SOFTWARE EQUITY REPORT 2003 A COMPREHENSIVE ANALYSIS OF SOFTWARE INDUSTRY VENTURE CAPITAL, INITIAL PUBLIC OFFERINGS AND MERGERS AND ACQUISITIONS Kenneth Bender Managing Director [email protected] Bryan Warren Senior Vice President [email protected] Larry Spelhaug Senior Vice President [email protected] Allen Cinzori Vice President [email protected] David Legacki Analyst [email protected] Software Equity Group, L.L.C. 12220 El Camino Real, Suite 320 San Diego, CA 92130 www.softwareequity.com (858) 509-2800 Software Equity Group, L.L.C. ECONOMY Figure 1: U.S. Gross Domestic Product 10% The U.S. economy gained considerable momentum 8.2% 8% in 2003. Most notable was a significant improvement in Gross Domestic Product (GDP), a 6% 4.7% leading economic indicator, which reached its 4.0% 4% 3.4% 3.1% highest level since 1984. While third quarter GDP 2.0% 1.9% 2.0% grew at the sizzling rate of 8.2%, the rate 2% 1.3% decelerated to a more sustainable 4.0% in Q4. For 0% -0.2% the year, GDP grew 3.1%, as compared to 2.2% in -0.6% 2002 and 0.5% in 2001 (Figure 1). Growth GDP Real -2% -1.3% -4% Key contributors to the upturn in GDP were a 20012002 2003 significant increase in business investments and Source: Commerce Department strong consumer spending, both of which surged in the third quarter. Business investments in PUBLIC MARKETS equipment and software jumped 17.6% in Q3 and 10.0% in Q4. A weaker dollar and an improving U.S. markets ended a torrid year on yet another global economy also drove the manufacturing upswing in Q4, with the Dow, Nasdaq and S&P 500 sector, as demand for U.S. exports grew 19.1%, a climbing 13%, 12% and 12%. For the year, these seven year high, offsetting a 11.3% rise in imports. same indices were up 25%, 49% and 26% (Figure Consumers, who single-handedly kept the economy 2). As a group, public software companies outpaced afloat in 2001 and 2002, continued to capitalize on the broader market. For the year, the average decade low interest rates. market value of the SEG-SEVENTY, our index of public software companies, climbed 57%. The The Conference Board's Composite Index of median market cap of the SEG-SEVENTY grew 78%. Leading Economic Indicators, an important short- Other Q4 market indices for the SEG- SEVENTY term forecasting tool, improved steadily the last compared to the prior quarter: three quarters of 2003, reaching the highest level in its history by year-end. Positive contributors • Median revenue multiple for the group grew included building permits, consumer optimism, new 11% to 2.8 times trailing-twelve-month (TTM) manufacturing orders for both non-defense and revenue. consumer goods, and stock market performance. • Median enterprise value (adding debt and deducting cash and cash equivalents) to While the economic indicators were largely positive, revenue multiple increased 26% to 2.1x TTM. there remained reason for caution. The number of • Median P/E ratio climbed 11% to 36.9x. unemployed was 8.4 million in December, 5.7% of • Median multiple of EBITDA was 25.2x, up 20%. the job force. While the number of jobless was down • Average operating profit margin before from the recent high in June 2003, the depreciation, interest and taxes declined to unemployment rate remained stubbornly high and 15.2% from 16.7% in Q3. reflected a drop-off in job seekers. The civilian labor • Average revenue multiple for the SEG-SEVENTY force fell by 309,000 in December to 146.9 million; was 3.6x (up from 3.1x in the prior period), and the labor force participation rate decreased over the the corresponding confidence interval at 80% month to 66.0%. was 3.3x to 3.9x. Entering the new year, consensus estimates put As expected, the markets continued to 2004 GDP at a sustained economic expansion rate disproportionately reward the industry’s largest of 4.5%, with business investments leading players – those public software companies with the consumer spending. Consumer spending is greatest revenue. Similar to last quarter, the 20 expected to flatten or decline slightly as home sales software companies in the SEG-SEVENTY with weaken, interest rates rise and consumers begin to revenue between $200 million and $1 billion had a feel the impact of increased household debt and 2.8x median revenue multiple in Q4, as compared reduced savings. to 2.6x for companies with revenues below $200 1| SOFTWARE EQUITY REPORT 2003 Copyright © 2004 Software Equity Group, L.L.C. Software Equity Group, L.L.C. Figure 2: Major Market Indices Year-to-Date 50% 40% 30% 20% 10% Percent Change Percent 0% -10% -20% Jan. Feb. Mar. Apr. May Jun. Jul. Aug. Sep. Oct. Nov. Dec. S&P 500 Nasdaq Dow million. Similarly, companies with revenue in excess Figure 3: SEG-Seventy Annual Revenue Growth of $1 billion recorded the highest median revenue (Year-over-Year) multiple for the quarter, 5.0x. On an earnings basis, companies with revenue greater than $200 million 80% had a median P/E of more than 40x, compared with 60% 28x for those with revenue less than $200 million. 