Q4 2008 Infrastructure Software Market Overview

The Infrastructure Software sector covers a lot of territory. We track deals in this sector across a wide range of infrastructure segments including Communications, Development Tools, SOA, Network Management, Security, Storage, Systems Management and Virtualization. Many of the predicted hot spots for trends and disruptive technologies reside in this sector.

Virtualization, server consolidation, performance management, etc., were hot topics throughout the year and this reflected in acquisition targets. Virtualization will be the highest-impact trend changing infrastructure and operations through 2012, according to Gartner. Virtualization will transform how IT is managed, what is bought, how it is deployed, how companies plan and how they are charged. As a result, virtualization is creating a new wave of competition among infrastructure vendors that will result in considerable market disruption and consolidation over the next few years.

The storage story of 2008 was growth with an accelerating explosion of information, much of it in the form of video. Overall demand for storage capacity is growing by about 60 percent per year, according to IDC. In 2009 we expect to see companies focus on efficiency, seeking to increase the utilization of their storage capacity. A big part of that effort is virtualization of storage, often going hand in hand with server virtualization and becoming a mainstream technology in 2008. But in addition to the trend toward disconnecting logical from physical resources, there were a handful of acquisitions this year that signaled other trends in the storage world. Brocade Communications acquired Foundry Networks and Cisco acquired Nuova to better position themselves in the next generation SAN segment, IBM acquired Diligent for its de-duplication technologies, and EMC acquired Pi, a provider of software and online services for consumers to keep track of personal information stored locally or online. With the economy weakening, cloud storage will be big in 2009. Paying for additional capacity on a monthly basis moves that expense out of the IT department's capital budget and into its operational budget, which tends to be easier to fund when times are tough.

To deal with the growing complexity and cost of application deployment, maintenance and performance, organizations are looking for solutions to streamline, secure and manage delivery of their most business-critical applications. As usual, security was a strong sub-sector. Even though security sees a significant number of deals in each of our reporting periods, the space is broad and still fairly fragmented. Consolidation in the marketplace is becoming increasingly necessary as more end user customers demand end-to-end, best of breed security solutions from a smaller number of vendors.

Communications

By the end of 2008, thoughts that the telcos would not be affected by the general market downturn had been swept aside as major job losses were announced by AT&T, Telecom Italia, Virgin Media, Nokia and Nortel, amongst others. In the UK, BT surprised the market with a shock profit warning attributed to the poor performance of the group’s IT Global Services division, and resulted in the loss of 10,000 jobs, including that of the Global Services’ CEO. The positive spin on 2008 is that things are not as bad as in 2001!

The turmoil in the financial markets seem to have finally undone what was to have been one of the benchmark deals of 2007 but left uncompleted at the beginning of 2008 - the $42 billion private equity takeover of Canada’s telecommunications giant BCE. Deals such as this, one of the largest leveraged buyouts ever proposed, are just not viable in the current climate. But communications remains an active sector, with a good flow of mid market deals throughout the year. Acquisition continues to be ‘normal’ business practice, allowing larger cash-rich companies to buy-in R&D or market presence. For example, despite its problems, BT completed a number of transactions including the $105 million (cash) purchase of Ribbit, extending BT’s presence in Silicon Valley and securing a groundbreaking development platform allowing users to merge mobile calls with the Internet and convert voicemail to text.

The year was mixed for the handset manufacturers as well. By the end of the year all were forecasting a drop off in unit sales, with Gartner forecasting that 2009 would see an overall percentage reduction in the low single digits compared to 2008. Nokia, Samsung and LG Electronics all reduced volume forecasts for Q4’08.

The big handset news in 2007 was Apple’s launch of the iPhone smartphone. This product continues to take significant market share, benefiting from the launch of the 3G version. Gartner reported 4.72 million iPhones sold in the third quarter, 12.9% of the smartphone market, leaving it in third place behind Nokia and RIM. T-Mobile launched the much awaited Google G1 phone in the U.S. and UK. The form factor of the device itself was something of a disappointment, but the Android platform that it used gave a further boost to the open source movement. Nokia then offered to buy out its partners in Symbian to make this also in to an open course platform. 2008 seems to have added to the writing on the wall for the remaining proprietary platforms.

