“Every problem is a gift—without problems we would not grow.”
martinwolf Annual Letter
To Clients, Partners and Friends of martinwolf | M&A Advisors,
2012 marked our 16th year in business and more than 115 transactions completed in seven countries. Our track record of completing deals makes us a world-leading middle market IT M&A advisory.
This past year we also went global with our MW IT Index®, proprietary research and analysis of the enterprise valuations of companies in the IT Services & Business Processing Outsourcing (BPO), IT Supply Chain, Software and SaaS industries. We initiated the Index for U.S. companies on January 1, 2008. In 2012, we expanded our analysis to include IT firms in India and China. We now publish our global Index and related commentary every quarter.
A Right Way and a Wrong Way
If there is one thing we’ve been reminded of over and over in the past 16 years, it’s that initiating, managing and completing the purchase (or sale) of a company is a complex process with many pitfalls along the way. Some pitfalls are external and cannot be controlled by either buyers or sellers. Others can be avoided, but not without a disciplined approach and a 100% commitment to getting the deal completed.
With so many things that can go wrong, it’s not hard to understand why a poorly managed M&A process will nearly always fail. And of course, while closing the deal is tough, getting two companies integrated and aligned after a deal is even tougher.
Add into the equation cross-border transactions – known inside our firm as “mixed marriages” because buyers and sellers are located in different countries – and the potential for mistakes multiply exponentially. It’s like moving off the farm in Wisconsin and buying a penthouse in a high rise off Central Park. Some people can make the transition – most people can’t. And no matter how hard he tries, the guy who runs around Central Park looking for cows won’t find them. They aren’t there.
By definition, cross-border transactions involve not just two companies in two countries with two organizational cultures, but two national cultures, two sets of accounting rules, business laws and norms for doing business, and, often, two languages. Some even involve companies in two very different kinds of businesses, which in my view dramatically diminishes the odds of success.
On this last point, think of Time Warner and AOL, an M&A deal that occurred back in 2000 when there was a really big difference between a traditional media company and an online community. More recently was HP’s multi-billion dollar overpayment for the business intelligence firm Autonomy. HP took an $8.8 billion write-off on that transaction in November. Even now, the deal has yet to produce any discernable benefit for either business and has instead Autonomy’s top-line revenue has declined.
Regardless of the challenges of closing deals and integrating companies, there are some very good reasons why some companies in some industries do it anyway. For starters, bigger really is better. That’s why in 2012 the pace of middle market M&A activity in IT can only be described as brisk and the outlook for 2013 is even better – especially for cross-border transactions, the most difficult nut to crack.
But before I dip a toe into the dangerous ocean of prognostication, I’m going to cruise calmer waters with a brief review of what happened in 2012 in the IT sectors and geographies we follow and in which we do business. These developments inform our view of how things will unfold in 2013.
SaaS Valuations Still Up and to the Right (Mostly)
M&A activity and valuations in SaaS over the past 24 months had a lot in common with a Ferrari: fast, expensive and definitely noticed.
Not much more than a decade old, the SaaS industry in 2012 transitioned from its “early” phase – when industries are first established and enterprise value is growing but unrealized – into its “growth” phase. The growth phase is when many companies start up and are sold as an industry begins to define itself. Enterprise value is accelerating (as in pedal to the metal). This is the case with SaaS.
Even though SaaS enterprise valuations were flat for the last six or seven months of 2012, they were up about 20% for the year. Salesforce.com did even better with valuations up 20% over the past six months and 50% for the year. Furthermore, SaaS is outperforming all of the other industries we track in our MW IT Index.
This growth in value has been jet-fueled by market demand and by some intense competition among major traditional Software players looking to establish a strong position in SaaS. New SaaS startups in their infancy are segmenting and specializing and this makes them prime targets for acquisition.
Just ask Salesforce.com. Between January 2011 and July 2012, Salesforce.com bought a string of a dozen young companies to beef up its mobile, social and cloud-computing portfolio, which it rightly believes is the future of enterprise tech. Most notable were Model Metrics, a mobile-social cloud consulting firm, in November 2011; and Buddy Media, provider of a social-media marketing platform, in June 2012.
These acquisitions went largely unanswered by competitors until September 2011 when Oracle announced that it would acquire SaaS enterprise CRM provider RightNow Technologies for $1.5 billion. Until then, Oracle focused its acquisition dollars on traditional enterprise software applications. From RightNow on, it is clear that Oracle hopes to rule SaaS over time, just as it has grown to dominate traditional enterprise software. Oracle paid more than 7 times trailing 12-month revenue for RightNow. My bet is that over the next year or two, Oracle will make that multiple look like a bargain.
