February 24, 2006

2005 Year-in-Review, 2006 Outlook

The highly active consolidation of 2005 continues in 2006 as the need for vertical depth, end-to-end solutions, compliance, scale and competitive differentiation drives M&A in the information technology (IT) industry. In 2005, Updata Capital advised companies across a broad spectrum of IT sectors, including application and infrastructure software and IT services, as well as specialized markets such as financial and government technology and IT security. Below, we offer our perspectives on M&A activity across these sectors in the past year, our interpretation of key trends and predictions for 2006.

Infrastructure Software as a sector experienced a marked increase in both the volume of M&A transactions and valuation multiples in 2005 as compared to the recent past. In 2005 as compared to 2004, the volume of announced transactions in the sector almost doubled from approximately 60 in 2004 to almost 100 in 2005. Likewise, the value of all disclosed transactions (excluding certain large transactions) increased from approximately $3.2 billion in 2004 (excluding the $11.8 billion Symantec/Veritas merger) to over $6.7 billion in 2005 (excluding the $1 billion Serena going private and the $3 billion Sun/StorageTek merger). More importantly, the median multiple of enterprise value to last twelve months (LTM) revenues for disclosed transactions increased from 2.5x in 2004 to 3.2x in 2005.

Transaction volume continued to be driven in large part by the dominant infrastructure vendors with CA, IBM and HP each completing multiple acquisitions during the year. In addition to continued consolidation (CA/Concord/Aprisma and IBM/Micromuse), M&A activity centered around areas with strong growth prospects such as integration of security (Altiris/Pedestal), and application management (CA/Wily). We continued to see a strong correlation between valuation multiples and revenue growth of target companies, as acquirers have demonstrated a willingness to pay significant premiums for fast growing businesses.

Predictions for 2006. During 2006 we expect the trends to remain consistent. Vendors will continue to consolidate functionality on their platforms, as CA did in its acquisition of iLumin in 2005, and will continue to seek out and pay up for vendors participating in fast growing segments. As we described in our recent Infrastructure Software M&A Update, we believe two areas that will drive growth will be Business Services Management (BSM) and Real-Time Infrastructure (RTI). We believe that deal activity in Q4 2005 (e.g. IBM/Collation) and Q1 2006 has borne this out (e.g. Symantec/Relicore). In addition, as we described in our recent Webinar, “Internet-Infrastructure Software Convergence,” disruptive changes in the enterprise software sector will lead to additional high growth opportunities and M&A activity.

Valuations. Mean trading valuations for Updata’s index of (currently 32) security companies decreased, from year-end enterprise value/forward-year revenue and EBITDA multiples of 3.8x and 19.8x, respectively, in 2004, to 2.8x and 13.9x in 2005. The sector’s mean disclosed M&A purchase price in 2005 was 6.6x trailing twelve-month Revenues, versus 8.7x in 2004. Declines mask continued high valuations for favored companies and subsectors.

These trends reflect IT Security’s coming of age. As market penetration has risen, and as more IT vendors embed security (note that most M&A volume is driven by non-security acquirers), the industry is mainstreaming, resulting in consolidation and valuation dynamics closer in line with the rest of the information technology universe. More industry data is available in our recent Infrastructure and Security Software M&A Update, available on our Web site.

Predictions for 2006. We expect sector consolidation to accelerate in 2006 as security remains an attractive space with higher-than-average annual demand growth of about 15 percent overall (and much higher in certain niches). Valuations on balance will rise as fewer security vendors remain to satisfy growing demand and as the technology convergence wave accelerates. Leaders in high-growth segments will continue achieving outsized private and public valuations; however, second-tier vendors in commoditizing areas will experience greater standalone pressures, necessitating extension of core competencies and/or inorganic growth. Security demand drivers for 2006 include the continued rise of compliance mandates, wireless Internet and online crime. Beneficiaries include vendors focusing on compliance monitoring and enforcement, mobile user and data protection, and strong authentication.

