ENTERPRISE APPLICATION SOFTWARE HELPS DRIVE THE MARKET REBOUND
Like most other industry sectors, the Enterprise Application software market is returning to more normalized levels. Updata's Enterprise Application software index has generally led the rebound in the major market indices, and M&A deal sizes and multiples are beginning to rise. While venture capital activity has slowed overall, enterprise application software continues to garner a substantial portion of all VC investments, second only to Internet companies. These promising signs strengthen our conclusion that we hit a bottom earlier this year and that growth should continue in the sector into 2010.
Enterprise Application Software Stocks Continue To Rise Enterprise Application software has been an outperformer in a rebounding equities market. Updata's Enterprise Application Software Index has largely outperformed the Big Three Indices year-to-date as of September 30 (see Figure 1 below).
Figure 1: Enterprise Application Software Index vs. Big Three Indexes, YTD September 30
Compared to the rest of the IT sector, Enterprise Application software has performed consistently with the other major subsectors that Updata tracks, with the exception of Internet stocks, which have outperformed all other groups.
Figure 2: Updata Sector Indices Vs NASDAQ, YTD September 30
Big Deals, Growing Multiples Suggest A Comeback in Application Software M&A The past nine months have proven to be very difficult for Enterprise Application software M&A, as they have for most of the sectors that we track. While the number of deals is not terribly far off the pace of the last few years, total deal value is down substantially, meaning that deals have been much smaller.
However, in the last quarter there have been two deals over $1 billion, which have put total M&A volume for 2009 roughly on track to match 2008, though still well below the pace of the prior years. In July, IBM announced its $1.1 billion acquisition of SPSS, a predictive analytics software company, and in September, Adobe announced plans to acquire Omniture, a provider of online business optimization software, for $1.8 billion.
Figure 4: Enterprise Application Software Transactions Over $500M, 2008-2009
Of particular interest are the LTM revenue multiples paid by IBM (2.9x) and Adobe (5.1x) for their targets. These are not recession-like multiples and may presage a change in attitude on the part of strategic buyers.
M&A Trends In Enterprise Application Software We have noticed a number of trends in the Enterprise Application software market through the past year:
Average deal sizes are down due to the recession. As noted above, deals have been much smaller this year, which is no surprise. Application vendors are typically more vulnerable to a downturn than other, more mission critical IT vendors, such as security or infrastructure software providers.
Target companies end up winners as aggressive bidding battles have proliferated. This year we have seen an increase in bidding wars for software companies, particularly in the enterprise application sector (see Figure 5 below).
Figure 5: 2009 Competitive Deals
We recently published our thoughts on the factors that may be driving this increase in bidding wars. For present purposes, suffice it to say that this increased competitive bidding activity has obviously had a positive effect on valuations. (To view the blog, visit http://blog.updataadvisors.com/public/item/243059)
The most active buyers account for more than a third of all deal value. Since 2005, the most active buyers of Enterprise Application software companies have accounted for more than a third of the total deal volume that we've tracked. IBM, Microsoft, Oracle and SAP have ample cash war-chests and have made no secret of their plans to continue to acquire properties that are strategic to them. These players view the recent equity market weakness as an opportunity to enhance their leadership positions and expand into new territories.
Smaller entities, such as Autodesk and Sage, have also been active acquirers in recent years, though they've been quiet over the past few quarters as they nurse their own wounds from the recession. We expect they will resume their M&A activity in short order.
Figure 6: Most Active Buyers of Enterprise Software Companies Since 2005 (Five or More)
M&A deal activity is concentrated within a small portion of sub-sectors. The majority of M&A activity in Enterprise Application software has occurred in a handful of industry sub-sectors. Since 2008, more than 20 deals have been announced in each of six sub-sectors, accounting for more than two-thirds of all deals. Our data also shows seven sub-sectors with more than $1 billion in total enterprise value since the beginning of 2008, contributing 81% of all enterprise value for the sector as a whole.
Figure 7: Deals and Total Enterprise Value Per Sub-sector, 2005-2009
Some Thoughts on the Most Active Sub-Sectors
Vertical Applications: Specialized vertical application vendors have been acquired at a faster pace than all of the more traditional, horizontal vendor "buckets" that we follow. This is not surprising and is consistent with our oft-stated theses that vertical application providers make very attractive targets for larger entities seeking to gain domain expertise in new industries. The largest vertical application transaction so far in 2009 has been the acquisition of SAF AG, which specializes in the development of ordering and forecasting software for the retail, logistics and industrial sectors, by SAP AG for $90 million. In another strong indicator of this trend, Microsoft recently added industry flavors to its Dynamic ERP applications by announcing the purchase of manufacturing, professional services and retail technologies from four of its Dynamics AX partners (amounts undisclosed). With this move, Microsoft clearly hopes to compete more effectively against those with "vertical expertise" as customers increasingly expect applications vendors to offer more vertical functionality "out-of-the-box."
