Does Software Consolidation Stifle Innovation?

Musical instrument maker Yamaha uses Oracle for ERP, but it bypassed the company's CRM software for Salesforce.com's on-demand product, using Tibco Software to connect its Salesforce.com apps with its ERP system. The main reason it chose Salesforce.com was because software as a service offered faster implementation and reduced complexity, says David Bergstrom, Yamaha's corporate planning manager. He's having a hard time understanding how Oracle's acquisition strategy will benefit his company. "It seems like it's just gotten more complicated for them," he says, considering the "menu of things" Oracle offers up. "It's not as simple, clean, and clear as with a Salesforce.com solution." Gartner analyst Alexa Bona says she has heard a fair amount of grumbling from Oracle customers about the maintenance Oracle provides after it acquires a software vendor. As support and other personnel from those acquired companies get laid off or move on, "some customers feel some of the skills sets are missing, yet support fees are higher," Bona says.

Case in point: Oracle Customer Aon, the $10 billion-a-year insurance company, has rolled out Salesforce.com to more than 5,000 employees worldwide. "The software option wasn't a positive one for us," says Phil Clement, head of Aon's sales systems.

By Mary Hayes

The software industry is quickly settling into a gang of four: IBM, Microsoft, Oracle, and SAP. Where will the next billion-dollar competitor come from?

Barry Libenson, CIO at Ingersoll Rand, considers himself fortunate. While the odds increase every day that the company's key software vendors will get caught up in disruptive takeovers, so far Ingersoll Rand has landed on the right side of every deal. "The companies we've aligned ourselves with are doing the acquiring," he notes, pointing to Oracle as a primary example. "The scary thing is when you're at the other end of the spectrum. Then you're at the mercy of who's doing the acquiring."

There's reason to be concerned, or at least cautious. With software industry consolidation barreling along, far outpacing any other U.S. industry, CIOs must plan carefully and think fast. Will an acquiring company stop innovating the technology you've standardized on, content to feed on a steady diet of your maintenance fees? Will a clammy-palmed salesman fronting a software giant replace your straight line to a smaller vendor's CEO? Or will the acquisition bring positive change, with a vendor's new parent investing more in research and development and giving you access to a larger, more knowledgeable support team?

Software consolidation isn't the voracious monster some people perceive it to be. True, it's driven by big vendors desperate for growth. But technology managers needn't fear that consolidation will eat away at competition or innovation in the software industry: There are still plenty of new ideas and novel approaches seeping in.

THE BIG PICTURE

When it comes to acquisitions, software dominates all technology sectors, accounting for 40% of the $298 billion in tech M&A deals done last year and half of the $306 billion in deals in 2005, according to Thomson Financial. The runner-up: Internet companies, which accounted for just 18% of last year's tech M&As.

While software always has been an acquisitive industry, the deals are getting bigger and more complex. Last year, 1,726 software companies were acquired, the highest number since 2000, according to investment firm Software Equity Group. But more impressive was the size of some of those deals: Hewlett-Packard's $4.5 billion acquisition of Mercury Interactive, EMC's $2.1 billion purchase of RSA Security, and IBM's acquisitions of FileNet and Internet Security Systems, both of which exceeded $1 billion.

These deals came on the heels of Oracle's big-bucks, high-profile acquisitions of PeopleSoft, Siebel, and Retek--as well as 23 other companies--over the past two years. IBM isn't far behind, with 22 notches on its belt over the same period. Microsoft has bought more than 25 companies in that time, though most of them were tiny startups acquired under the radar.
This year, megadeal watchers are training an eye on Cognos and Business Objects, both with annual revenue in the $1 billion range, as potential acquisitions. Business intelligence is hot, and the biggest vendors want in--hence Microsoft's acquisition of ProClarity last April. NCR's recent decision to spin off billion-dollar-plus data warehousing specialist Teradata is viewed by some as making Teradata a more attractive acquisition target to big tech companies or even a private equity firm. Siemens last week acquired UGS, a maker of product life-cycle management software, for $3.5 billion in cash from three private equity firms.

In the past four years, 430 publicly traded software companies, most of which had grown through acquisitions themselves, have been swallowed up, says Ken Bender, managing director at Software Equity Group. Also, more private investors are getting into the fray. Witness Hellman & Friedman's recent $1.3 billion acquisition of Intergraph. "Private equity firms and larger software companies are awash in cash," says Bender.

