In a week in which giant software deals were topic one for many technology investors, it was easy to overlook a key point: The current urge to merge is a sign of fundamental weakness, not strength.
Simply put, organic growth in the software industry has slowed to a crawl, and companies find themselves unable to satisfy Wall Street's voracious appetite for year-over-year gains. In part, the stall can be blamed on a customer revolt. There hasn't been an exciting business software breakthrough in years to entice new spending, and customers complain that the limited success of their multimillion software deployments hardly justify the expense.
Sure, those complaints are old news. But a recent survey by Goldman Sachs found that IT spending is expected to grow by just 3.7% in 2005, despite a reasonably healthy economy.
CEO Larry Ellison probably said it best at his company's analyst day earlier this year: "This is the recovery -- you'd better enjoy it."
Oracle's marathon pursuit of
illustrates both legs of the industry's new dynamic. Without currency gains generated by a weakening dollar, the database giant would not have exceeded, or even met, Wall Street's goals in its last quarter, said Richard Williams, software research director of Garban Institutional Equities. Rather than face the wrath of investors, Oracle is simply buying PeopleSoft's $1 billion-a-year stream of maintenance revenue.
In addition to making Oracle richer, the acquisition allows it to sell products it couldn't develop on its own.
IT buyers are looking for vendors that can provide as many of their software needs as possible and vendors want to bulk up with a wide variety of offerings. "We've moved from market share to wallet share," said Chris Lochhead, chief marketing officer and strategist for
. With growth slowing, vendors want to extract as much money as possible from each customers' wallet by having additional products to sell," he explained.
Case in point:
, which is rumored to be buying
, is hoping to become much more than a provider of security software. Combined with Veritas it would offer one-stop shopping for Web-security needs and software to manage and protect the critical data stored on its servers. Add a company like
and the brawnier new Symantec would then have identity management in its portfolio of offerings, Williams suggested.
That may sound like a great concept, "but a concept is not enough to do a deal," said Transamerica Investment Management fund manager Chris Bonavico. "The product offerings have to work together. It's not obvious upfront that putting one and one together here will get you to three."
In fact, technology mergers in general, and software in particular, are notoriously difficult to pull off. Melding different code bases, cultures and customer sets is not easy and it's much easier to name failures (remember
?) than successes.
Growth by Acquisition
Oracle is hardly alone in its dependence on currency fluctuations. Williams surveyed 40 public software companies and found that when currency gains were excluded, revenue growth on average ranged from negative 2% to negative 4% on a trailing four-quarter basis.
Interestingly, the growth dilemma gets worse the more companies grow, said Yefim Natis, vice president for research at Gartner, a Stamford, Conn.- based researcher and consultancy. "A small company can easily match last year's $10 million or $20 million in revenue. But companies like Oracle or
not only have to repeat last year's
multibillion dollar performance, they have to exceed it," he said.
At some point, that much organic growth is simply impossible, even if the company is essentially healthy and supplying a useful technology. "Excellent companies, like PeopleSoft, with useful technology can be destroyed by the hunger for growth," Natis said.
Natis may be right, but all of the blame doesn't belong on Wall Street's shoulders. The technology companies aren't doing enough to convince IT managers that spending money on software will pay off.
"I think of software as a series of waves," said Daniel Morgan, a portfolio manager with Synovus Investment Advisers. "You had databases, then ERP, then CRM -- but there hasn't been a truly new wave in some years. So what do you do if you're big and want to win customers? Go buy someone," he said.
Fred Hickey, the bearish editor of
The High Tech Strategist
, takes a darker view. "Mergers are a sure sign of a top -- not a bottom," he said. "Companies that can't find any other way
of growing are taking advantage of high stock prices."
Actually, there may be another path -- the subscription model, which IBM has used for decades for selling mainframe software but which has only recently gained popularity among other software vendors.
Business software companies have traditionally sold software via perpetual licenses, whereby customers pay a large initial fee for the right to use software forever; vendors recognize that revenue upfront on their income statement. Companies also typically pay annual maintenance fees -- about 20% of the license fee -- for the right to upgrades.
Under a subscription model, customers pay a lower fee to rent the software over a set period of time and receive frequent upgrades or enhancements. Vendors initially recognize the bulk of the subscription sale as deferred revenue, which is recognized over the life of the contract. So, if a customer pays $100,000 for a one-year software subscription, $25,000 is recognized by the vendor each quarter for four quarters.
"Under this model, every sale creates a revenue stream. It solves the problem because revenue is more predictable," Natis said.
Broader use of a subscription model would likely remove at least some of the artificial pressure from the backs of software companies, but it's hardly a panacea for slowing demand. More realistic -- read "lower" -- valuations are coming, and investors will have to get used to it.
Pip Coburn, global technology strategist for UBS, said technology issues are trading at a premium to the broader market of about 40%, a rate that is high historically and probably unsustainable given the anemic expected growth in technology spending.
When multiples contract, mergers will become a bit tougher as companies are forced to use cash instead of inflated stock. Rising interest rates may also make borrowing too expensive for some players. But as long as revenue growth remains sluggish, merger mania is here to stay.