For much of the 12-month period ended June 30, 2008, M&A deal activity in infrastructure software proved relatively immune to negative trends in the capital markets, systemic problems in the credit markets, and weakening economic conditions in the US. In fact, the number of transactions tracked in this sector during that period is up in comparison to the previous 12-month period. Based on a significant drop in both the number of deals and the announced value of deals during the most recent quarter (Q2 2008), however, this sector has begun to show serious signs of weakness. The key question going forward: how severe will the impact be and how long will it last? We believe that the underlying drivers of M&A in infrastructure software will continue to create pockets of strong M&A activity and provide a source of ongoing deal flow during this downturn. These drivers include: buyers seeking growth and leadership in emerging sectors such as virtualization and data center automation; consolidation within and across sub-sectors; and consistent demand for M&A opportunities from sector leaders.
Public Equity Performance
For the 12-month period ended June 30, 2008, our index of public infrastructure software companies outperformed the NASDAQ as well as the other broad market indices during the same time period (see Figure 1).1 However, much of this performance is attributable to large-cap companies whose solutions span multiple sectors (Large-Cap Multi-Sector Software Companies). When these "stack" providers are excluded from the various sub-sector indices (Storage Management, IT Operations & Management, and Application Infrastructure), a different picture emerges for the relative price performance of "pure-play" companies. The Large-Cap and IT Operations & Management indices performed well in comparison to the NASDAQ while the Storage and Application Infrastructure indices performed markedly worse than the NASDAQ (see Figure 2).2
Figure 1: Infrastructure Software Stock Price Performance Against Broad Market Indices, Period Ended June 30, 2008
Figure 2: Infrastructure Software Sub-Sector Stock Price Performance, Period Ended June 30, 2008
M&A ACTIVITY IN INFRASTRUCTURE SOFTWARE Q3 2007 - Q2 2008
Infrastructure software M&A activity was generally strong during the 12-month period ended June 30, 2008. During the year, Updata tracked more than 80 infrastructure software deals aggregating just over $15 billion in transaction value, in comparison with approximately 70 transactions with an aggregate announced deal value of about $8.4 billion during the previous 12-month period. There are several indicators of weakness, however, emerging across the sector. First, both the number of deals and the aggregate announced value are down sharply in Q2 2008 (see Figure 3). Second, much of the aggregate announced value of transactions (about 80%) over the past year was attributable to a small number of very large deals such as Oracle's acquisition of BEA Systems and HP's purchase of Opsware (see Figure 4). Finally, the median multiple of enterprise value to last twelve months (LTM) revenue for transactions during the year is down to 2.9x from 4.2x during the previous year.3
Figure 4: Selected Large Deals In Infrastructure Software
While the data indicates weakness within the sector, there is also support for specific areas of strength in terms of deal activity and valuations. We believe these underlying areas of strength will provide some momentum for the broader infrastructure software M&A sector during this period of economic uncertainty. The key areas of support for infrastructure software M&A are continued consolidation by both existing sector leaders and emerging sector participants, and strong interest in areas of fast growth such as automation, virtualization, and storage.
The Usual Suspects Dominate Infrastructure M&A
Big 4 infrastructure software players (BMC Software, CA, HP, and IBM) continue to dominate M&A deal activity comprising almost a quarter of all announced deal value in this sector during the past year. IBM alone completed nine infrastructure deals in this time period totaling over $700 million in announced enterprise value. BMC Software bought four companies in this space: Emprisa, RealOps, BladeLogic, and ITM Software. HP completed two deals in this space, securing Neoware and Opsware for a combined $1.8 billion in enterprise value. Noticeably absent from the Big 4 buying activity was CA, which has not made an acquisition since October 2006.4
While the Big 4 companies have set the pace for infrastructure software acquisitions, we continue to see demand for infrastructure software targets from new and emerging players in the sector. For instance, EMC has continued to extend its resource management portfolio with its acquisitions of Voyence and Infra Corporation. Additionally, we have noted continued activity from other buyers that are seeking to expand on an existing footprint in the sector (such as Quest Software, Sun Microsystems, and Avocent) as well as activity from new entrants (such as VMware and Dell).
Enterprises Are Spending On Virtualization, Automation, And Storage Software
The emergence of a high-growth market opportunity related to virtualization and data center automation technologies continues to be a key contributor to M&A activity (see Figure 5).5 Driven by the need to reduce costs and increase flexibility, enterprises have begun to spend liberally on technologies that allow users to virtualize various elements of their infrastructure, focusing first on servers but extending to other elements as well. Automation solutions result in lower personnel costs in terms of labor expense, improved productivity, and higher levels of performance. In addition to having a strong value proposition for end users, sales of these types of products are expected to do well even in weak economic conditions because although IT spending may be limited, these solutions allow users to defer capital expenditures and manage operational expenses.
Figure 5: Virtualization And Automation Deals
The storage sector also showed relative strength among the infrastructure deals in the period tracked (see Figure 6) as the volume and value of stored data continues to grow rapidly across enterprise, SMB, and consumer segments. IBM bought five companies in this space (Arsenal Digital Solutions, Diligent Technologies, FilesX, Princeton Softech, and XIV) and EMC bought two (Illuminator and Mozy).
