Infrastructure Software: Adoption of virtualization technologies and service-oriented architecture (SOA) is presenting new convergence opportunities across the stack, sustaining M&A activity and rising multiples.  Read More >>

IT Security: With record levels of consolidation in 2006, the sector is poised for accelerated consolidation in 2007 with valuations holding or improving as larger technology vendors seek to provide end-to-end solutions.  Read More >>

Application Software: Strategic and financial buyers are vying for innovative companies leveraging SaaS, business analytics, service-oriented architecture (SOA) and open source technologies to address new markets.  Read More >>

Internet: Web 2.0’s strong deal activity with high valuations for smaller deals is differentiated by targets showing greater revenues and clearer paths to profitability.  Read More >>

IT Services: Key trends include bi-directional acquisitions between U.S. outsourcing firms and their offshore counterparts, strategic acquisitions of software technologies and private equity buyouts.  Read More >>
 

We welcome the opportunity to dialogue with you on a more detailed level within IT sub-sectors about drivers of value and strategic alternatives for financial growth or liquidity through M&A events.

We wish you all great health and prosperity in 2007!

We expect that ongoing changes in the market for infrastructure software (which we define to include solutions for IT management and operations as well as application integration and development) will support continued strong levels of M&A activity over the next twelve months. While the volume of transactions in this sector during the course of 2006 was similar to that of 2005, we did experience a continued expansion in announced deal multiples as large, incumbent vendors led the way in undertaking acquisitions to consolidate functionality on their platforms as well as stake out positions in areas of emerging growth.

Sector	Announced Deals	Median Multiple*
IT Management & Operations
2006	52	4.7x
2005	50	4.2x
Application Infrastructure & Development
2006	23	4.9x
2005	20	2.4x

*Implied target enterprise value/last twelve months revenue
 

Key trends contributing to M&A transactions that take place during 2007 to include the following:

• Supportive Macro Environment: Positive performance of capital markets, continued low interest rates and growing interest of private equity in the software domain;
   
• Web 2.0 to Drive Integration: Web 2.0 phenomena combined with rapid reductions in the cost of technology driving broader utilization across the enterprise and deeper integration with a range of business processes;
   
• SMB: Growing influence of the SMB market as a substantial consumer of advanced IT solutions;
   
• IT Management: Consolidation of IT management functionality across infrastructure silos and improved alignment of IT with business objectives;
   
• IT Operations: Continued adoption of server virtualization and emerging adoption of other virtualization technologies creating challenges for data center managers and opportunities for focused vendors;
   
• SOA: Wide-spread SOA deployments triggering growth in related development and testing tools and integration solutions in the application infrastructure and development sector.

Top

2006 saw unprecedented consolidation in the IT security industry. Total announced security M&A volume tracked by Updata jumped 59% over 2005, to a record $6.8 billion of target value and 92 deals. This includes eight acquisitions of public vendors, up from four in 2005: 

Announce Date	Seller	Buyer	Deal Value	LTM Rev	Mult of LTM Rev
Nov-06	Protect Data	Check Point	$607	$66	9.2x
Oct-06	Citadel Security Software	McAfee	$60	$14	4.2x
Aug-06	Internet Security Systems	IBM	$1,089	$337	3.2x
Jul-06	WatchGuard Technologies	Francisco Partners	$83	$77	1.1x
Jun-06	RSA Security	EMC	$2,100	$322	6.5x
Apr-06	NetIQ	AttachmateWRQ	$303	$189	1.6x
Feb-06	nCipher (terminated)	SafeNet	$75	$29	2.6x
Jan-06	Identix	Viisage	$740	$80	9.3x

Deal valuations remained steady versus 2005: Mean/median multiples of enterprise deal value divided by last 12-month revenues in 2006 were 6.5x / 4.7x, versus 6.5x / 4.1x in 2005.

For 2007, we expect consolidation to accelerate, and valuations to hold or improve, for several reasons:

• Investor sentiment and sales momentum favor broad technology vendors over pure-plays. Illustrating this, Updata's IT security share price index declined by 3% in 2006; in comparison Updata’s index of major consolidators including Cisco, EMC, IBM and Microsoft rose 17%.
   
• Deal activity suggests that consolidators seek to provide end-to-end security functionality across platforms – software, appliance and managed services – rather than simply market share.
   
• Since the start of 2005, 35% of public security firms in Updata’s index have been acquired, pressuring the remainder who have seen overall price declines.
   
