Survival of software's fittest

Experts say the business software industry will consolidate as companies try to increase their range of products to better compete for tight IT budgets. That pressure is prompting midsize firms and the industry's largest players to consider combinations that might have been dismissed only a few years ago.

Sun Microsystems' chief operating officer and president, Jonathan Schwartz, created a stir earlier this month when he disclosed that Sun has considered buying Novell. Although the notion of a Sun-Novell merger was dismissed as unlikely by many industry analysts, the hint of the discussions in Sun's executive suite demonstrates the dramatic moves that technology suppliers are considering.

Sun is not alone. Two straight quarters of declining license revenue, along with a string of executive departures and a reorganization at BEA Systems have rekindled questions about the company's long-term viability as a standalone software maker.

Indeed, during trial testimony involving Oracle's unsolicited offer to buy business application maker Peoplesoft, Oracle disclosed that BEA was a potential takeover target. At the same time, Microsoft and SAP dropped a bombshell by announcing that they had held exploratory merger talks in the wake of Oracle's pursuit of PeopleSoft.

"When you can't grow organically, you look to grow or better position yourself through consolidation," said Paul Crisci, managing director of Broadview, a division of Jeffries, which advises companies on mergers and acquisitions. "The worst job in the world right now is a software salesman--there are too many software companies fighting for too few dollars in the marketplace."

Swallowing up the minnows
Smaller companies continue to be prey for larger technology suppliers. Hewlett-Packard, IBM, Sun and Veritas have each purchased several smaller companies to fill out their utility computing product portfolios. With limited opportunities to go public on the stock market, the great majority of new start-up companies need to consider an "exit strategy" that involves a close partnership or merger with a larger company, according to market observers.

Many smaller companies are already doing just that, building close alliances with the industry behemoths through partnerships and technical integration. Similarly, large corporate customers are choosing to do business with a few suppliers and technology platforms on which they build and run applications, analysts note.

"New technology solutions have become narrower and narrower because there are fewer big problems that need to be solved," said Paul Maeder, managing general partner at venture capital firm Highland Capital.

Maeder suggests that new companies should apply technology to underserved industries, such as health care and transportation. Customers are likely to rely on their tried-and-tested suppliers for the technology in their data centers, which may ultimately mean that the big will get bigger.

"Whatever piece of software you provide in the IT-intensive part of the economy, like the data center, is by definition going to be part of another solution," Maeder said.

These conditions--in which providers fight over dollars in flat or slow-growing IT budgets--will lead to a quicker pace of mergers and acquisitions, even compared with the software industry's rich history of deals, some experts predict. If the enterprise software market does see more weeding out, it could change the makeup of the industry.

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"We argue that in a couple years, most of the names you're familiar with will no longer be around," Martin Wolf, president of Martin Wolf Securities, a mergers and acquisitions advisory firm. "They'll just get added on as features to another company."

Changing buying patterns are helping fuel the trend. Businesses have spent the last few years reducing the number of providers they work with, and are counting on fewer suppliers for more capabilities. That's driven larger suppliers to buy technology to fill out their portfolios. IBM's software group, for example, has made 17 acquisitions since 2001.

Despite a general upturn in technology spending, analysts do not expect a return to rapid growth in software. Instead of launching large-scale projects, many customers are looking to make better use of the systems and data they already have in place, according to analysts.

With limited hope of growing business by landing new clients, many companies will be forced to merge to expand their customer bases, Crisci said.

Software's midlife crisis
Analysts say the anticipated wave of consolidation reflects the aging of the software industry. Instead of an industry littered with thousands of high-growth outfits, enterprise software is starting to resemble industries that are more mature, such as pharmaceuticals, where a smaller number of large companies dominate.

In court testimony over his hostile attempt to buy PeopleSoft, Oracle CEO Larry Ellison said a "radical" shift in the market spurred his company to pursue its smaller rival. Oracle has made clear that it intends to make other multibillion-dollar acquisitions even if the PeopleSoft deal falls through.

