Tech Banker

Larry Ellison

It's always entertaining when Larry Ellison speaks.  Here is Larry's latest riff courtesy of Forbes.

Transaction Alert: HP buys Mercury Interactive

Well, HP finally did it!  After years of showing at best tepid support for its software business, HP finally showed some conviction.  HP's purchase of Mercury interactive is a blindingly obvious strategic move with the only question being, what took them so long.

Target: Mercury Interactive

Mercury Interactive was founded as a software quality testing vendor.  In simple language, Mercury created software that tested software.  Mercury's software stress tested newly developed software products to catch bugs and performance issues before the software was released to the market or installed.  Mercury dominated this niche, and still does, but as growth became harder to achieve Mercury was compelled to extend its product scope.  Several years ago, Mercury began selling software to manage the performance of applications which were already deployed and running.  Today Mercury Interactive competes quite effectively with companies such as IBM, CA, BMC, Symantec, Quest and even to a limited degree HP.   

Transaction Terms

Enterprise Value:                                                 $4.5 billion ($52.00/share)

Premium to market:                                             33% above pre-announcement price

Valuation Multiples:

     Aggregate Value / 2006E Revenue                       4.8x

     Price/2006E Earnings Per Share                         34.0x   

Strategic Rationale

Strategically,this has been one of the most obvious transactions to not get done for years.  HP has long had a strong reputation around its Openview product set but it's been perceived as strong at managing the network layer, alright but emerging at managing the systems layer and weak at managing the application layer.  Mercury is the leading player at the application layer providing a perfect complement to HP's product weaknesses.  Very importantly for HP, they are also acquiring an industry leading team of professionals which we are sure will be an important catalyst to reinvigorate HP software business.

Architect Partners Assessment

Timing is everything.  Several events transpired to make this transaction achievable.  First, the departure of Mercury Interactive founder, Amnon Landon, last year as fallout from the well described option dating scandal.  Amnon was a fighter, not a seller.  Second, HP's change in leadership has clearly resulted in a new level of respect for its software business, resulting in corporate resources now being allocated to building what had been an oxygen starved business under Carly's watch.  Third, the loss of credibility  and uncertainty caused by the senior leadership changes and accounting issues at Mercury Interactive brought its valuation down to earth, making it a relatively affordable acquisition for HP.

This is one of those deals where both sides win.  The takeout valuation of Mercury is actually quite good at 4.8x revenues, particularly when one considers that revenue growth was expected to be only on the order of 12.3% from calendar 2006 to 2007 based on Wall Street analyst consensus.  Assuming solid execution, not a given, we believe the business will thrive under the HP umbrella making the relatively hefty purchase price quite reasonable. 

Here is a take from Vinnie Mirchandani and James Governor and Tony Baer.

EMC / RSA Follow Up

A follow up to our original post.  Network World published a decent assessment of EMC's recently announced intent to acquire RSA.  It's a positive perspective on the transaction, a position in the minority.

Underwriter Profits

Recently we commented on a post by Tom Evslin regarding how underwriters profit from an IPO.  We felt that Tom's post was an unfair assessment of underwriter motivations and incentives.  Let us try to explain simply how and where underwriters make money on an IPO.

Gross Spread -- The Easy Part

First the easy part, underwriters earn a commission (known as a gross spread) calculated as a percentage of the capital raised for the issuing company.  As a rule this is 7%.  When all is said and done, on average about 70% of the gross spread is actually kept by the underwriters and split amongst themselves in a very disproportionate manner.  Where does the balance of roughly 30% go? To pay the salespersons' (employees of the underwriters) commissions who sold the shares and the underwriters' expenses of the deal (legal and travel mostly).  These fees are quite lucrative, for example a $75mm IPO will net roughly $3.7mm in fees to the underwriters as a group.  If your a lead, book running underwriter (managing the deal) you get a big chunk of these fees.  If your a co-manager, not quite so interesting, but crumbs are better than no crumbs.  If the deal is large enough, those crumbs tend to be large also.