In the fourth quarter of 2011, software industry giants IBM and SAP also bought SaaS companies – IBM purchased DemandTec and SAP went for SuccessFactors. Both also paid more than 7 times trailing 12-month revenue. In fact, SAP paid more than 12 times trailing 12-month revenue for SuccessFactors, a leader in SaaS-based human capital management solutions. SuccessFactors had revenue of $291 million in the 12 months prior to its purchase; SAP paid $3.5 billion. Not a bad return for SuccessFactors stockholders.
(To put the prices that were being paid for SaaS companies in perspective, over the same timeframe, companies sold in IT Services/BPO space went for .5 times to a little more than 2 times trailing 12- month revenue.)
SaaS acquisition fever continued throughout 2012. But what started out looking like a land grab among titans quickly became a mano a mano between Salesforce.com and Oracle.
I’ve already talked about the 12 acquisitions made by Saleforce.com in 2011 and 2012, five of which were announced in 2012.
After buying RightNow in late 2011, Oracle went on to make 11 (mostly cloud) acquisitions in 2012. The streak started in February with Taleo, a provider of cloud-based talent management services, which Oracle acquired for 5.8 times trailing 12-month revenue, or $1.9 billion. It was punctuated in May with the purchase of social marketing platform provider Vitrue (financial terms not disclosed). And it was capped by the acquisition of Eloqua in December for an implied 8 times trailing 12-month revenue, or $810 million.
(To be fair, IBM acquired human capital management company Kenexa in August 2012 in a cash deal for 3.8 times trailing 12-month revenue, or $1.26 billion. While this was a significant transaction, IBM’s overall acquisition activity did not rival the moves made by Salesforce.com and Oracle in 2012).
Despite dueling acquisitions by Oracle and Salesforce.com in 2012, ultimately, success will boil down to the ability to execute. Compared to Oracle, Salesforce.com is a relative novice. And in terms of both strategy and execution, Oracle is really, really good at acquisitions. The company has spent billions on about 90 companies since its acquisition of PeopleSoft closed in 2005. Oracle’s chief skills are identifying companies that fit well into its long-term business strategy at the front end of the process and its ability to integrate and act on these strategies at the back end.
But I wouldn’t bet against Salesforce.com. The company beat Wall Street’s third quarter 2012 estimates for sales and profit, reporting revenue of $788 million, up 35% year over year and 7.6% from the previous quarter – in no small measure the result of being able to rapidly capitalize on some of these acquisitions. While the jury is out, initial results are positive.
We’ve just closed our fifth transaction in the SaaS space ourselves – and we have five additional active engagements in the space.
Of course, given the outsized SaaS valuations we’re seeing, there are some naysayers who ask: Is SaaS another bubble like the Internet was in 1999? I addressed this precise question in April of 2012 in an article I wrote for Mergers & Acquisitions.
My answer – which I stand by today – is definitely not.
Unlike the dotcom companies of the late 1990s – whose IPOs and market caps were fueled by too much venture money being poured into too many companies that failed to turn a profit – SaaS companies are the real deal. They have real solutions, real customers, real sales, real profits, and real enterprise value – because they provide real ROI to their customers.
So no, this is not a bubble. Instead we’re witnessing the coming out party of an industry that is destined to define how enterprises plan and execute IT strategies for many years to come. And while the ultimate winners are yet to be determined, there is plenty of jockeying for leadership in the lucrative SaaS market – with Salesforce.com responding to competitive threats with a smart business strategy – supported by smart acquisitions.
And by the way, Salesforce.com’s stock price at the close of market December 31, 2012 was $168.10 per share – a gain of 66.1% for the year.
If I Were a VAR
Of all the sectors we track, none has fared worse in 2012 than IT Supply Chain. It’s not a pretty picture.
In fact, it was marked by a mid-year explosion – the decision by Microsoft to blow up the ecosystem (that Microsoft and Intel created some three decades ago) by announcing in June that it would for the first time in its 37-year history make a hardware product: the Surface tablet. With the announcement of Surface, the decades-old network of partners that Microsoft and Intel built got a formidable new asset- rich competitor: Microsoft.
I get Microsoft’s motivation for this shift in strategy and it’s perfectly understandable: the company desperately needed a new business strategy that would allow it to compete in the post-PC era and with Apple as the de facto leader heading into it.
Still, the June announcement was stunning because it signaled that Microsoft is willing to do whatever it takes to re-tool – including blowing up the partner network that has been the linchpin of the company’s dominance for the past 30 years.
This shift in strategy was terrible news for Microsoft’s hardware OEMs, which will be relegated by Microsoft to the low-margin desktop and laptop PC business. But it was devastating news to other players in the supply chain, an industry that has been in a “mature” phase for several years now and contributed to an unprecedented decline in enterprise valuation in the IT Supply Chain sector.