40% Public software company performance, however, 20% Median: -2.6% did not keep track with escalating market caps and 0% higher PEs. Median revenue of the SEG-SEVENTY actually declined 2.6% in 2003 from 2002 (Figure -20% 3). Earnings of the group improved however, with -40% the median growing 6.8% (Figure 4). Given the belt tightening that has occurred over the past three -60% years, top line growth will likely be required to % Change Growth Revenue YOY -80% generate earnings sufficient to justify current market valuations. Prospects for software company revenue growth Figure 4: SEG-Seventy Annual Earnings Growth appear better in 2004 than anytime in the past three Year-over-Year years, but opinions vary. Both Gartner Group and 300% IDC project a 5.0% increase in IT spending, but Goldman Sachs’ December survey of IT executives 200% portends only a 1.5% increase in IT budgets (down from a 2.3% estimate in August, and a 3.5% 100% estimate in June). Gartner also projects that IT Median: 6.8% spending will be greatest in the government and 0% health care sectors during the next five years, each averaging in excess of 12% compounded annual -100% growth. The financial services, education, manufacturing and communications sectors are -200% each projected to increase IT spending by more than 6.5% over the same five year period. YOY Earnings Growth % Change -300% 2| SOFTWARE EQUITY REPORT 2003 Copyright © 2004 Software Equity Group, L.L.C. Software Equity Group, L.L.C. Figure 5: SEG- Seventy Median Multiples by Sector 5.00x 4.50x 4.00x 3.50x 3.00x Median Revenue Multiple Revenue Median 2.50x 2.00x 1.50x 1.00x Q1 2003 Q2 2003 Q3 2003 Q4 2003 Software Industry Business Intelligence CAD/CAE Customer Relationship Management Developer Tools EAI Enterprise Resource Planning Information Management Security Supply Chain Management 3| SOFTWARE EQUITY REPORT 2003 Copyright © 2004 Software Equity Group, L.L.C. Software Equity Group, L.L.C. The market valuations of public software companies Figure 6: U.S. IPO Activity, Annual continued to vary widely according to principal 600 product focus, although virtually all categories saw 500 473 quarter-over-quarter and year-over-year increases 400 340 (Figure 5). SEG-SEVENTY median revenue multiples 245 by principal product category for Q4 were: 300 215 200 . 83 81 73 • Business Intelligence (BI): 4.2x (up from 3.4x in IPOs of No. 100 41 24 29 Q3) 0 • CAD/CAE: 2.8x (up from 2.2x) 1999 2000 2001 2002 2003 • Customer Relationship Management (CRM): U.S. IPOs U.S. VC Backed IPOs 2.0x (up from 1.5x) Source: Thomson Financial • Developer Tools (DT): 2.5x (down from 3.2x) • Enterprise Application Integration (EAI): 2.6x Figure 7: U.S. IPO Activity, 2003 (up from 2.5x) 60 • Enterprise Resource Planning (ERP): 3.4x (up 46 from 2.4x) 50 • Information / Data Management (IM): 3.0x (up 40 from 2.5x) 30 19 17 20 . • Security: 4.5x (up from 3.6x) 9 No.of IPOs • Supply Chain Management (SCM): 2.6x (up 10 3 1 5 2 from 1.8x) 0 Q1 2003 Q2 2003 Q3 2003 Q4 2003 As in Q3, publicly traded security software developers boasted the highest market values, with U.S. IPOs U.S. VC Backed IPOs Source: Thomson Financial median Q4 revenue multiples increasing an additional 24% over the prior quarter. Business aggregate $2.3 billion (15% of overall funds raised). intelligence software companies posted a 25% Perhaps signaling a trend, foreign issuers garnered increase in the quarter, even though Cognos guided more than 40% of 2003 IPO proceeds. The financial down next quarter expectations after beating services sector led the IPO market with the largest analyst expectations. Public software companies number of offerings at sixteen. focused primarily on enterprise resource planning (ERP) and customer relationship management Eight software companies went public in 2003, with (CRM) posted dramatic gains for the year of 227% seven coming to market in the second half of the and 87%, respectively. The developer tools year (Table 1). By year-end, these software segment, which has held much of its value in the companies were up a group average of 21% from past two years was hardest hit in the quarter, their initial offering price. This contrasts sharply with declining in market value 21.6% to 2.5x.