Aftermarket Trading -- A Bit More Tricky

Okay, now lets get to the part that is a bit more complex, the aftermarket.  This is the area there there seems to be some misconception that underwriters stand to profit handsomely.  Let's look at exactly where and how underwriters make money in the aftermarket.  There are two ways that underwriters can profit in aftermarket trading of an IPO, (1) trading and (2) inventory profits.

Trading: First underwriters act as a market maker and essentially match buyers to sellers.  In doing so, the underwriter is buying shares from willing sellers at the "bid" price and reselling them to willing buyers at the "ask" price.  There is a small difference between these prices and the underwriter pockets that "spread" for every share which is purchased then resold.  So, how much do these profits represent in a typical IPO?  Well in the first 10 days following an IPO (a rough approximation of the stabilization period following an IPO) these profits average only about 9% of the gross spread that we described in the paragraph above.  This equates to about $473,000, again assuming a $75mm IPO.  This statistic is according to the research paper, When the Underwriter is the Market Maker: An Examination of Trading in the IPO Aftermarket published in June 1999 which studies 306 IPO's completed between September 1996 to July 1997. 

So trading can be a decent business but is hardly a gold mine.  This business has actually become far less attractive with the advent of decimalization in 2001 as spreads used to be at minimum increments of 1/16 ($.625/share) because that was the smallest fraction available.  Now average spreads are more on the order of $.01-$.02/share as decimal-based quotation has enabled competition to drive spreads down.

Inventory Profits: The second way for underwriters to profit in aftermarket trading is to actually make a bet on the direction of the stock by either owning the stock (holding inventory and being long) and speculating that the stock goes up or being short the stock (naked short) and speculating that the stock price will decline.  In my direct experience, holding material inventory positions, either long or naked short, in an IPO during its stabilization period (again lets assume the first 10 days) is NOT a position underwriters intend to be in.  Any inventory held is usually the result of the underwriters' attempt to stabilize the issue following pricing, not an attempt to make a bet on direction.  In fact, the same research paper as referred to above, also evaluated profits generated from inventory positions following the IPO.  Their findings were that on average underwriters generated NO net profits from inventory positions during this stabilization period.

Conclusion

So, IPO underwriting is a lucrative business but the vast majority of profits are generated via the gross spread that is paid by the issuer to the underwriters.  The aftermarket activities of the underwriters are certainly generally additive to profits but do not represent a mother lode.

Secure Computing / CipherTrust Follow-Up

A good article by Sara Lacy at Business Week published today on the Secure Computing / CipherTrust transaction.

Transaction Alert -- Secure Computing Acquires CipherTrust

Another security deal was announced with Secure Computing announcing an agreement to acquire private software vendor, CipherTrust.  This represents another in a long line of promising software IPO candidates who have elected to take the M&A exit prior to public debut.  What is most striking about this transaction however are two other elements (1) a significant portion of the purchase consideration is expected to be financed with a syndicated bank facility and (2) Secure Computing announced concurrently a huge Q2 miss vis-a-vis expected financial performance.

The Future is Debt my Son

While that is certainly an overstatement, this transaction is another example of how debt has become an important component of software company capitalization.  Why is this happening?  A few factors:

1.  Bank are aggressively looking to deploy their capital.  Ironically, software vendors used to be radioactive to the credit folks in big banks because of the unpredictability of revenues and product obsolescence risk.  No longer, software vendors are seen as reasonably good credit risks with high switching costs combined the support and maintenance revenue annuity.

2.  The 2000-2004 technology capital spending drought proved that well managed software companies can manage to maintain significant positive cash flow from operations even through a down cycle.

3.  Private equity firms have "socialized" the concept of debt as a prudent component of a software company's capital structure via how many buyouts are financed.  In this case, Warburg Pincus is a large shareholder in Secure Computing.

4.  Large software firms have also taken a leadership role in integrating debt as a permanent part of their capital structure.  Firms like CA, Oracle and Symantec have relatively significant levels of debt on their balance sheet, a big change from as recently as 5 years ago. 

5.  Debt has a lower cost of capital thereby, at prudent levels, enhances returns on shareholder equity.

Another Miss!