IT Healthcare: IT Healthcare has become one of the most active application sub-sectors over the past few years. While most deals to date are small (only two are valued over $100 million since 2008), we expect robust growth in this area. The federal government awarded $19 billion worth of stimulus money to healthcare providers through the American Recovery and Reinvestment Act of 2009 for the purposes of buying IT, including incentives for adopting electronic health records systems.3 This is effectively a venture capital investment that dwarfs all other VC investments in the rest of Updata's sectors over the past two years -- combined. The most notable deals for 2009 have included AMICAS, Inc.'s $39 million acquisition of Emageon, a provider of IT systems to hospitals, healthcare networks and imaging facilities, as well as Merge Healthcare's $20 million acquisition of clinical trial software provider eTrials Worldwide.
Enterprise Content Management: The Enterprise Content Management sub-sector has been active, with total deal value at nearly $2.1 billion for the past two years. Autonomy Corporation's $775 million purchase of Interwoven Inc. and Hewlett-Packard's $700 million acquisition of Exstream Software (a software provider that streamlines the creation and delivery of personalized documents) accounts for the majority of the activity. OpenText's $310 million purchase of Vignette, a developer of software for managing and delivering business content, was also notable.
Business Analytics: The largest deals in Enterprise Application software recently have occurred in Business Analytics, namely the IBM/SPSS and Adobe/Omniture deals discussed above. While the sector has largely been consolidated, we expect to continue to see more deals. One reason is obvious: there are still too many small vendors in a tough IT spending environment. But also, there are some exciting new areas that we expect will become more active. One is social analytics, an emerging sector in which vendors (such as Telligent) apply sophisticated analytics to social media to measure the effectiveness of community sites, which are becoming more and more prevalent in enterprise software. Salesforce.com, for example, announced recently the addition of selective community functionality as part of its Service Cloud 2 offering. This move was intended to further the company's goal of helping customers manage all threads of conversation, whether it is via email, IM, chat, Twitter, Facebook or some other form.
Human Capital Management: Noteworthy recent deals in HCM include Vista Equity Partner's acquisition of SumTotal Systems, a learning management systems vendor, for $160 million and U.S. Investigation Service's $246 million purchase of HireRight, Inc., a provider of on-demand employment background and drug screening solutions.
Product Lifecycle Management: PLM has seen $1.3 billion in deal value since the beginning of 2008. Currently, all eyes are on the bidding war for MSC.Software Corporation, a provider of integrated enterprise simulation solutions. As this goes to press, the latest bid is from a group of private equity buyers for $8.30 a share, or $382.7 million in deal value.
Enterprise Application Software Still Attracts Venture Investments, But Slips Relative To Internet Companies Enterprise Application software has consistently brought in the lion's share of total venture investments relative to most other Updata sectors over the past few years. However, since 2005, it has given up venture investment share to the Internet sub-sector. Enterprise Application software's market share has slipped to 18% of all VC investments for 2009, down from 31% in 2008. Much of this decline can be attributed to the huge increase in investment dollars being relocated to Internet businesses, which has garnered 58% of total IT venture capital investments in 2009.
Figure 8: Venture Investments By Sector, 2005-2009 ($M)
Within Enterprise Application software, IT Healthcare, Software-as-a-Service and Vertical Applications have attracted the most venture investments recently (see Figure 9 below). These three sub-sectors account for 45% of all venture investments in IT for 2008 and 2009.
Figure 9: VC Investments In Enterprise Application Software, 2005-2009 ($M)
Like the rest of the VC market, each application sub-sector has seen decreased investments in 2009. Research from Pepperdine University recently concluded that private capital lenders and investors may not engage in any meaningful volume of lending for another two to three years, until rates of return increase to more enticing levels.6 The third quarter of 2009 in particular brought very dramatic declines in venture capital investments, with several more mature and already consolidating sub-sectors such as CRM, GRC, HCM, PLM, Search and SCM not receiving any VC investments.
Conclusion For all the reasons discussed above, we believe the Enterprise Application software industry has re-gained much of the investor community's confidence over the last two quarters and is now in the vanguard of the market rebound. Publicly traded enterprise application equities are outpacing the major indices and holding their own with other major IT sectors that we follow. M&A activity has been poor, but we expect it will improve given that M&A activity typically tracks public equity activity. A few large deals (at strong valuations) in the third quarter may be a harbinger of things to come. Moreover, there are several drivers of the Enterprise Application software sector that are simply not going away, such as the imminent explosion in healthcare IT and the relentless demand for greater vertical expertise and data-rich, predictive, analytical dashboards and applications. Lastly, the enterprise application sector continues to attract its share of venture capital, which suggests that a new crop of young companies may - assuming the overall industry continues to grow and barring a severe "W" shaped recession - rise to challenge the established competitors and drive M&A activity in the years ahead.
3. Howell, Chanley. "Stimulus package contains $19 billion for health care technology spending and adoption of electronic health records." Wisconsin Technology News, February 19, 2009. http://wistechnology.com/articles/5523/