Figure 6: Storage Software Deals
WHAT'S AHEAD: INFRASTRUCTURE HEADS FOR THE CLOUDS
Within the broader infrastructure software sector, certain areas such as virtualization, data center automation, and distributed software architecture have experienced growth faster than the overall market. Solutions in each of these areas have their own unique value proposition that has driven rapid growth in enterprise spending. These value propositions tend to center around cost savings, performance improvement, and enhanced operating flexibility. While there is substantial ongoing demand for these discrete solutions, we believe that these disruptive technologies, in combination with other disruptive market forces (such as open source software, deep penetration of high speed connectivity, and declining hardware costs), are driving a much larger and more compelling market opportunity - often referred to as cloud computing.
The promise of cloud computing is the ability to provision infrastructure quickly, on-demand, and to scale up or down flexibly based on fluctuations in actual demand and usage. This architecture allows all types of subscribers - from large multinational corporations to small startups and even to consumers - to have access to powerful computing resources and deliver services to customers, employees, and partners while providing better management of both fixed capital investments and ongoing operating costs. Cloud computing can be offered by an independent third party to external customers or by the IT department of an enterprise to its internal users.
Cloud computing is enabled by and relies on many of the new disruptive technologies around virtualization and data center automation. It also leverages ongoing commoditization of processing hardware, storage resources, and nuts-and-bolts infrastructure software (such as operating systems and web servers - think Linux and Apache). Cloud computing offerings are now available from a number of sources including Amazon (EC2) and Rackspace (Mosso). In this type of offering, a user subscribes for access to a fractional component of a full computing platform. A typical use case is to test the development of an application or host a website or on-demand application. Users pay for the resources they need and can increase or decrease their resources over time.
While penetration from some of these pioneering offerings could be considered modest, the promise of cloud computing has been demonstrated by several more limited and narrowly focused offerings that utilize a similar architecture. One of the most pervasive and fastest-growing examples of a targeted cloud computing offering is online backup and storage. In this relatively simple application, users subscribe for storage "in the cloud," pay for what they use while they use it, and can increase or decrease their capacity over time without having to buy additional systems or software licenses. While there has been a proliferation of online backup vendors, a number of these have achieved phenomenal growth by focusing on small- to medium-sized businesses (such as EVault) or on the consumer (such as SwapDrive). As this sector demonstrated strong growth, high levels of M&A activity have followed (see Figure 7).
Figure 7: Selected Online Backup Deals
In these cloud computing examples, the vendors are responsible for provisioning and managing the resources to deliver the service to customers. Delivering this type of service with this amount of flexibility would be uneconomical and operationally impossible without the assistance of key virtualization, automation, and management technologies. As the underlying technologies become more pervasive and well-integrated, the emergence of cloud computing will drive a wave of innovation that is similar to the innovation driven by the increased penetration of broadband connectivity. New technology-based business models will be introduced and powerful computing resources will become even more readily available to users without regard to their size, affiliation, or geography. As a result, the cloud computing opportunity will drive deep and broad demand for the key enabling technologies in virtualization, automation, and management far beyond the already compelling demand for these technologies at present. Given the size of the IT infrastructure market, the number of large key stakeholders, and the disruptive nature of this trend, we expect cloud computing to fuel M&A activity for a long time to come.
1Source: FactSet. One-year period ended June 30, 2008. All Infrastructure Index is comprised of MSFT, IBM, HPQ, ORCL, CA, CVLT, DBTK, DDUP, EMC, FALC, ISLN, NTAP, RVBD, SYMC, AVCT, BMC, CPWR, KEYN, MOTV, NOVL, NTCT, NZ, OPNT, QSFT, VMW, InfoVista, CTXS, INFA, JAVA, PEGA, PRGS, RHAT, TIBX, and Software AG. All Infrastructure Index is market-cap weighted. Dow Jones Software Composite consists of 91 US-based, mid- to large-cap companies drawn from all across the software sector. 2Source: FactSet. One-year period ended June 30, 2008. Storage Management Index is comprised of CA, CVLT, DBTK, DDUP, EMC, FALC, ISLN, NTAP, RVBD, and SYMC. IT Ops and Management Index is comprised of AVCT, BMC, CA, CPWR, KEYN, MOTV, NOVL, NTCT, NZ, OPNT, QSFT, SYMC, VMW, and InfoVista. Application Infrastructure Index comprised of CTXS, INFA, JAVA, PEGA, PRGS, RHAT, TIBX, and Software AG. Large-Cap Multi-Sector Index comprised of MSFT, IBM, HPQ, and ORCL. All Updata Indexes are market-cap weighted. 3Multiples vary widely based on individual transaction circumstances and are unobtainable in many cases. This median value was taken from the 27 infrastructure deals tracked by Updata between Q3 2007 and Q2 2008 that had publicly disclosed multiples. 4According to FactSet Mergerstat, the last acquisition made by CA was the IT services and configuration management solutions provider Cendura Corporation, announced October 12, 2006. 5See the Updata Advisors Infrastructure Software M&A Update, Q2 2007.