Revenue-hungry vendors are eyeing the software-as-a-service model, too, which is getting tons of interest from both the venture capital and the user communities. A buyout of Salesforce.com, one of the most successful SaaS companies, would provide a big IT vendor a splashy entrée. IDC predicted last month that Salesforce will be acquired this year.

LET'S MAKE A DEAL

Why all the big deals? Theories typically center on industry maturity, vendors in search of new growth and market opportunities, or a combination of the two. Some view consolidation as the natural progression of an aging industry, invariably dredging up a comparison to the global auto industry. But consider that both software suppliers and buyers have more cash to spend than in years past. IT budgets have increased steadily since bottoming out five or six years ago, and it's universally forecast that spending on software will continue to rise this year, as long as something unexpected doesn't derail the economy. Meanwhile, software companies, which were under Wall Street pressure to focus on profitability several years ago, have shifted back to revenue-growth strategies to capture more of those rising IT budgets. So they're buying companies with technologies that either complement their own or drive their businesses into new areas.

Gary Scholten, CIO at $9 billion-a-year Principal Financial Group, says he has highlighted software industry consolidation as a "risk issue and an opportunity" with the company's board. Scholten learned the hard way. A while back, one of the financial services company's software providers was acquired by an IT infrastructure vendor that wanted to take the software in a completely different direction, one that didn't mesh with Principal Financial's IT infrastructure. So Principal had to dump the software and transition to something else.

On the other hand, acquisition by a larger company can put a struggling software supplier on more solid financial footing and allow it to scale its architecture, Scholten says. And consolidation can actually increase a customer's influence with an alpha vendor. For example, Principal Financial's influence with Oracle has increased as Oracle has acquired companies Principal does business with. "For every negotiation we have with them, that plays a part," Scholten says. Premier customer status can mean better volume licensing deals, better access to vendor executives, and inclusion on customer advisory boards to influence the vendor's technology road map and strategic direction.

THE FEWER, THE BETTER

Despite rising budgets, the dictate to run a lean IT organization hasn't changed. Working with fewer vendors means spending less money managing relationships. As a major Siebel account and a large Oracle customer, Ingersoll Rand's Libenson says he had significant negotiations going on with both companies. Now he deals with only one. "The fewer companies I have to deal with, the easier my job is," Libenson says. And he applauds Oracle's acquisition of Oblix, which Ingersoll Rand was using for identity management. "It really legitimized the technology and helped tremendously from an integration perspective," he says.

Still, when it comes to software moving from one owner to another, integration is a major concern, along with upgrades and licensing. Oracle co-president Charles Phillips said at Oracle OpenWorld in October that there will be "no forced march" migrations from one application platform to another, even as the vendor continues its own march toward the integrated applications framework known as Fusion, the first part of which is due next year. Oracle will provide upgrades soon for its Oracle E-Business suite and the JD Edwards, PeopleSoft, and Siebel product lines. The JD Edwards upgrade will be the first in 10 years, the company says. In December, Oracle announced an umbrella software licensing scheme for all its applications, in an effort to eliminate the complexity of sifting through the various schemes of PeopleSoft, Siebel, and others.

Ingersoll Rand's Libenson has had some experience integrating Oracle's and Siebel's apps, and he'd like to see Oracle make faster progress. "But being realistic, integrating two monolithic platforms is a huge amount of work," he says.

Oracle's acquisition strategy is losing it some deals. Sport Chalet, a $350 million-a-year retailer, chose SAP's retail offering over Oracle's because of the lack of integration between Oracle financial apps and the retail apps of Retek (acquired by Oracle in 2005), says Sport Chalet CFO Howard Kaminsky.

Musical instrument maker Yamaha uses Oracle for ERP, but it bypassed the company's CRM software for Salesforce's on-demand product, using Tibco Software to connect its Salesforce apps with its ERP system. The main reason it chose Salesforce was because software as a service offered faster implementation and reduced complexity, says David Bergstrom, Yamaha's corporate planning manager. He's having a hard time understanding how Oracle's acquisition strategy will benefit his company. "It seems like it's just gotten more complicated for them," he says, considering the "menu of things" Oracle offers up. "It's not as simple, clean, and clear as with a Salesforce solution."

