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  New Bain & Company study suggests nearly two-thirds of software companies aren't profitable and may find themselves forced onto an acquisition path.
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Even as software giants Microsoft and SAP divulged that they had considered a merger but had been unable to reach agreement, forces of consolidation are mounting and are beginning to reduce the ranks throughout the software industry. This is according to a study of the software industry by Bain & Company, which revealed that mounting industry forces and a rebound in software M&A; volume could signal a new wave of consolidation.

A key finding presented in the study is that 65% of software companies are not profitable, although most over $1B in revenue are. And when this fact is coupled with customers' continued rationalization of their vendor base and slowed IT spending that makes organic growth more difficult, the result is that small and medium software companies are increasingly prime targets for the large software vendors – companies Bain refers to as “gorillas” – that are seeking even greater size and scale.

The study analyzed a wide spectrum of software industry sectors and looked at 12-month trailing data through January 2004. It revealed several findings that suggest a looming consolidation, including:

— Many sectors, such as security software, ERP, CRM, supply chain management, and content management remain fragmented, with the top four players in each sector accounting for less than 50% of overall market share;

— Correspondingly, a number of these sectors represent the highest growth opportunities. Sectors such as security software, storage management, business analytics, application servers, and application life cycle management software, have projected growth rates through 2005 that are nearly double the overall industry average;

— Though sizeable, “gorillas” account for only 1/3 of the market in many of these sectors and as these “gorillas” begin to stake out broader footprints, the category boundaries across applications like ERP, CRM and SCM and infrastructure software such as network and systems management, security management and storage management are beginning to blur.

— “Gorillas” beyond the software pure plays such as IBM, Cisco and HP have signaled their intent to increasingly focus on software to achieve profitable growth through both organic investments and M&A.;

And the front edge of the consolidation may already be forming according to Bain. Software M&A; deal volume is beginning to rebound and although valuations are no longer fueled by 'bubble' equity, the proportion of tech deals in software by value is over one third.

“The writing seems to be on the wall,” said Simon Heap, Bain partner and co-author of the study. “There are too many unprofitable players selling too many niche products in a slowing market where customers want fewer vendors – and that's a recipe for consolidation.”

Centers of Consolidation

While not handicapping buyers and sellers, the study did look at various dynamics of the software industry. Irrespective of technology cycles, the main underlying success factor has been the ability of software vendors to translate point products – single solution products – into platforms with high levels of integration and high associated switching costs. The 'winner takes all' nature of software economics has given firms that have achieved major platform status massive profit pools from which to fund forays into adjacent software categories.

Take for example Microsoft, which can use profits from its leading position in desktop operating systems and applications to fund investments in enterprise applications, security, systems and management. Similar investments in many of these sectors can be funded by fellow tech “gorillas,” IBM and Cisco, given their positions in mainframe data centers and networking, respectively. Defenders in these sectors include players that could be considered category champions in their own right; Symantec and Checkpoint (security), Veritas (storage management), and BMC Software and Computer Associates (systems and management).

A similar scenario illustrated in the study shows how Oracle, atop of the database market, seeks to expand into enterprise applications, application servers and business analytics. Equally focused on these same sectors is enterprise application giant SAP. Fiercely defending this ground are the likes of Siebel, i2, BEA Systems and Cognos.

But to help truly understand where buying power is concentrated, Bain took a deeper look at the tech “gorillas”. Mr. Heap pointed to the investment capacities of companies like Microsoft, IBM and Cisco. Their investment capacities, which are defined by their relative war chests – cash less debt plus debt capacity – and market valuations dwarf even other large software “gorillas” such as SAP and Oracle. “There are tech gorillas in this market and then there are 800-pound tech gorillas,” added Mr. Heap, “the latter have the financial wherewithal to truly reshape the landscape.”

Increasing private equity participation

One final factor in the reshaping of the software industry is the increasing role of private equity buyers. As customer spending on new IT and software has slowed and the imperative has shifted to recouping existing investments, a greater proportion of software revenue will come from the maintenance, expansion and upgrading of existing installations. Gaining control of locked-in installed bases has become an important motivator of corporate M&A.; But these relatively predictable revenue streams have also attracted private equity buyers who can apply leverage against these cash flows. Although still a small percentage of overall value, the share of private equity deals is growing. Further, these companies are not just acquiring stand-alone assets, but they are shaping multiple deals into consolidated positions in specific sub-sectors, e.g. the combination of SSA Global and Baan.

Early signs of upheaval

Are signs of consolidation already appearing? Yes, according to the study. A look at recent M&A; activity in the software industry revealed examples of M&A; deal-making after a recent slowdown. M&A; dollar volume fell from a peak of $15.5 billion in 2000, to $8.1 billion in 2001, to $6.4 billion in 2002. In 2003 and the first half of 2004, the industry again witnessed mega-deals such as IBM-Rational ($2.1 billion), PeopleSoft-J.D. Edwards ($1.7 billion), EMC's acquisition of Legato ($1.3 billion), Documentum ($1.7 billion) and VMWare ($635 million) as well as the proposed Oracle-PeopleSoft deal ($7.7 billion). A stream of more modest deals has occurred as well, including Business Objects-Crystal Decisions ($840 million), Veritas-Precise Software Solutions ($500 million), IBM-Candle ($350 million – estimated) and Serena-Merant ($303 million).

What should executives be doing?

The study provided recommendations for executives leading companies on both sides of the consolidation equation.

First of all, every software vendor should develop a point of view on the evolution of the categories in which they play and the potential consolidation scenarios that will create value for both customers and shareholders. Not every scenario will involve major M&A.;

For the Hunters

— Focus on the fundamentals – building platforms and extending is key.

— When major M&A; seems like a valid option, it will require a compelling vision to get many target company CEOs who have built their companies from the ground up to come to the negotiating table. Hostile bids will be challenging in such a people-driven industry.

— When negotiations can be launched, rigorous due diligence still needs to be applied to value installed base revenue streams, the potential of technology assets as well as creating a detailed blueprint for combining development groups, sales forces and channels.

— Finally, the post merger integration must be planned to focus above all else on realizing the few key sources of value established in the diligence process.

For the Hunted

— Don't let pride get in the way of shareholder value. Sometimes the best decision may involve losing control of a business you've helped to build.

— Take proactive steps to position the business in the most attractive consolidation pathways through technology partnerships and reseller agreements.

— For those companies 'in the middle' who could either be bought, left behind or become potential consolidation points in their own right, first moves will be critical to gaining control of assets that can provide the bulk and springboard to fund an independent future.

“At the end of the day, the best moves for executives to consider are those that create the most value for shareholders,” said Vince Tobkin, co-head of Bain's global technology and telecommunications practice and co-author of the study, adding, “shareholders aren't big on moral victories.”
 
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