China and Asia remain markets of enormous potential for telecoms and especially mobile telecoms. In addition, technology continues to drive growth and acquisitions. IP convergence, broadband and wireless infrastructure and location-based services are enabling technologies from which new applications are only now emerging. As income from the provision of communication itself continues to drop away, so these applications become more of a necessity to the large telcos. So, although 2008 ends more quietly in this sector than it started, opportunities remain for strong mid-market M&A activity in 2009.

Software Development

Organizations get more performance and higher productivity from their applications, databases, Windows infrastructure and virtual environments by implementing infrastructure software solutions. Solutions like SOA, security, SaaS and cloud computing are creating a need for better ways to manage the various solutions and all the information exchange between them. Beyond doubt, the growing market for applications and the amount of information residing on servers within most organizations require better systems to utilize the tools and organize the information flow.

It is expected that more and more organizations, small and medium sized as well as large, will increase the use of cloud computing applications, or SaaS solutions, rather than installing packages of software on their own computers. All the BI and BPO solutions available in addition to CRM and ERP solutions require sophisticated infrastructure software in order for the user to fully utilize what these solutions offer. Stronger and better infrastructure is needed to make the various applications work together and open access to the information residing in various formats on various servers.

Software that supports those outsourced offerings should have a bright future, whether it's data-integration software that connects SaaS to on-premises applications or IT-management software designed to measure IT service levels. Larger vendors that do not have adequate offerings in these areas may go shopping for them in order to seek out new revenue sources, which will be hard to find in the coming year.

Thus we expect deal volume in 209 in the infrastructure-management software segment to be substantially higher than in 2008, while the deal value will end up substantially lower in 2009 than it did in 2008.

Gartner Group predicts that the future of corporate IT is in private clouds, flexible computing networks modelled after public providers such as Google and Amazon, yet built and managed internally for each business's users.

Cloud computing hype centers largely around the outsourcing of IT needs to cloud services available over the Internet. While this trend is expected to accelerate, Gartner predicts it will also become standard for large companies to build their own highly automated private cloud networks in which all resources can be managed from a single point and assigned to applications or services as needed.

These new features and solutions require better infrastructure software. There is a need for new and/or improved infrastructure products and we will see deals next year where middleware and infrastructure vendors are looking to strengthen their development capacity or product portfolio through acquisitions. We will also see stronger signs of consolidation in this space. Some companies will try to concentrate their resources and focus on core activities and thus sell out their infrastructure assets, while others will have the opposite strategy, seeing infrastructure software as having a lot of potential and try to strengthen their product development resources and product portfolio in this space.

One example of this was Satyam’s acquisition of Motorola’s development centre in Malaysia. Another is Quest’s acquisition of NetPro where two companies with strong product portfolios go together to build an even stronger portfolio and to be well positioned for future growth. Earlier this year Sun acquired MySQL in order to strengthen its position in the infrastructure space. We think 2009 will show more transactions similar to these as the established software companies look for new technologies or quicker market access to stay competitive in a segment expected to stay vivid even in difficult times.

Legacy Exension / SOA

NOT A GREAT DEAL of SECTOR ACTIVITY: Very slow fourth quarter for the sector, which was in line with the year overall.

Some of the notable deals include:
§ Oracle acquires BEA
§ Progress Software acquires IONA
§ Micro Focus acquires NetManage
§ IBM acquires ILOG

MORE OF THE SAME: Like most market sectors, the value of comparable publicly traded companies dropped sharply in the fourth quarter, with companies in the sector losing close to 40% of their market value in this quarter alone.