• Public software firms have lots of cash, while costs of capital remain low by historical standards.
   
• Private equity firms and other financial buyers also have large pools of cash. Several large PE firms have indicated interest in buying into the sector due to high growth rates and moves by other PE firms.

Notwithstanding consolidation pressure, opportunities for security vendors and their investors will remain promising in 2007:

• The number of competitors by sub-sector is declining due to M&A activity, combined with reduced venture investing: “A” round investments in security declined, from 56 in 2005 to 35 in 2006, and total investments fell from 177 to 125 in 2005 (through November of each year), according to Updata research. Sector private investment volumes also declined, to $0.8 billion from $1.2 billion.
   
• Despite maturation of established security segments, overall industry growth remains at an estimated 15% - about 3x growth in the overall IT market. In certain sub-sectors such as managed security, filtering (in- and out-bound) and application security, the growth rate is materially higher.
   
• 2007 security spending demand drivers include:
  
  
  • Growing sophistication of online criminals who foil progressively more sophisticated defenses to steal and spy. Techniques on the rise include targeted phishing that leverages victims’ personal information, sophisticated keylogging “trojans”, and placement of downloadable exploits in websites.
     
  • Continual creation of new security threats “in the wild”, some of which will inevitably emerge as major threats. This process is aided by hacker sites and ongoing introduction of new applications and devices creating new threat vectors.
     
  • Technology landscape evolution drives new security risks. These include emergence of Enterprise 2.0, VoIP and proliferation of wireless/portables and IM in the workplace.
     
  • Migration of government and business activities online creates greater web-based threats requiring heightened security in all respects, from fortified code development to stronger vulnerability management.

Reflecting the market, Updata also experienced a busy year serving IT security M&A clients. In 2006 we announced five security M&A deals, plus two under signed term sheet. We foresee at least an equally active 2007. (See press release summarizing Updata deal activity: http://www.updata.com/interior_capitalnews.asp?newsid=226)


 

Top

Valuation multiples mirror the increase in deal volume as well. Per Updata’s proprietary database, the median EV/LTM Revenue multiple for all enterprise application deals in 2006 was 2.5x compared to 2.0x for 2005, a 24.1% increase.

Sector	Announced Deals	Median Multiple*
SaaS
2006	30	4.1x
2005	9	2.7x
Business Analytics
2006	30	3.1x
2005	33	2.6x
Enterprise Resource Planning
2006	12	1.7x
2005	21	1.8x
Supply Chain Management
2006	26	2.6x
2005	23	1.5x
Workforce Management
2006	14	2.6x
2005	9	1.7x

*Implied target enterprise value/last twelve months revenue
 

We believe several factors contribute to this increase in valuation multiples in 2006. Strategic buyers are benefiting from improved profitability and strong cash flows. In addition, more CEOs are viewing M&A as a viable and effective growth strategy. Large software vendors with significant cash war chests tend to prefer to deploy cash towards acquisitions rather than share repurchases and dividends. Financial buyers, flush with capital from equity and debt investors, are as aggressive as ever and will often outbid strategics. Sellers and their financial advisors are recognizing the opportunity to maximize value given a highly active M&A environment that includes hungry strategic and financial buyers. As a result, broader M&A processes or auctions are being conducted.

We see the following trends in application software for 2007:

• Moderate Increase in M&A Volume: We believe 2007 will experience increased deal volume, however, the rate of increase will not be as lofty as that of 2006. Drivers influencing our view as well as other observations include:
  
  • Acquisition sprees over the last few years by large strategic buyers have filled out many of their product and technology gaps
     
  • Many high quality software companies with scale and/or niche domination have already been rolled into larger software vendors or have been bought out by private equity groups
     
  • Technologies and “models” in high demand, specifically SaaS, business analytics, service-oriented architecture (SOA) and open source, will continue to solicit interest from larger software companies; smaller, best of breed providers can garner attractive multiples
     
  • Active consolidators will be busy digesting and integrating the acquisitions made over the last couple of years
     
  • The IPO market is predicted to become more receptive to technology companies in 2007, especially with the prospect of regulators easing Sarbanes-Oxley requirements for small companies. As a result, more companies will be able to consider both exit strategies and potentially pursue a dual process to explore both IPO and M&A
    
   
• M&A Valuations to Hold or Improve: In general, we believe valuation will remain steady or slightly improve in 2007 compared to 2006. Larger deals will continue to attract more attention from financial and strategic acquirers in 2007, hence, resulting in more attractive valuation multiples. In 2006, Updata’s database shows that enterprise application software deals valued over $50 million had median EV/LTM Revenue multiple of 2.6x while that figure for deals valued less than $50 million was 2.2x, a 20.5% difference.
   