As we reported in our most recent MW IT Index report for the third quarter of 2012, Between April 1 and November 30, 2012, valuations for companies in the IT Supply Chain industry in the United States decreased 23.3%. The decline was the result of a confluence of factors disrupting this portion of the PC industry. We expect valuations to continue sliding, if not accelerate.
Bottom line, prospects for companies in this sector are dimming rapidly as consumers shift from PCs to smartphones and tablets, and enterprises from on-premise data centers to the cloud. There are simply few easy paths to growth left.
The mature phase of any industry is marked by slower growth, declining margins and lower valuations. For the supply chain industry, the recession accelerated this inevitable market evolution – end-user IT customers slashed IT budgets to survive and VAR customers reduced the number of partners they support to cut costs. Things are looking up with IT budgets as confidence in the economy slowly improves. But it’s unlikely that VAR customers will look to add new partners.
To keep growing, VARs have moved up the value chain, offering managed services to attract new and larger customers. They have made acquisitions or been acquired to breathe new life into their businesses through scale. They have acquired their way into new businesses.
A good example of a company that has chosen the last option is Presidio. Privately held with annual revenues of roughly $2 billion, Presidio employed more than 2,000 people in 50 locations and offered a range of managed and cloud services, hosted infrastructure and hosted backup and recovery when it announced it was acquiring BlueWater Communications in February 2012. BlueWater was a roughly
$250 million solutions provider focused on unified communications, cloud computing and data center technologies, and its acquisition carries the additional benefit of providing executive leadership going forward. The transaction followed close on the heels of Presidio’s acquisition of INX, a U.S. provider of
IP-based unified communications and data center/cloud solutions, in November 2011.
Nevertheless, this is a truly a time in the industry when smaller VARs will have a hard time surviving. And it begs the question: what now?
Well, if I were a VAR, there are five things I’d do right now to optimize the value of my company. They all have to do with staying relevant in an industry that has undergone seismic shifts in just about every way you can think of.
1. Size matters
If you’re a VAR and you have scale, capital and management ability, you need to get bigger. In this market, the least risky way to do this is to consolidate and become more profitable by cutting expenses.
2. If you can’t go big, go niche
Sometimes the way to deepen a company’s value is to narrow its focus. For example:
- Go mobile: I’d want to help my customers manage their end-user mobility strategies, including mobile device management, apps, data and
- Explore healthcare: Healthcare presents several great opportunities, especially with provisions of the Patient Protection and Affordable Care Act going into effect on January 1, This means companies will require new strategies for workforce management, health benefits management and healthcare IT. That’s an opportunity for VARs.
The key is to go beyond core business processes into specialized ones so customers can outsource them – for example, in business analytics, security, electronic data integration and payment processing systems.
3. Either way, head for the clouds
My top priority would to get into the business of selling cloud services and reinvent my business model to do it – white label, partner or acquire to make it happen quickly – because building it takes too long. Also, I’d put the cloud’s efficiencies to work for my own company.
4. Find strategic partners to fill the gaps
I don’t believe a VAR can do everything under one roof, but it can create partner networks that deliver complete solutions to customers. If I were a VAR, I’d rethink what “strategic partner” means. Above all, I’d work hard to make my partnerships real.
India: Keeping An Eye on China
Indian IT companies have long been the global leader in IT Services and BPO by offering better, faster, less expensive solutions. But its days of easy growth are gone, victims of five long years of global economic uncertainty, low-cost outsourcing becoming a low-margin business and increased competition from other geographies with even lower cost structures.
In attempts to spark new growth, Indian IT companies have moved up the enterprise value chain, turning their attention to cloud computing and cloud services.
This is a good thing, because the solution to new strategies for growth is evident in this simple statement: “What you do matters.” When I say matters, I mean matters to the value of a company. Here are some results from the past 12 months that make my point:
- BPO companies (voice) sold for 7 times EBITDA, while Managed Services & Infrastructure Services companies were sold at 15.6 times EBITDA, or 3.3 times more than BPO.
- Smaller, specialized vertical niche players like Healthcare IT Services companies were sold at
11.7 times EBITDA, versus 9.5 times EBITDA for Financial IT Services – both outpacing valuations of much larger BPO companies. Yet, healthcare is worth more right now.
What is clear from these examples is that many of India’s IT companies must change or adapt what they do – or they will continue to work harder for less.
In our view, however, Indian IT companies face the most serious threat yet to their global leadership in the space: the rise of China.
China: Keeping Both Eyes on the Prize
Despite high volatility of Chinese IT companies over the past decade, they are currently outperforming Indian Tier I and Tier II IT companies by more than 1.5 times on enterprise value based on EBITDA,, and by more than 3 times on enterprise value as a multiple of revenue. This is despite the fact that Chinese IT companies’ sales are increasing while profits are relatively low.
