given the organic revenue growth constraints enumerated earlier in this article, many more public software companies are expected to embrace mergers and acquisitions in 2005 as a viable topline growth strategy.

As for earnings growth, some analysts are predicting NASDAQ/tech sector annual income will surge 40% in 2005. Analysts covering our SEG-100 companies are even more optimistic, forecasting an average 55% increase in EPS, according to our company-by-company tally.

Much of the earnings growth in 2004 came from cost savings, but there wasn’t much left to squeeze out by year-end. In 2005, an increasing number of public software companies will pursue accretive acquisitions in order to achieve the earnings growth necessary to satisfy investors and enhance their valuations.

Bountiful corporate deal capital. During the four-year period following the burst of the tech market bubble, most public companies conserved cash and disposed of non-core assets, adding more cash to the kitty. Many corporate balance sheets are now awash with cash and there is growing investor pressure to either use it or distribute it to shareholders. According to CFO Magazine, the average cash balance of the S&P 500 is more than double the average cash balance in 1999.

As noted in our 2004 Annual Report, the strength of public software company balance sheets varied considerably by size of company. Those with revenues greater than $1 billion improved their cash position by 19.3% by year-end; mid-cap SEG-100 companies ($200 million to $1 billion) saw their year-end cash erode by 4.9%; while public software companies under $200 million realized a 30% decline in cash. The implications for 2005 M&A? Look for the very large software companies to do large, expensive acquisitions, using cash when necessary as a component of the purchase price. Expect smaller software companies to focus on smaller, highly strategic acquisitions using all or mostly stock whenever possible.

Those software companies not awash in cash have other options available, as well. PIPEs are increasingly popular, and secondary offerings to raise acquisition capital are once again a viable option, thanks to a resuscitated IPO market. The debt markets have also made a strong comeback. With hedge funds moving aggressively into debt financing, the price of debt has declined and its popularity as deal currency, especially in mega-deals, is growing. The high yield market, in particular, had a major impact on mergers and acquisitions in 2004. Indications are that high-yield issues will remain strong in 2005, assuming the fundamentals remain strong: a strengthening economy, improved corporate performance, low cost of funds, and strong investor demand that exceeds supply.

Unprecedented number of financial buyers with strategic buyer mindset. Always hungry for undervalued assets with good upside, and flush with investment capital, the appetite of private equity firms was voracious in 2004 after three lean years. When public companies sought to dispose of non-strategic businesses, equity investors responded. As Sarbanes-Oxley and an unforgiving market made going private much more appealing for a host of mid and small-cap companies, private equity firms, once again, were quick to respond. Leveraged buyouts represented almost 10% of the $664 billion total spent in 2004, a fifteen year high.

Many private equity firms, under great pressure to put their significant cash reserves to work, targeted the software industry. More than one-third of the buyers of North American software companies in 2004 were private equity firms and venture-backed privately held companies, a phenomenon we expect to continue. The real surprise, however, was the mindset of these financial buyers. As more capital became available and pressure from investors and limited partners mounted, private equity firms began to shed their conservative, “value” investment criteria and offer strategic buyer prices, a phenomenon not seen since 2000. By the fourth quarter, private equity firms were repeatedly out-bidding strategic corporate buyers, and they show no signs of backing off in 2005.

Growing product category creep and new mega-categories. We’ve paid much attention in our 2004 Quarterly Reports to the changing acquisition motives of buyers. Last year some 16% of software M&A transactions were “market extension” plays, with buyers acquiring their way into new vertical markets, new geography or new software categories. Their motives, predictably, are incremental revenue and profit, and greater customer control. Transactions such as Symantec’s $13.5 billion acquisition of Veritas in December; Yahoo’s $576 million take out of European online comparison shopping site Kelkoo; and EMC’s $260 million acquisition of network management provider SMARTS, are but a few examples. We expect market extension acquisitions will grow to 22% of all software M&A transactions in 2005.

Marked Increase in Software IPOs. Sixteen software/Internet companies went public in 2004, twice as many as in 2003. Most were well received, and despite some predictions to the contrary, these newly listed companies saw an average year-end gain in stock price of 66%. Over 120 IPOs are in the current pipeline, including eight software companies. The pace of IPO pricings and filings in 2005 should reach a more normalized level of 200 to 250, including some estimated 30 software companies. What implications do these new public software companies have for software M&A in 2005? A corresponding increase in the number of potential acquirers, flush with IPO proceeds, and hungry for deals to spur their growth.

And so it appears the “Boom Year” in M&A some have predicted may come to pass in 2005, barring unforeseen circumstances – which no one can these days.

All bets are off in the event of another recession, substantial and sustained market correction or major attack on our country. But if the stars remained aligned, we project North American deal volumes will increase 18% in 2005 to 1,925, and median valuations will grow from 2.4x TTM to 2.8x TTM. Stay tuned.

This article was an excerpt from Software Equity Group’s 2004 Annual Report, consisting of 60 fact-filled pages and available for download from www.softwareequity.com. The Report is a comprehensive analysis of software industry mergers and acquisitions, initial public offerings and venture capital investments of the past year. The Annual Report analyzes public software company financial and stock market performance and identifies key trends affecting the software equity markets in 2004. For more details, please visit the above website, or phone (858) 509-2800.


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