Tech Targets for the Big Fish

This column was originally published on RealMoney on Sept. 5 at 2:01 p.m. EDT. It's being republished as a bonus for TheStreet.com readers.

When I wrote about the six suitors circling Mercury Interactive(MERQ Quote) a few weeks ago, a number of readers asked for the names of other likely takeover candidates in the tech sector. While naming names would be pure speculation on my part, we can certainly narrow the list down somewhat.

Essentially, there are two types of acquisitions: strategic and financial. Most of the high-profile acquisitions we've seen of late have been strategic in nature, but I think that tech companies will be targeted for financial reasons by private equity much more often over the next few years.

Strategic Acquisitions

It doesn't take a rocket scientist to understand the whats and whys of a strategic transaction. EMC (EMC Quote) and Oracle (ORCL Quote) have been on acquisition binges in recent years in efforts to plug product holes, bolster top-line growth and/or enter into new markets.

In addition to the aforementioned pending acquisition of Mercury by Hewlett-Packard (HPQ Quote), IBM (IBM Quote) announced plans to acquire security-software vendor Internet Security Systems (ISSX Quote), MRO Software (MROI Quote) and FileNet(FILE Quote). Seagate (STX Quote) bought Maxtor, and EMC is again targeting RSA Security (RSAS Quote). There's plenty more, but the tune is the same: Big company plugging a hole with smaller company.

Software companies make attractive acquisitions because of their high-level intellectual property and the fact that there is virtually no cost of goods, which yields very high margins. Software also has three added advantages:

• It tends to generate an attractive cash-flow stream for extended periods of time.
• It doesn't break or wear out. Users' needs may change, but on the last day of its life, software still does the same thing it did on day one.
• It's highly flexible, in that it can improve its performance by updating the underlying hardware. As CA (formerly known as Computer Associates) demonstrated (aside from the some other questionable practices) throughout the 1980s and early 1990s, layering new products onto an existing sales organization can generate significant leverage.

So what are the current likely strategic acquisition targets? There's no way to know for certain, but trends within IT offer clues.