SIZE MATTERS: Some companies fared a lot better than others in 2008, with small cap companies appearing to take a bigger hit than the larger software vendors in the sector. For example: Unify ($22 million in revenue, and 11% Net Income) lost close to 55% of its market value, while Tibco ($600 million in sales, and 5% net income) saw its value decline only 28% in 2008. Compare the current market multiples to that of BEA Systems which was acquired earlier this year by Oracle for $7.2 million, and with revenues of $1.4 billion this deal represented an EV/Sales multiple of close to 4x.

Clearly, size is important but the timing of your exit event is even more critical.

PROGNOSIS: It is our collective wisdom that the 0.90x to 1.25x EV/Sales multiples we are currently seeing in the sector will not see any significant change for the foreseeable future, and in fact it may take another 3-4 years (or longer) before we reach market multiples in the 2.00 to 3.50 range again.

History provides us with some great insight and correlation of what we should expect in the way of future valuation multiples. The last time we encountered such a major correction was in the HOT dot.com cycle of early 2000 when we saw an EV/S multiple as high as 6.7, followed by a rather dramatic drop in software valuation multiples. As noted in the following chart, it took almost 6 years for the software industry in general (from 2001 thru to 2007) to reach equivalent market values.

In spite of today’s low market multiples, if timing is truly everything we should definitely see a lot more activity in this sector. Some companies will leverage their strong cash position and further consolidate the sector, others may try and ride out the economic storm and wait for higher multiples which as suggested above may still be years away, while others will just not survive. Even in tough economic times, experience has shown that firms actively engaged in M&A discussions are seeing good interest and attention from buyers and an opportunity to become part of something even larger, while those looking only to survive will probably either close their doors or be gobbled up in a bankruptcy sale.

Hopefully, common sense should prevail, knowing that that 50% of something is a whole lot better than 100% of nothing.

Security

As the crisis is now roaring in many sectors (where a lot of companies won’t survive) some sectors seem to appear crisis resilient. Among them is certainly software security. In a recent conversation with an industry executive who founded a security software company in Idenity Management solution, he said that they increased revenue by 50% over 2008 and that they are feeling very positive about the year ahead. He added confidently, “We are in a sector which should have some protection from the recession - as organisations look to cut costs by increasing the amount of home/mobile working.”

This quote actually sums up quite well what is going on in the IT security market right now. Security is a “must have”. In most organizations using IT as their main communication means – that is to say almost every organization on Earth – security is seen as a cost and not as a something that helps IT production. But would you do any cost cuts in electricity security? Nonsense! So 2009 should still be a good year for this sector. Three factors help to sustain that idea: 
    -    Cost cutting is good for any industry: it helps providers to re-think their products, solutions etc to match the expense criteria of their customers. Quite often adaptation means innovation and/or simplicity and/or understanding the deep market trends. There are new ways of “consuming” security; SaaS seems to be a good example. 
    -    Mobile/remote workers: security needs to be adapted to this huge new trend. Oil price makes us work from home. What a huge IT security impact: imagine if 25% of your employee organization would like to work from home to save oil, to be greener etc…
    -    Make it simpler: what is simple works better! In IT security, this is truer than in any other sector of IT.

Q4 transactions are somewhat confirming these trends. Symantec acquiring MessageLabs is a good example on how to fasten a vision accomplishment (compared to Symantec Protection Network), be ahead of the curve meeting customer needs and costs expectations. Acquiring almost at the same time Eurekify and IDFocus (two companies that are in advance in their markets), CA shows that instead of adding new complex security layers, they simplify their own solutions, make IAM proactive and closer to business (role-based) and compliance needs. (DM is becoming user centric and distributed fully compliant with remote users / partners).

Barracuda with its 3SP acquisition should quickly provide SSL VPN for all; Marshal with its 8e6 acquisition is also bringing to market a more complete and simplified solution. And last, with Checkpoint acquiring Nokia’s Security Appliance Business, the trends are also confirmed. Customers will have one provider, one simpler solution widely deployed.