Gartner analyst Alexa Bona says she has heard a fair amount of grumbling from Oracle customers about the maintenance Oracle provides after it acquires a software vendor. As support and other personnel from those acquired companies get laid off or move on, "some customers feel some of the skills sets are missing, yet support fees are higher," Bona says.
Not so, argues Oracle senior VP Sonny Singh. Oracle surveys its customers periodically on their experiences with support and communications, and their understanding of Oracle's vision, Singh says. In the last year, Oracle's customer satisfaction rate, as measured by its Global Customers Program surveys, is up 16%, though he won't disclose the base number for that increase other than to say it was high.

That satisfaction is in large part because of Oracle's structure, Singh says. After companies are acquired, they're placed in the appropriate vertical business unit, such as retail or utilities. That makes it easier for customers in a particular vertical to interact with the development, marketing, and implementation folks for the software they're running, because their services are all under one vertical umbrella.

Not surprisingly, Oracle's competitors are trying to poke holes in its acquisition strategy. Marc Benioff, the flamboyant founder and CEO of Salesforce, calls Oracle "the GE of software," because it runs those software business units as separate profit-and-loss centers, much like the conglomerate GE runs its aircraft engine, plastics, and broadcasting units. "It would be a breakthrough in software management if they could make it work," he says.
Steve Mills, senior VP and group executive of IBM Software, cracks, "Fusion is about confusion." IBM should talk, having practically pioneered the big-bang software acquisition--and interplatform integration headaches--with its $3.5 billion buyout of Lotus Development in 1995.
In recent years, IBM has taken a more focused, smaller-scale approach to acquisitions. Yes, it's biggest was a doozy: the $2.1 billion acquisition of development toolmaker Rational. But that was back in 2001. Mills says IBM isn't avoiding big acquisitions--it paid $1.6 billion for FileNet in a deal that closed in August--but it's more focused on the middleware market, including software related to IT infrastructure and application integration. "It gives us the greatest leverage," he says. "If we moved outside these connected spaces, we'd have a much harder time getting return." IBM's fourth-quarter earnings results showed an 11% boost in profit to $3.54 billion; the company attributed a chunk of that growth to its 2006 software acquisitions.

Mills insists that IBM has taken great care in preserving its customer relationships during acquisitions. "We invest more in technology than prior to the acquisition," he says. "We invest more in sales and support than the company did prior to the acquisition." The antithesis, he says, is the "Charles Wang model," referring to the founder and former chairman of Computer Associates, which tore through the software industry in the 1990s with acquisition after acquisition, engendering animosity among its acquired customer bases by cutting off development, milking maintenance fees, and forcing users toward software they didn't want. "I don't think customers are distressed that acquisitions are occurring; they're distressed when the acquiring company shows no level of commitment and investment in the technology," Mills says.

But IBM can't please all the people all the time, either. David Hauser, CTO of telecom firm GotVMail and a former Tivoli customer, says Tivoli changed dramatically after it was acquired by IBM 10 years ago. In just the last four years, 15 IBM acquisitions have been absorbed by the Tivoli brand. "Tivoli became too much cost, too much hassle, and really went away from its core business of monitoring," Hauser says. As Tivoli grew, Hauser had difficulty finding information about the original technology. He finally gave up and moved to an open source network monitoring tool from GroundWork called Nagios.

THE GANG OF FOUR

Principal Financial's Scholten says he'll steer clear of a hot startup's promising new technology if that company appears to be a takeover candidate. Ultimately, it will hurt innovation in the software industry if influential customers like Principal Financial shy away, he admits.

But not all technology users think that way. "I don't think people are so focused on operational efficiencies that they're incapable of seeing when something interesting, and perhaps better, is happening," says longtime industry watcher Amy Wohl. What's more, venture capital spending on tech startups is on the rise.

Certainly, consolidation means fewer choices. When you have two main ERP options, rather than the five or six that existed five years ago, you have less negotiating leverage, Scholten says.
There's no getting around the fact that the largest software companies--IBM, Microsoft, Oracle, and SAP--are getting bigger. Some insist that a weak IPO market, acquisitive IT vendors, and buyers' desire to work with fewer vendors will make it impossible for a sizable fifth or sixth rival to emerge. "You will never see another billion-dollar enterprise software company," says Glover Lawrence, managing director at McNamee Lawrence & Co., an investment firm specializing in tech M&As. "Google may eventually compete with Microsoft, but not as an enterprise software company."

