Fuel for CRM Mergers & Acquisitions: Maintenance Revenues

During the last downturn nearly every enterprise software vendor stayed alive for a quarter or more due to their support and maintenance revenue streams. Today, support and maintenance comprises the majority of revenue for many CRM vendors, both public and private.

Existing customers are carrying the financial load of the CRM industry today. With the era of the elephant-size deals in CRM over, every CRM software vendor is nursing the support and maintenance revenue streams like never before. These revenue streams make for a very attractive merger or acquisition target for any other enterprise software vendor to capitalize on. Expect to see much more M & A activity in 2005 as a result of CRM vendors getting squeezed by their customer base for lower maintenance costs on the one hand, and smaller deal sizes on the other. Hosted CRM’s impact is unmistakable on deal sizes today; license deals are shrinking as a result.

Industry Ripe for M & A

In the middle of the downturn one of the best questions to ask during an earnings call was what percentage of revenue came from support and maintenance. In the depths of the downturn, it was typical that the figure would be 70 percent or more, at times up to 85 percent. Since the recovery started taking hold it’s clear that the lesson learned during the downturn — how to mine and cultivate a customer base for higher revenue streams — is being perfected especially in CRM companies today.

In fact, if you look at the latest earnings announcements, you can see that support and maintenance is outstripping new business by a factor of seven to 10 times or more, and that ironically, the interest earned on short-term investments is even outpacing new business growth. Those two points signal major consolidation of the CRM arena soon. When you can make more at the low interest rates of today even on short-term invested capital than your sales force can deliver in new business, you can bet you’ve made an M & A firm’s scouting report.

High Dependence on Support and Maintenance

So how acute is the dependence in software companies on M & A? It becomes clear after reviewing the research presented by Rahul Sood, managing partner, Tech Strategy Partners, and JB Wood, president and CEO of Service & Support Professionals Association. They presented research completed on this topic at Sand Hill Groups’ Software 2005 event held April 26 and 27 in Santa Clara, Calif. The research Sood and Wood presented can be viewed here. I didn’t attend this years’ event but have in the past, and found it to be one of the best conferences on enterprise software available.

Interpreting Sood’s and Wood’s research leads to the following take-aways:

• One in three software customers are successful negotiating lower prices for the same level of service. Given the backlash over higher maintenance costs, many customers threaten to cancel their maintenance but few do. Instead vendors are pushed to deliver the same levels of service for lower costs and are frequently pushed to deliver longer contracts at lower costs. Just a 10 percent reduction in maintenance revenue led to a corporate-wide drop of 3 percent in contribution margin.
• Infrastructure vendors are the most dependent on their maintenance revenues. The research showed a bar graph by year of percentage of maintenance revenues for one unnamed application vendor and two anonymous infrastructure vendors. The median value for the apps vendor was 37 percent, and 50 percent and 45 percent, respectively, for the infrastructure vendors. In the 40 to 50 companies I tracked as an analyst, the figure in CRM, PRM, order management and product configuration consistently hovered in the 70 percent range and still does today.
• R & D spending follows the maintenance revenue stream. One of the most interesting insights from the research presented is that 75 percent of R & D spending is for bug fixes, tweaking mature products and non-revenue generating enhancements. The takeaway here: once you get entirely dependent on maintenance as a primary revenue strategy, R & D follows — which means the cycle of development needs a major infusion of capital to get back onto a forward-thinking roadmap.
• Vendors are not articulating the hidden value of support. Another key takeaway is the fact that the savviest customers ask for and get priority access to a dedicated support resource and downtime insurance. If you’re a customer of any of the major ERP vendors, for example, and looking to upgrade any aspect of your ERP system, waiting until the end of a quarter and asking for dedicated support resources may be a good strategy — I’ve seen that work for larger Oracle ERP accounts — especially those with locations scattered around the world.

M & A Juggernaut Rolling

The fact that in calendar Q1, 2005, there were 250 mergers announced in the U.S. and nearly an additional 500 in the rest of the world with the globally based ones being nearly 25 percent cross-border, shows that M & A’s robustness is driven more by the increasing interest in security-related technology and the buyer’s market for many CRM and customer-facing technology companies today.

M & A exit valuations have hovered at the 3X range; a remarkable recovery over 1.9X multiples in 2003 and 1.8X in 2002 according to MergerStat. These figures were presented at the conference by Silicon Valley Bancshares (SVB Alliant). Security companies are driving these figures up, with SVB Alliant reporting a remarkable trailing revenue 9.2X multiple for security company acquisitions from 2004 to present.

Bottom Line: Watch for CRM vendors to get snapped up in this buyer’s market as they get squeezed by customers to deliver the same levels of service and maintenance for less on the one hand, and larger enterprise vendors looking for an annuity-like revenue stream to harvest on the other.