The aftermath of mergers & acquisitions

All the news about the enterprise software space indicates it's in the midst of the kind of consolidation common to the history of just about any other major industry—from banking to shipbuilding. Looked at another way, as recent data from AMR Research shows, enterprise resources planning (ERP) software is reaching the stage of commoditization common to database, operating system, and other "mature" technologies.

Given the demonstrated intent of Oracle Corp. and other large enterprise players to grow rapidly via acquisition, it might seem at first blush that small companies will be hard pressed to thrive and that buyers will purchase software primarily from the largest vendors.

This is only partially true, as opportunities will continue to exist for small software providers, given the right value proposition and business model. However, the software business of the next 10 years will be very different than that of the past decade.

Throughout the 1990s, corporate purchases of packaged software grew rapidly for three main reasons: 1) users moved from building to buying packages; 2) Y2K pressures; and 3) the desire to automate manual business processes. These catalysts propelled software from less than 30 percent to 50 percent of IT capital budgets.

Spending growth fueled the founding of many new software vendors. But with, in quick succession, the Internet bubble bursting; a short—but hardly sweet—recession; and a brisk trade in software mergers and acquisitions; buyers took a hard look at their software investments and how best to deploy what they bought.

Buyers soon realized that a glut of software assets and their associated support costs for integration and maintenance were consuming too-large chunks of the IT budget. By 2003, a move toward standardization began to impact software portfolios much as it previously had hardware, networks, and other segments of the high-technology market.

For example, a recent study by UBS Investments Research indicates 42 percent of CIOs surveyed said they preferred to buy software from a provider of product suites. Less than 30 percent surveyed said they preferred to buy from point solution providers; this despite a prior UBS survey where more than 50 percent of all buyers were seeking point solutions.

This "suites" trend has accelerated. For one, users have set up competency and resource centers for large software vendors. These centers consume budget and expertise, and they have become a penetration hurdle for smaller vendors that fall outside the corporate "standard." In addition, it's often assumed that the larger vendor has—or will have—functionality that is close to that of the small, highly-focused niche vendor.

This is the case for the mature application segments, including supply chain, procurement, and sales-force automation. It's less true for certain types of analytical or business intelligence solutions, and for narrower or newer vertical application segments, such as price management. Regardless, many corporations are looking to buy software from fewer sellers.

As evidenced by large-player acquisitions in the last few years, a movement is afoot in the enterprise software business to focus not on market share, but rather on the customers' "wallet share." A fairly consistent stream of software merger and acquisition activity over the past six years—not counting a blip in 2000—shows a software industry aggressively consolidating.

Testimony during the Oracle trial (see sidebar, "Keller on DOJ versus Oracle") focused on how the enterprise application market for the largest players—SAP, Oracle, IBM, and Microsoft—has moved from consisting of an individual application, such as ERP, to encompass the entire stack of software technology—including integration, security, infrastructure, and applications. This too supports the idea of wallet share trumping market share.

This significant development, part and parcel of the changes already discussed, is changing the nature of software companies and how they will compete in the future.

Software sellers are quickly dividing into two groups: very big and rather small. The big vendors are those with total revenues in excess of $3 billion. They include Microsoft, Oracle, IBM, and SAP. They are somewhat immune to buy outs except from larger versions of themselves, have a captive customer base, and have a critical mass that enables them to survive better than other companies during tough times.

These high-tech industry leaders sell a wide range of products and services, each having some products considered best in class. For example, SAP's financial software is generally thought to be a paragon. On the other hand, its operational software for the retail sector is not considered in as good a light.

A second group of smaller vendors focuses on a specific slice of business functionality or a niche vertical market. Their yearly revenues are less than $500 million, and, in many cases, less than $100 million. Vendors in this category include Agile Software, Ariba, Aspen Technology, JDA Software, and others too numerous to name.

These vendors will continue to thrive under one of three specific conditions: first, the technology they sell is in its infancy and still in the process of becoming a market with revenues in excess of $1 billion. Second, it solves a very difficult, industry-dependent problem that doesn't have wide application. In either of these two cases, the target market is limited, which keeps the solutions and the vendors out of the competitive spotlight of the largest software vendors.

The third case is where either great execution or a new cost model permits them to "beat" the incumbent. Two examples would be Salesforce.com and Manhattan Associates. Salesforce.com has had a great deal of success based on its deployment model, low cost, and "good-enough" functionality. Manhattan Associates has the industry know-how and application prowess to succeed in supply-chain execution and RFID. Such companies will be increasingly rare.

Another group of vendors, however, find themselves between these two extremes. This group, with revenues between $500 million and $3 billion, are in a difficult position. They include companies such as PeopleSoft and BEA. Their challenge is that they have neither the critical mass of the larger players, nor do they have the anonymity of the smaller ones. These type of companies will be targeted for acquisition, particularly if they have a large base of customers. Companies in this range must move quickly to ensure long-term success; SSA Global is a good example of a company on the move.

As buyers consolidate their software providers, only those suppliers with highly differentiated offerings and demonstrable ROI will flourish. Providers in software segments that are forced to compete with either open-source-based offerings or large enterprise vendors will either languish—and thus depend solely upon an installed base and cost cutting for survival—or become acquisition targets.

For many software companies the days of unbridled growth using standard operating procedures are over. A new way of thinking will be required to fuel both growth and potential exit strategies via a merger or acquisition.