New sharks -- private equity firms -- and wary old sharks like Oracle ( ORCL ) are snapping up computer software companies. Both are prowling the waters for one-time highfliers made more appetizing by weakened valuations.
There's been a wave of software M&A in the first seven months of 2016. The stocks of many software developers have pulled back from highs struck in 2014, a year filled with lofty initial public offerings, or from 52-week peaks.
With private equity firms and many technology companies holding plenty of cash, observers expect the software binge to continue as long as valuations do not become too rich.
"A lowering of valuation expectations into the second half of the year should theoretically result in more transactions as more buyers say, 'Now we're talking reasonable numbers," said Todson Page, a partner at PricewaterhouseCoopers.
What the sharks are willing to pay in acquisitions, usually looked at in terms of a revenue-based multiple, has been an issue amid 2016's acquisition spree. The hope among sell-side analysts is that the multiples of acquired companies will trend higher into next year.
"Not all of these deals have been competitive so the multiples have been different," said Joel Fishbein, analyst at BTIG. "It's not going to be blanket M&A where everything gets bid up to crazy multiples. But we expect to see multiple expansion."
He says it's unclear to what degree large-cap tech such as IBM or Hewlett Packard Enterprises ( HPE ) are going to take part in software M&A.
Oracle agreed to buy NetSuite ( N ) for $9.3 billion in late July. In earlier deals, Microsoft ( MSFT ) bought LinkedIn ( LNKD ), Salesforce.com (CRM )acquired Demandware, and private equity firms purchased Qlik Technologies (QLIK), Marketo (MKTO), SciQuest (SQI), and others.
A Taxonomy Of Sharks And Targets
What companies loom as sharks? Analysts have flagged Adobe Systems (ADBE), Amazon.com (AMZN), Google, and Palo Alto Networks (PANW) as potential buyers.
And whose for lunch? Here's a list of potential acquisition targets, culled from several sell-side analysts, in alphabetical order: Cornerstone OnDemand (CSOD), Hubspot (HUBS), Proofpoint (PFPT), Real Page (RS), ServiceNow (NOW), Shopify (SHOP), Ultimate Software (ULTI), Workday (WDAY), and Zendesk (ZEN).
IBD tracks 11 different computer software groups. Among the highest ranked are those focused on firms that sell into the "enterprise" market -- large companies and government agencies, as well as firms focused on small- and medium-sized businesses. The enterprise market spans e-commerce platforms, big data analytics, security, and more.
IBD'S TAKE: Price performance of the stocks in an industry group can reveal an influx of institutional-scale investment. Rising industry groups appear in IBD's 197 Industry Group Rankings , helping investors focus on potential seed beds for leading stocks.
Corporate spending on software remains a bright spot compared to other IT (information technology) sectors. "Cloud technologies, cybersecurity technologies and IoT (Internet of Things) platforms are sought-after assets, there are a lot of trends in the broader tech industry that are being driven by software, said Page, PWC's U.S. technology deals leader.
Software firms are in better shape than hardware makers, analysts say, as large customers shift business workloads to cloud services such as Amazon Web Services. Salesforce.com forged a partnership with AWS in May. There has been speculation Amazon could buy Salesforce.com outright to offer customers more apps and tools, in addition to leasing its cloud hosting hardware resources.
Cloud computing also includes software companies with web-based subscription-based business models. Dubbed software as a service (SaaS) models, these tend to trade at higher multiples than noncloud based providers firms who see revenue mainly from licensing agreements or from one-time sales of packaged software. SaaS companies also tend to have low customer turnover, high renewal rates and book recurring revenue over the long-term.
"Strong SaaS providers with sticky customer bases are attractive assets as the world gravitates toward public cloud offerings," said Mark Murphy, a JPMorgan analyst in a report.
Among the SaaS companies acquired in 2016 have been NetSuite, Demandware, Opower, Textura, Marketo, and Cvent.
Brendan Barnicle, an analyst at Pacific Crest Securities, said in a report: "It's likely that SaaS multiples will continue to increase and we expect much more M&A activity in SaaS."
A decline in SaaS company stock prices has enabled buyers to find some assets at a better price tag. In 2015, the stocks of cash-burning SaaS companies began selling off, particularly in overcrowded markets such as big data analytics, as investors focused more on profitability.
Achieving GAAP profitability is a high bar for many software companies. Richard Davis, an analyst at CanaccordGenuity, said in a report that some are having trouble even at a lower bar. "Today's crop of software firms are losing money on a non-GAAP and EBITDA basis," Davis wrote. He says companies in the "IPO class of 2013-14" loom as acquisition targets.
There have been large swings in the valuation of SaaS companies, with some having multiples of 6-, 8-, and above 10-times revenue in the "best of times" while they've dropped to the 2-, 3- and 4-times revenue range for companies that fall out of favor, says Pacific Crest's Barnicle.
Tableau Software (DATA), Splunk (SPLK), security firm FireEye (FEYE), ServiceNow and Hortonworks are among stocks that have pulled back the most.
Private equity firm Thoma Bravo's purchase of Qlik in June marked the first recent takeover in the data analytics sector. Thoma Bravo's $3 billion offer valued Qlik at just over three times revenue.
Shares in Marketo, a marketing software company, jumped in 2014. When its stock fell in early 2016 on light full-year revenue guidance, Vista Equity Partners swept in with a $1.8 billion deal - valuing the company at more than six times its annual revenue.
New Private Equity Playbook
"For 11 technology M&A deals this year, the offer prices were, on average, a 46% premium to the closing price, but a 5% discount to the 52-week high and a 20% discount to highs achieved since 2014," said Pat Walravens, a JMP Securities analyst in a report.
There's a new private-equity playbook, says Kris Beible, a vice president at Software Equity Group, an advisory firm which publishes research reports on M&A. He says PE firms are more focused on growth, rather than turnaround stories and harvesting free cash flow from older companies. Beible says 60% of public SaaS companies are generating positive cash flows from operations.
"PE firms are seeking more growth opportunities," he said. ""But they're not looking at acquiring companies losing significant cash from operations. Marketo is an example of that. They were GAAP-negative but generating cash flows."
Barclays analyst Raimo Lenschow says in 2016 some software companies have sold "ahead of tougher times" amid "cracks in their growth momentum."
Among those was Salesforce.com's acquisition of web-based e-commerce platform Demandware -- a $3 billion deal.
"Demandware's filings show that the company did not want to sell in December 2015 at $63 per share but re-engaged after its Q4, 2015 miss and subsequently lower management forecasts for the future of the business," said Lenschow in a report.
Salesforce.com, though, paid a nearly nine times revenue multiple for Demandware, the highest so far in 2016. Analysts say Adobe and Oracle were also stalking the web-based e-commerce platform, which gave its board more bargaining chips.
Microsoft bought LinkedIn, a provider of online social networking services for professionals, in June for $26.2 billion. LinkedIn's stock sold off 44% in early February on disappointing guidance. While Microsoft paid a hefty premium in June, the deal was done below LinkedIn's stock price heading into 2016.
Rising stock-based compensation costs may have contributed to LinkedIn's decision to sell, some analysts have speculated. Based on 2015 equity grants, Citigroup says companies facing the most GAAP earnings dilution are ServiceNow, Palo Alto Networks, Splunk and FireEye. Citigroup, meanwhile, says Workday and ServiceNow are lagging in improving profitability, amid high valuations linked to revenue growth.