Conventional wisdom--but is it true? Salesforce predicts its revenue will exceed $700 million in the coming year. Another Silicon Valley highflier, VMware, reported that its fourth-quarter revenue rose 101% over the year-earlier quarter to $232 million, putting the company on an annual run rate of $900 million. It was the fifth consecutive quarter that VMware's year-over-year growth surpassed the previous quarter's, an exception to the rule that as big software companies get bigger, growth must slow down.

But even though VMware, acquired by EMC in 2004 for $625 million, operates as an independent subsidiary (separate sales, marketing, and R&D from the mother ship), it isn't an independent company. Even if it were, "VMware is a real anomaly," CEO Diane Greene says. For a software company of its size to grow as fast as it is, it must add a new layer to the software industry's "stack." In VMware's case, it's virtualization. For Salesforce, it's software as a service. For Google, it's selling ads. "Those new layers don't come around very often," Greene says. "There aren't that many really significant new things."

Maybe. Or maybe we just haven't seen them yet. "There's not a country in the world that's not trying to foster some sort of indigenous software industry," says IBM's Mills. Salesforce's Benioff says he's searching for the next killer app, but it won't come from his company: He thinks it will come from a developer in Shanghai, Bangalore, Eastern Europe, or some other remote place, delivered over Salesforce's AppExchange platform. "There's no way that developer is going to get to a Merrill Lynch or other big customer without us," Benioff says.

SAP is hoping for something like that with its service-oriented architecture strategy. With its SOA technology, called NetWeaver, SAP doesn't need to acquire. Instead, it's partnering with hundreds of smaller vendors whose software services snap into SAP's ERP suite, mySAP, explains Bill McDermott, CEO of SAP Americas. With big software acquisitions, "you have to rewrite the code base of the individual companies, integrate the culture and people from very different companies, and then get the customer to procure disparate pieces," McDermott says. Oracle's acquired apps aren't yet service-enabled. "So theirs is like a lung-and-heart transplant," he says, "where ours is plug and play."

Software companies essentially have two growth alternatives: innovate or acquire. SAP is hoping its growth will come from the former, by way of NetWeaver and an upcoming software-as-a-service offering that, it claims, will be different than what's currently available.
There's a lot riding on that innovation. SAP's financial results last week were disappointing: Software revenue for its fourth quarter was up 7% to 1.3 billion euros and 10% to 3.1 billion euros for the year, lower than what SAP had expected. At the same time, SAP said it's preparing a software service for midsize companies that they can test on the Web before committing, will cost them considerably less than a package software suite, and, unlike Salesforce's, will let them store data on local systems. It's unclear when the offering will be available; SAP says it will provide details within a few months.

Microsoft, on the other hand, is both acquiring and innovating. Perhaps more than any software company, it's moving aggressively beyond its core software business, into unified communications, security, and mobility. And then there are the consumer products: Zune, the iPod challenger, and the wildly popular Xbox 360, itself something of a technology platform and driven by the innovation of outside developers. Salesforce's Benioff describes Microsoft--with obvious envy--as one of the few successful "multicategory, multiproduct" tech companies.

Microsoft isn't averse to throwing around its considerable weight. In November it announced new client access licenses for several products, including Exchange and SharePoint; they require additional licenses for certain features--antivirus protection, for example. That will drive up costs for some customers, but not all: Many Exchange customers already have antivirus software in place, so they won't pay Microsoft extra for that feature.

Microsoft in the past few years also has gotten more aggressive about persuading customers to buy broader license agreements, by charging higher fees for selective agreements that cover specific products. IBM executives called a meeting with several Forrester Research analysts, complaining that through its license practices, Microsoft is trying to eat up so much of IT budgets there won't be enough left for other vendors, says Forrester analyst Julie Giera. Forrester offers coaching classes for companies entering negotiations for Vista, Office 12, and other new Microsoft apps, so they end up with--and pay for--only what they need.

"All the vendors would love to have you do an all-you-can-eat buffet," says Scott Rosenberg, CEO of Miro Consulting, which helps IT buyers negotiate software licenses. "It's kind of like those vacation packages that say, 'Don't worry, relax, you don't have to worry about scrambling for your credit card, just belly up to the bar.' But unless you drink heavily or eat like a football player, you're going to overpay."

Indeed, in this era of bigger is better, it's wise to keep an eye on not only what you're consuming, but also what's getting consumed, and by whom. A few weeks of secret negotiations between two software companies could leave a customer with an impressively bigger and better vendor, or a bellyache of uncertainty and obstacles.