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Fewer IPOs.  While the IPO market is by no means closed, the bar remains high as the economic costs of being public and the associated risks and scrutiny make it much less attractive than in prior periods.  Simply put, most VCs are investing and Boards and managements are operating under the assumption that liquidity will be achieved via M&A. One notable area of exception is "on-demand" or "software as a service (SaaS)" where IPOs for Vocus, Rightnow, Kenexa and, of course, Salesforce.com are evidence of strong investor appetite.

Battle for Market Share in a Maturing Industry.  M&A activity will continue among players in the maturing traditional application software industry where earnings growth will often be delivered via greater efficiency and cost savings. Examples are Oracle/PeopleSoft, Infor/MAPICS, Lawson/Intentia and Saba/Thinq.

Oracle vs. SAP.  While the two behemoths have different strategies and levels of aggressiveness on the M&A front, both are considering many deals - large and small - all the time and the mere presence of the other will impact key decisions about when, where and how to take action.  Moreover, the rivalry between Oracle and SAP and their respective appetites for deals makes other players more anxious to consider M&A as an exit sooner than they might otherwise.

Best of Breed or Integrated Suite.  The pendulum swings, as always, but is leaning more toward suites which results in more combinations.  Oracle/Siebel, Oracle/G-log, SSA/Epiphany, Manhattan Associates/Evant and Infor/Formation Systems are examples.

Emphasis on Vertical Applications and Domain Knowledge.  Owning a vertical or domain is critical to survival in a world largely dominated by Oracle and SAP.  Existing vertically-focused players are acquiring to hold their ground.  Examples include Oracle/Retek/ ProfitLogic/360Commerce (see more in BI), SAP/Triversity/Khimetrics, Blackboard/WebCT, Activant/Profit21/Speedware, Deltek/Wind2, Infor/MAPICS.

Battle for Mid-market and SMB.  These two market segments are large, underpenetrated and served by a highly fragmented group of solutions providers.  However, the market is consolidating rapidly.  For sure, Microsoft continues to move in this segment, while SSA, Infor, Activant, Intuit, Sage and others are aggressively acquiring market share, reducing costs and focusing on maintenance streams and recurring revenue.  

Emergence of Private Equity Buyers and the Use of Leverage.  Banks are becoming much more willing to lend to software companies and now appreciate recurring maintenance, subscription and services revenue, high renewal rates, mission critical (sticky) applications and diversified customer bases.  As a result, financial buyers have become very aggressive and, at times, will out-bid strategic buyers.  A key question is how long this lasts in an environment of rising interest rates.  Examples here are Golden Gate/Geac, Francisco Partners/Red Prairie, Carlyle/SS&C, Vista/Applied Systems, Thoma Cressey-Trident/Datatel and New Mountain/Deltek.

Too Many Public Companies in the "Microcap Dungeon."  There remain dozens of publicly-traded application software companies that are not growing, are barely profitable (or losing money), have little to no Wall Street research sponsorship and suffer from lack of stock liquidity or low trading volume.   For most, it is very difficult to escape this "dungeon" and M&A, either through strategic sale or going private, will be the preferred route.

Predictions for 2006.  Consolidation for 2006 and beyond will continue to be driven by the above trends, combined with broader, emerging trends such as SaaS, increased adoption of open source/Linux, vertical software "stack wars," Business Process Management (BPM) and convergence in the Business Intelligence (BI) sector (see BI sector review below).  A key question is what mega-deals are around the corner?  Will Oracle slow its pace, focus on integration of prior deals and consider only smaller "tuck-ins"?

Increased M&A activity reflected the success of the BI sector in the equity markets.  The interest in BI M&A is coming from all directions including database vendors (e.g. IBM and Sybase), broad application vendors (e.g. SAP, Epicor and Oracle) and pure play BI vendors (e.g. Cognos and Business Objects).  In particular, we noticed significant activity in the higher level BI space, particularly around predictive analytics and corporate performance management – these are trends Updata expects will accelerate further in 2006. 