• Private Equity Platform Plays: If the debt capital markets aimed at buyouts continue to remain healthy, private equity groups should still be highly active in the software M&A market. We expect to see more M&A activity from “platform” portfolio companies (such as Red Prairie/Francisco Partners, Activant/Hellman & Friedman/JMI/Thoma Cressey, M2M/Battery/Thoma Cressey) than private equity groups making the initial platform acquisitions. However, we do believe that there are still sectors with opportunities for private equity groups to make a platform acquisition and pursue a consolidation strategy. The business analytics sector for example is due for consolidation and we would not be surprised to see one of the established vendors in this sector go through a LBO in 2007.
   
• SaaS Convergence with BPOs: The public equity markets began to recognize the large potential for SaaS in 2005 but we believe adoption from customers began to take off last year in 2006. With so much attention paid to SaaS over the last 18 months, many more potential customers are now educated on the value propositions of SaaS and the early adopters of this model are validating the benefits for those sitting on the sidelines. We see a strong movement towards the convergence of SaaS with traditional outsourcing/services companies take place with deals such as ADP acquiring Employease and Accenture acquiring Navitaire. In addition, our regular dialogues with business process outsourcing and IT services companies tell us that these companies view SaaS as a natural fit with their current business and financial model and they are on a prowl for SaaS companies with special domain expertise.

Top

The total number of Internet deals tracked by Updata in 2006 held steady, with 128 compared to 130 in 2005, while overall median deal multiples increased from 2.8x to 3.5x revenues. The real story is the shifting composition of deals and valuations differentials within the six main sub-sectors we track within the internet universe. For example, 2006 saw increased activity in e-commerce, as well as strong growth in the number of deals and consistently robust valuations for internet applications. There were fewer digital media deals, but buyers paid up for select properties. The more unique nature of worthwhile search targets drove valuations up.

A summary of deal activity and median valuations across internet sub-sectors follows:
 

Sector	Announced Deals	Median Multiple*
E-Commerce
2006	27	1.8x
2005	18	2.1x
Internet Applications
2006	27	4.8x
2005	19	2.4x
Digital Media
2006	32	4.0x
2005	42	5.0x
Internet Infrastructure
2006	19	2.0x
2005	17	1.4x
Internet Search
2006	5	15.6x
2005	15	3.2x
Internet Marketing Services
2006	18	3.6x
2005	19	2.9x

*Implied target enterprise value/last twelve months revenue
 

What differentiates the shopping spree over the last two years from the 1990s bubble era is the greater business substance of acquired targets in terms of revenues and the path to profitability. This is due to technology and business model advancements, e.g. the advertising model has been proven to work.

Traditional media companies are still paying some of the highest M&A valuations. This is due to their pressing need to enter higher-growth markets and a sense that they are fighting a defensive battle against the Internet pure-plays – many of which are evolving to becoming broad digital media companies in their own right.

Looking ahead to 2007, we expect the following:

• Continued Strong Deal Activity: There will be more press-grabbing mega-deals like YouTube, but there will also be many more, smaller transactions. We’ve talked with several of the larger acquirers in the internet space: some are more focused on acquiring technology, IP, or exceptional teams, others talk about audience and market share. But, most said they would continue to do most of their deals under $100M and even under $40M.
   
• Higher Valuations in Smaller Deals: Valuations will remain strong with the highest multiples not reported because the deals are small. Lower operating costs and better monetization enables more desirable properties to hold out longer for favorable valuations. The low cost of operations also facilitates viability, at least temporarily, for many me-too vendors, which will defer the impending shake-out and keep valuations higher longer than might otherwise be expected.
   
• Private Equity Competes with Strategic Buyers: Private equity and venture capital firms have become much more aggressive in internet deals and with valuations. This is driven by the abundance of private equity capital and supported by our own experience on deals where PE players have even outbid strategics.
   
• First-Movers Exit Early: Expect more “below the radar” deals where little known companies with a handful of engineers get snapped up after only a year or two in existence because they've hit on something new and exciting – this marks the return of first-mover advantage psychology and audience “land grabs.” We see this mostly occurring in the digital media or web applications sub-sectors.
   