While GDP growth in China was, until recently, slowing, the upward potential of the Chinese domestic market for cloud computing remains huge and it’s in its early days. According to IDC, the market for cloud computing in China in 2011 was nearly USD 286 million, or about 10% of the global market. IDC expects cloud computing in China to reach USD 410 billion in 2012 – a growth rate of nearly 44% – and it is on track to exceed USD 1 billion by 2016.
With a pace of growth that fast in the domestic Chinese market, it is easy for individual companies to post big sales gains. Profits are not keeping pace with sales growth, though, because Chinese IT companies are still delivering relatively low-value, low-margin, mostly application development and staffing-oriented services.
However, Chinese IT companies are not going to just settle for the low-end services market share. How do we know? Because the Chinese government is making a huge investment in cloud computing infrastructure – one that directly benefits Chinese companies providing cloud services that are higher up the value chain and is enticing others to make a similar transition.
As one of the seven “national emerging industries” targeted as a way to boost GDP growth in China’s 12th Five-Year Plan (2011-2015), cloud computing will be the focus of a Chinese government investment of more than USD 150 billion in 25 cloud computing centers by 2015. The intent is to shore up the country’s relatively immature cloud computing infrastructure so that the market can flourish.
The impact of this large and focused government investment in cloud computing will no doubt be a rapid acceleration of the growth and development of the domestic market and of the companies that make up the Chinese cloud ecosystem that is growing up to support it.
Bottom line, it won’t take nearly as long for Chinese IT Services companies to move up the value chain to offer cloud services as it has taken Indian IT companies.
But, will Chinese companies be able to break into the global market? The answer: yes, but maybe not overnight. Chinese IT companies have clear political and cultural disadvantages compared to Indian companies – a situation that cannot be overcome with government investment alone.
Simply put, there is distrust between the U.S. and Chinese governments that has culminated in trade wars and thwarted deals between the two countries.
Further Chinese government policies affect investments by U.S. companies in China. There are barriers to U.S. companies investing in China – more numerous and much greater than U.S. companies investing in India.
Examples include China’s censorship and sweeping state secrecy laws, which cause concern about data security and privacy, especially for foreign companies unaccustomed to such restrictions. Another is China’s weak intellectual property law.
However, the potential opportunities for U.S. companies in China are so huge that most companies invest anyway. But for U.S. companies to be successful in China, they need Chinese partners.
An example of investing in China despite hurdles is Microsoft. Its latest investment in cloud computing in China, announced in September 2012, will add 1,000 employees in China and invest an additional 15% in R&D. It is part of a cloud push aimed at competing more effectively with Apple and Google in the world’s most populous mobile Internet market.
Cross-Border M&A: A Path to Growth and Value
With the state of IT industries being what they are, it makes sense that IT companies around the world are looking to cross-border mergers and acquisitions as a path to higher valuations.
Cross-border M&A is a natural evolution for the IT Services industry. Consider India. In the 1990s and early 2000s, companies such as Infosys, Tata Consultancy Services and Wipro grew to USD 1 billion+ in annual revenues based on more and higher value work coming from multinational companies seeking to cut costs.
Starting in the mid-2000s, cross-border M&A became a new strategy for growth, market access and global reach for Indian IT Services companies. The impact on second tier IT Services was immediate and dramatic: they had to grow or perish. This sparked a wave of consolidation that continues today – with the reward being higher valuations to companies with revenue of more than USD 500 million compared to companies with less than USD 500 million.
There is every reason to believe that the IT Services industry in China and other markets will evolve in a similar fashion, with companies looking outside their home market and to cross-border M&A as a new growth strategy for Tier 1 companies and as a survival strategy for Tier 2 companies.
An Art, Not a Science
Creating value across two cultures is an art, not a science. Many such deals don’t work because buyers commit the following errors:
- Focus on price not value. Buyers must factor in stability and cultural fit of the seller’s staff or value can quickly
- Buy only what is presented to them opportunistically. Chances are the best companies are not “for sale” until the right buyer comes Buyers need a comprehensive search to seek out acquisition targets.
- Don’t really know what they are Buyers need to understand market dynamics and think through a post-acquisition integration and long-term strategies for creating value before they buy.
While cross-border M&A offers the best opportunity for many IT companies to grow and scale, a rigorous process is a must and a random process spells disaster. In our experience, competent advisors are critical to identifying, recruiting, negotiating and managing transactions.
So for 2013, we expect a robust year of deals, with market pressures causing China, India and U.S.- based companies to do cross-border deals. Success will be measured both on whether a deal gets done and whether the companies and cultures can mesh and perform well going forward.
Going in, each party should remember: there are no cows in Central Park; and with the rapid pace of change in IT – few sacred cows in deals.
I wish you a Happy New Year, and continued success! Sincerely,