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Software Makers: Soon They'll Be Fewer

By Steve Rosenbush Vast fortunes were built over the last two decades as the leadership of the computing world shifted from hardware to software. Yet, every day seems to bring fresh evidence that the era of boundless growth for software may be over. On July 8, application developer Siebel Systems (SEBL) and e-business software maker BMC Software (BMC) warned that their results for the second quarter would be lower than expected. Shares of software infrastructure company Veritas Software (VRTS) fell 30% on July 7 when it said second-quarter results would be disappointing (see BW Online, 7/9/04, "Hard Times for Software").

That growing financial pressure will likely spark a powerful wave of consolidation throughout the industry over the next few years. Investment bankers say half of the sector's 600 publicly traded companies are likely to be eliminated. "I do think there's going to be a lot of consolidation in the software sector. As IT [info-tech] spending slows, it's harder for companies to grow organically. Big companies will add customers by acquiring smaller companies," says Paul Crisci, an investment banker at Jefferies & Co.'s Broadview unit, which specializes in tech deals.

Some analysts doubt that the consolidation will be quite that dramatic. Many smaller, unprofitable companies have cut costs and have lots of cash on their balance sheets. That means they can hang around "like vampires," slashing prices and depressing margins industrywide. "There might be a need for consolidation, but that doesn't automatically mean it will happen," says analyst Bill Whyman of investment researcher The Precursor Group.

SMALL IPO WINDOW. Yet, sooner or later, many smaller software companies will have little choice but to sell. About one-third of the industry's profits are concentrated in the hands of the 20 biggest players, according to Simon Heap, a software merger specialist at consultant Bain & Co. That was O.K. during the bull market of the 1990s, when the benchmark of success was fast revenue growth and a hot IPO. But earnings have replaced revenue growth as the new measure of success on Wall Street.

What's more, most software companies have little hope of going public. Despite the hype over Google's IPO, only 35 tech companies have had initial offerings in the last 12 months, according to Broadview. That's a big increase over the last year but still low by historic standards.

A more troubling sign is that the upturn in IT spending isn't reaching software, usually the last tech market to bounce back after a downturn. But the tech recovery is well under way, and one would expect to see signs of a rebound in software by now. Yet chief executives at software companies say their customers are extremely conservative when it comes to spending money (see BW Online, 7/8/04, "Corporate America: Stuffed with Dough").

THE CEO DECIDES. "A whole bunch of factors are putting economic pressure on customers, forcing them to cut costs and improve earnings," says Tony Hill, chairman and chief executive of Micro Focus, a privately held software company in Newbury, England. Hill's outfit helps companies extend the life of their old mainframe computer systems and has a partnership with Microsoft. That gives him a window into the broader world of IT.

He says customers want to renegotiate contracts to lower their prices. At the same time, IT spending decisions are being made at higher levels of the organization, and the payoff has to be faster than ever before. "It's the CEO, not the CIO, who's making the software investment decisions now," says Bob Calderoni, chief executive of Ariba (ARBAD), which makes software for managing corporate spending.

After plowing huge investments into IT during the last few years, companies are looking to integrate the plethora of systems cluttering up the digital attic. They have very little appetite for massive new spending outside of a few crucial areas such as security and business intelligence. Companies also are looking to reduce the number of vendors they deal with, purchasing a wider array of products from a smaller group of suppliers.

"LIKE AUTOS." These trends could portend a long drought for software spending and could make it more difficult for smaller companies to drum up business and expand their way to profitability.

Two kinds of consolidation are under way. One might be called the Oracle-PeopleSoft model. "In maturing areas, we'll see more consolidation, like [Oracle's bid for] PeopleSoft (PSFT). That's the way industries work in mature areas like autos, and we'll see the same thing in IT," Oracle Chief Financial Officer Jeff Henley says. Oracle's plan is to buy PeopleSoft for its customers and sell them a broader range of products and services.

Another obvious target in the maturing software infrastructure market is BEA Systems (BEAS), which was on a list of nine possible targets that Oracle considered, according to documents made public during the Oracle-PeopleSoft antitrust trial.

ANOTHER APPROACH. BEA, which makes software for application servers, could be a target for a company like Sun Microsystems (SUNW), which is trying to move beyond the hardware business. And Lawson Software (LWSN), in the maturing application sector, could be a logical target for Microsoft. While the Colossus of Redmond has considered a blockbuster deal with German applications giant SAP (SAP), it gave up on that idea because it was too cumbersome to pull off. Lawson has an advantage because it's based on Microsoft technology.

A second type of consolidation will develop in the few growth markets that remain, industry watchers believe. The demand for security software is very high, and revenues are growing at a compound rate of 15% to 17% over the next five years, according to Sarah Friar, a security software analyst at Goldman Sachs. That's about twice as fast as the industry average.

Internet router make Juniper Networks (JNPR) kicked off consolidation in the sector by acquiring security-software developer Net Screen. Now speculation is swirling that router giant Cisco Systems (CSCO) could acquire a software security company like Check Point Software (CHKP).

"HORRIBLE TRACK RECORD." Beyond the security sector, business-intelligence software is also in great demand. A tool for culling and analyzing information in vast databases, business-intelligence specialists like Business Objects (BOBJ) or Hyperion Solutions (HYSL) would make sense paired with a broader application provider like Microsoft, SAP, or Oracle, investment bankers say.

Software companies will have to work hard to make sure deals don't create more problems than they solve. "The track record for such deals in the IT sector is horrible," warns Heap, the Bain merger consultant. These deals are difficult to execute because they often force the acquiring company to enter a new and unfamiliar market.

Acquirers have one thing working in their favor this time around, however: The price of target companies has fallen since the '90s boom, reducing the risk of overpaying. And given the passage of time, it's easier to evaluate the strength of a company that's being acquired.

Consolidation won't be a panacea for software's woes, but it's bound to help the industry adjust to the realities of a maturing market. Rosenbush covers finance and technology for BusinessWeek Online in New York

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