• Appeal of Web Infrastructure IP: Continued increased interest in infrastructure technologies that make streaming faster, search better, etc. These companies have real IP and are less susceptible to the changing winds of consumer tastes.

Top
 

Updata tracked 371 deals in 2006 across all the IT Services sub-sectors representing an 11.7% increase in deal activity over 2005. All sub-sectors were up over 2005 numbers except for the government IT sub-sector which showed an 16% decline from 56 deals in 2005 to 47 deals in 2006. From a valuation perspective, the median deal multiples (measured as EV/LTM Revenues) in 2006 rose modestly for systems integrators, IT consultancies and IT staffing companies but fell slightly for IT outsourcers and government IT service providers.

Sector	Announced Deals	Median Multiple*
IT Consultancies
2006	45	1.15x
2005	38	1.06x
IT Outsourcing
2006	51	1.18x
2005	44	1.19x
IT Staffing
2006	17	0.44x
2005	14	0.39x
Systems Integrators
2006	88	0.70x
2005	63	0.52x
Government IT
2006	47	1.10x
2005	56	1.16x

*Implied target enterprise value/last twelve months revenue
 

For 2007, we expect underlying business trends to remain positive for commercial IT services providers. We look for several primary business trends to shape the 2007 market for IT Services including:

• Continued Emphasis on Global Delivery of IT Services: every IT services sub-sector is being impacted by the end-customer demands for utilization of offshore resources. This is still largely a cost of service value proposition and it continues to gain share in nearly all IT projects. Evidence of this trend is widespread: simply looking at the offshore headcount of the major IT providers tells the story. Expect the M&A market to follow this trend with more deals in 2007 that follow the pattern of Capgemini’s acquisition of Kanbay and EDS’ acquisition of Mphasis. In particular, look for the larger U.S. players to acquire Tier 2 Indian offshore providers and look for the Tier 1 Indian offshore companies to acquire middle market, “front-end” IT services companies in the U.S. Even the large Indian service providers are finding it necessary to use M&A as a means to grow their U.S. sales capabilities.
  
  

  
  

  Service Provider	2005 India H/C	2006 India H/C	% Change
  IBM	38,500	53,000	38%
  EDS	14,500	21,100	46%
  Accenture	16,000	27,000	69%
  Capgemini	4,600	12,000	161%

   

• Continued Interest in Acquiring SAP Integrators by Larger IT Consultancies: IT service providers consistently have SAP integrators at the top of their M&A priority list and the shortage of SAP certified consultants has not abated. From an M&A perspective, over 20 SAP service providers were acquired in 2006. The most aggressive buyer continues to be Axon Group, which has acquired four US-based SAP firms in the last two years – Zytalis, PermierHR, TUI Consulting and Feanix. The most notable SAP services deal last year was Kanbay’s $165 million acquisition of Adjoined Consulting.
   

• Large Private Equity Funds to Aggressively Pursue IT Outsourcers and BPO Companies: Private Equity buyout funds raised almost $150 billion during 2005 and 2006 and they have record amounts of uncommitted capital looking for deals. Interest rates remain low and lenders show no sign of pulling in the reigns on sponsor-led deals. Look for the large buyout funds to acquire BPO companies that have strong cash flow, recurring revenues and oligopolistic positions. An indication of deals to come in 2007 is seen in the 2006 acquisitions of Sabre Holdings, Worldspan LP and Travelport Corporate Solutions: these 3 transactions represented over 75% of the entire world-wide market for global travel distribution services and had a cumulative transaction value of over $10 billion.
   

• Continued Interest by Large Software and Infrastructure Systems Companies in Middle Market Systems Integrators: Companies like HP, Symantec and EMC are aggressively pursuing strategies to capture the broader data center infrastructure market which is increasingly a software and services opportunity. As these large systems companies transition from “product” sellers to “solutions” sellers, they must build or acquire IT service organizations capable of selling into the CIO/COO suite and then have the capability to follow up the sale with systems integration expertise. Many of these large systems vendors have already stated their public intentions to acquire services companies and several transactions have already been consummated. We expect this trend to become more evident in 2007.
  

Top
 

For more information, contact:

Greg Ager: gager@updata.com
Ira Cohen: icohen@updata.com
John MacDonald: jmacdonald@updata.com
Don More: dmore@updata.com
Joel Strauch: jstrauch@updata.com



Updata Capital, Inc. Disclaimer
The information and opinions in this report were prepared by Updata Capital, 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.