"We wanted to be a survivor and a consolidator, and we felt the only way to survive and prosper was through acquisition," Ellison said in June.

Other signs of maturity are evident. Microsoft, once considered the prototypical growth company, last month decided to pay regular dividends, in the mold of more staid corporations.

New software license revenue is also harder to come by. In the second quarter this year, several large software companies, including BMC Software, Siebel Systems and Veritas, said they would fall short of their earnings and revenue targets because of weak spending.

Even if software spending improves, some market watchers say, established software companies are becoming increasingly dependent on maintenance and consulting revenue, rather than money from new license sales.

A shift to lower-margin revenue, in the form of maintenance and services, makes software companies less valuable as entities, and ultimately, more apt to merge with others, Wolf said. The professional services business is particularly susceptible to consolidation because suppliers need to compete with cheaper, offshore alternatives, he said.

"As you move revenue to the least-attractive segment of the business, which is professional services--which is good but not as good as selling software licenses--a different set of economics apply," Wolf said.

Tight spots
Analysts note that particular niches, such as security, will likely spur the creation and growth of a number of companies. Also, the consolidation process could take several years. In the past, major technology breakthroughs, such as the Web or the client/server model, opened up opportunities for upstart companies. But without any evident shift of that scale in the industry today, many say, several segments of the software industry appear ready for more mergers and acquisitions, including business intelligence, management software and business process management.

Midsize companies, in particular, stand to suffer from software heavyweights' efforts to get bigger, some observers say. SAP, for example, is investing heavily in NetWeaver, infrastructure software designed to connect SAP with other systems. The product pushes SAP into more direct competition with infrastructure software providers, such as BEA Systems.

"Once you're a midlevel company, that's the point where your technology being the best is not as important as the depth and breadth of your product offering and your distribution reach," said Yoav Schreiber, an analyst at the Precursor Group.

Although BEA has been relatively inactive on the acquisition front, other midsize companies have been investing in smaller outfits in an effort to gain sufficient market heft and avoid being combined into a larger entity. Novell, for example, purchased SuSE Linux and open-source desktop software company Ximian last year. Both purchases were meant to reorient Novell around selling services for open-source software.

Large-scale acquisitions could face some hurdles, however. Mergers between software companies can be difficult to pull off, particularly between companies with large customer bases. Indeed, open-source software company Red Hat considered purchasing SuSe Linux but decided against it, in part because of the difficulties foreseen in integrating the companies.

"Red Hat has made over 14 acquisitions and not all of them have been very successful, I am not proud to tell you," Red Hat CEO Matthew Szulik told CNET News.com recently.

Government regulators also closely scrutinize mergers between large companies. For instance, the U.S. Department of Justice filed suit over Oracle's takeover attempt of PeopleSoft, on grounds that the deal would be anticompetitive. The merged company, the government said, would have too much market clout. A decision in the trial resulting from that suit is expected to be announced this month or next.

What's in it for customers?
Whether an increase in consolidation of enterprise software suppliers will benefit customers depends very much on the particular market segments, analysts said.

In the business application market, where there are few players, consolidation worries many companies. In arguing against Oracle, the Department of Justice brought PeopleSoft customers to the stand who voiced fears that Oracle would raise prices and no longer update PeopleSoft software. Likewise, J.D. Edwards customers have complained that they are not getting the same level of attention that they got before PeopleSoft acquired the company last year.

But in the area of infrastructure software, there is less concern regarding the lack of choice that too few suppliers might bring, said Mike Gilpin, an analyst at Forrester Research.

Consolidation among integration software providers, for example, has occurred more slowly than Forrester had predicted three years ago, in part because integration companies are highly specialized and their personnel have a great deal of industry-specific expertise in services. Combining a financial services specialist with a health care market expert doesn't necessarily double market clout. But given the growing maturity of the technology industry, the real question is mainly just how fast consolidation will occur.

"In markets where services don't have a big a role to play, it's much easier for technology to commoditize, and it's easier for the dynamics to favor the really, really big player and make it difficult for a smaller company to be sustained," Gilpin said.