SoftWare In The Head?

So fine: IBM won. It took just one week of relatively painless negotiations. On June 11, Chairman Louis V. Gerstner Jr. cheerfully announced that Big Blue would indeed acquire Lotus Development Corp. All it had to do was keep Lotus Chairman Jim P. Manzi on as a senior vice-president--at least temporarily. And shell out $3.5 billion.

The deal immediately raised one nagging question on Wall Street: What could justify such a lush valuation? After all, IBM will pay $64 a share for a company whose stock had been stuck in the low 30s. The price is four times Lotus' 1994 revenues, and IBM will write off some $1.8 billion in goodwill after a one-time charge.

IBM-Lotus isn't the only software deal raising eyebrows: Valuations in software megamergers have gone through the roof. Late last year, database maker Sybase Inc. acquired software hotshot Powersoft Corp. in a deal valued at $1.3 billion--roughly seven times Powersoft's projected $185 million in 1995 sales. On May 25, Computer Associates International Inc. announced it would pay $1.78 billion, more than three times revenues, for Legent Corp., a developer of systems management software. Last fall, Microsoft Corp. tried to buy Intuit Inc. for $1.5 billion--almost seven times lagging revenues. The deal fell apart--not because the price was too high, but because Microsoft chose to avoid a prolonged Justice Dept. antitrust probe.

What's going on? Chalk it up to the rapidly changing nature of the software business. Once brimming with small and midsize companies, each with a specialty, the industry increasingly is dominated by big players--bent on getting bigger still. "What's clear is that size and scale are becoming critical," says Bruce D. Smith, a technology analyst at Morgan Stanley & Co. Software makers are finding they need a range of products to compete with Microsoft and to provide the soup-to-nuts "solutions" customers prefer.

With ambitious software makers scouring the field for potential targets, demand is driving up prices. Indeed, Sybase shares jumped 14% on June 14, to $28.50, on speculation that it had become a target of either IBM, Sun Microsystems, or Microsoft. Such deals allow big players to get new products in a hurry: It's faster and easier to buy into a new technology than to spend years and huge sums of money developing products. "It's not as much about acquiring a revenue stream as gaining quick entry into markets," says Jeffrey Tarter, publisher of Softletter.

That certainly was the case for IBM. Although it sells $11 billion worth of software a year, it has struggled to develop products for the PC and client/server markets. It considered spending hundreds of millions of dollars to develop its own product to compete with Lotus' Notes groupware, say insiders. But such a product would have taken years to complete--and IBM wasn't even sure it could market the package effectively.

With the Lotus acquisition, IBM gained the top spot in the highly strategic groupware segment with the stroke of a pen. It also gained a team of developers with more than a decade of experience developing Notes. However, IBM paid more than 10 times Notes' revenues. The bet is IBM can sell more of Notes than Lotus would have on its own--and that will drive the sale of all sorts of software, services, and even computers.

STRATEGIC VALUE. Ultimately, IBM's stock recovered from the initial hit it took after news of the deal. Not all the recent deals have been as well received, though. Analysts say Sybase overpaid for Powersoft, a maker of development "tools." And Charles H. Federman, chairman of investment bankers Broadview Associates, characterizes CA's buyout of Legent as simply "taking a competitor out." Charles B. Wang, CA's chief executive, says Legent speeds up his move into distributed computing. "It's a fair price," he says.

What determines "fair" value? It comes down to what is strategic. Microsoft, for example, dominates in crucial desktop operating systems and office applications "suites," and its market value is a massive $50 billion--10 times revenues. Novell Inc., the $2 billion leader in network operating systems, has a market cap of $7 billion. In strategic deals, conventional valuations may be meaningless--and IBM's entry into groupware with Lotus just may qualify. "If IBM is successful in driving Notes to dominance, then they stole the company," says Morgan Stanley's Smith. $3.5 billion may be a bargain after all.

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