The other unusual feature to this transaction is that Secure Computing simultaneously announced a major miss on Q2 number.  They are now expecting Q2 revenues of between $38.5mm - $39.0mm vs. previous guidance of $43.0 - $45.0mm.  The excuse?  Slipped deals.  We've heard that one before.  What this means is that at the 11th hour Secure Computing introduced this fact to the CipherTrust board and management team and still got the deal completed!  Given that roughly 30% of the consideration is being paid in stock, I'm sure that made for some interesting conversations.  Kudos's to someone for holding this deal together.

Target: CipherTrust

CipherTrust, backed by Battery Ventures (Thomas Crotty), Greylock (Asheem Chanda), USVP and Noro-Moseley, is an appliance based email (and instant messaging) security vendor.  The consideration is $185mm cash ($115mm financed via a syndicated bank facility), 10mm shares of Secure Computing stock (worth $50mm after today's stock price drop of 38%) and a $10mm note which will be paid (or not) upon achieving certain benchmarks.  It looks like CipherTrust was on something like a $60mm revenue run rate off of Q2 2006 numbers.  So $245mm in total consideration at today's Secure Computing stock value translates into a 4.1x revenue multiple.  Frankly, we would have thought that CipherTrust could do better.

Strategic Rationale

Here's Mike Rothman's (Security Insight) take.  Maurene Caplin Grey also has some good perspective on the sector and recent competitive dynamics.

Software as a Service Economics

Scott Bolick, George Gilbert and Rahul Sood of Tech Strategy Partners have assessed the economic model of software as a service (SaaS) in their recent post on Sandhill.com.  It is worth reading.  Their conclusion is the the SaaS model is likely a superior economic model, particularly once scaled.  They estimate that SaaS vendor operating margins will range between 34%-40% in its mature manifestation.  These margins are superior to the traditional model as evidenced by SAP with a 27% operating margin and Oracle at a 34% operating margin.

Lessons Learned -- Mercury Interactive

Mercury Interactive has been one of the darlings of the software industry for the past five years.  Their darling status collapsed last year when the Company announced the forced resignation of its founder and CEO, Amnon Landon, its CFO Douglas Smith and General Council Susan Skaer. 

This week, Mercury Interactive filed its long delayed 2004 10K which describes what turned out to be 54 instances of stock option grant backdating.  Mercury certainly isn't the only company who engaged in this ethically unacceptable and perhaps illegal activity, but they are certainly the software industry poster child. 

We've personally worked with companies where, in retrospect, it was discovered that certain executives conducted themselves unethically and in some cases illegally.  These have been disappointing and disheartening experiences as we were lied to and deceived directly.  It's incredible discouraging to have the covenant of trust broken by someone whom you respect.  The only consolidation we've found is to try to learn lessons from the experience.

Mercury Interactive has many lessons to teach on how greed and hubris can break people and even fundamentally change a companies course.  Enron may be the most striking example but there are many other examples to learn from.  Jack Ciesielsky posted an excellent analysis on Mercury Interactive today at SeekingAlpha.  We encourage all to read carefully.

Disruptive Pricing

Tom Evslin reminded us of a potent theme today, disruptive pricing.  Within the telecommunications industry it's a core strategy for many vendors.  In our world, software, pricing certainly plays a strategic role but perhaps more is to come.

Disruptive pricing is certainly a theme that we've seen on the consumer side fairly consistently since Netscape used "free" as a weapon to proliferate its browser.  In fact, "initially free" has seemed to have become the de riguer pricing strategy on the consumer side. 

Within the enterprise software world, however, the aggressive use of pricing as a weapon has been somewhat muted.  While there are certainly examples, including open source and hosted applications sold on a low monthly cost subscription basis (aka Salesforce.com), widespread disruptive pricing is not a big industry theme.  We've often contemplated how pricing will begin to play a more prominent role within the enterprise software sector.  We suspect that we will see a day, not too far in the future, where disruptive pricing will become a more prominent strategy.

Google = Software

Well it looks like the technology press is starting to let the old word "software" slip into their stories about Google.  Here's c|net's recent review of the Top 10 Google Apps.  Please see our last post on this subject, Google's a Software Company.

Google is the dominant hosted software vendor.  What makes Google different is it's revolutionary revenue model driven by highly-targeted advertising.