Deal of 2005:  Profit Logic acquired by Oracle.  The retail-focused optimization software provider was acquired by Oracle for what Updata believes to be greater than 4x revenues.  With predictive analytics at the top of the BI value chain and with vertical expertise a highly desirable trait, this was not a surprising transaction, but at the estimated transaction value, it was certainly a great deal for Profit Logic and its investors.  Oracle out-maneuvered SAP again here (remember Retek) in the M&A game but SAP responded quickly with its own retail pricing optimization deal when it acquired Khimetrics. 

Predictions for 2006.  Updata expects M&A to accelerate in 2006 with more overall deals, multiple expansion and more significant transactions.  2005 was a good year for BI in the retail vertical and we expect financial services to be the vertical of choice for 2006.  Predictions include: 

• One of the large pure play vendors will be acquired for a multi-billion dollar price tag
• Broad application vendors will continue to compete for BI technology as a way to further differentiate their solutions and provide demonstrable value-add.
• BI applications that are vertically focused will be more attractive in the M&A market as compared to those horizontal applications.

2005 saw multiple M&A transactions surpass the billion dollar mark including Ameritrade’s acquisition of TD Waterhouse (EV of $2.9 billion), E*Trade Financial Corporation’s acquisition of BrownCo (EV of $1.6 billion) and the $6.7 billion merger of Certegy and Fidelity National Information Services. In addition to industry consolidation, financial technology vendors attracted attention from outside the core financial technology arena highlighted by Oracle’s majority investment in India-based i-flex Solutions.

Deal of 2005: SunGard LBO. The year’s most headline-grabbing transaction occurred when a consortium of private equity investors announced the $11 billion acquisition of SunGard Data Systems, the largest leveraged buyout (LBO) transaction since the acquisition of RJR Nabisco in 1989. SS&C also followed suit and opted for the going private route via a leveraged buyout with equity from The Carlyle Group for an enterprise value of nearly $985 million.

Predictions for 2006. We expect 2006 to yield a similar deal environment to that of 2005 with strong consolidation and M&A activity anticipated. Acquirers will continue to fill in product gaps via acquisitions as well as leverage M&A to expand current market share. Heightened regulatory issues and changes, such as Basel II and Check 21, will likely drive continued activity in the M&A markets as compliance is a leading concern of financial institutions, as is minimizing expenses while enhancing customer interactions. In the payments market, recent acquisitions by CheckFree and Fiserv could fuel continued consolidation in the sector with new opportunities coming from emerging areas such as micropayments. With numerous transactions across the financial technology markets already announced in the first four weeks of the year, Updata expects 2006 to provide opportunities for both acquirers and sellers to extract value through M&A.

In the first three weeks of January alone, Updata tracked 22 IT services deals, a pace which, if sustained, will surpass 2005 by a healthy clip. Interestingly, two notable deals in January involved IT services firms with mixed commercial and Federal customer bases: in a precedent-setting move, EMC acquired Updata client Internosis, a high-end infrastructure consultancy serving both the Federal Government and commercial clients; and KForce closed its acquisition of Pinkerton, an IT staffing and services firm focused in both the Federal and commercial sectors.

Predictions for 2006. In the main, M&A activity in 2006 will be driven by increased willingness among boards and management to assess strategic, if not ground-breaking, acquisition opportunities bringing differentiated services offerings and expertise. Valuation expectations of buyers and sellers are well-aligned and continue to tick up moderately and steadily. And in this highly-competitive rate and margin environment, cost synergies arising from consolidation will remain an attractive underlying financial driver of M&A activity for the foreseeable future.

2006 will be another active year for consolidations throughout the information technology industry. We look forward to providing you with timely news and commentary through quarterly sector research and bulletins on significant transactions. If you would like more in-depth information on activity in your company’s sector, contact us for an assessment of your company’s valuation as well as market metrics and benchmarks by which you can gauge your performance.

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.