Valuation of the Custom Software Industry

Weekly Corporate Growth Report, Dec 8, 2003 by Dolbeck, Andrew

The custom software industry covers organizations that provide computer programming services on a contract or fee basis. Companies in the industry write computer code and offer services such as providing ongoing maintenance and modification of custom software, training, and systems analysis and design.

The industry grew rapidly during the tech boom of the late 1990's. When the economic downturn hit, however, business spending on equipment and software contracted even more than the overall economy. Information technology spending has decreased. Not only have IT budgets fallen with company revenues, but the percentage of revenues allocated for IT budgets have been reduced as well in many cases.

There may be hope for the future, however. The past year has seen a wave of technological innovation that may lead to the reinvention of the corporate data center. Innovations include the separation of data and data management from the individual software applications, allowing it to be accessed in a greater variety of ways; the ongoing adoption of industry-standard integration protocols based on XML Web services; and the emergence of composite applications that integrate data from multiple applications.

As the spending environment improves, companies are likely to proceed cautiously. Companies that specialize in enterprise computing solutions, such as Avnet, Arrow Electronics, GE Access, and Agilsys will need to educate their clients, providing Return On Investment (ROI) analysis to motive potential customers.

Mergers and Acquisitions

Over the years 1999 to 2002, significantly more custom software industry M&A deals occurred in the mid cap market than in the large cap market. Deal activity has declined in recent years in both markets. In the mid cap market, the number of deals peaked in 2000, while the peak occurred in 2001 for the large cap market. Deal activity may be on the rise in the large cap market, however. The first six months of 2003 have seen almost as many large cap deals as the year 2001. Selling prices in both markets have steadily declined, relative to company revenues, net worth, and assets, since 2000.

Part of the rise in mergers and acquisitions is due to corporate investment in information technologies. Hewlett-Packard, for example, is investing in software companies that help IT departments manage information systems, deploy software, and report errors. The company recently acquired Talking Blocks, and will be incorporating its technology into an HP software line used to manage Web services.

Whatever Happened to Web Services?

A few years ago, one area of software development received a fair amount of attention. The concept was called "Web services," and it involved Web-driven computer interactions that would allow automated systems to perform complex tasks across multiple computer systems or even platforms. Web services would allow automated systems to circulate documents electronically between companies or even send data to other platforms such as pagers or handhelds.

When the economic downturn hit, Web services projects were impacted by decreasing information technology budgets. Web services has since settled into a predictable adoption curve. A few bold companies are running trials, while most firms wait for the relevant standards to mature. Vendors like Sun, Microsoft, and IBM will need to show a track record of successful deployments and support services before most businesses will be interested in adopting complex new systems.

Outsourcing Overseas

Many software engineers lost their jobs to the economic downturn. IT budgets are often based on a percentage of revenues and as revenues fell, so did IT spending. But even as the economy shows signs of recovery, software design jobs are not necessarily coming back, at least not in the United States.

Instead, IT jobs are being outsourced overseas. Many software developers have found their positions exported to India, China, Russia and other countries. Lumenare Networks, a California company that creates programs for testing software and networking equipment, nearly shut down in 2001 under heavy debt. When the board hired new executives to rescue the company, one of their first moves was to fire contractors writing software for $180 per hour and replace them with a team of programmers earning $10 to $20 per hour in Noida, India. The switch was so successful that the company soon laid off 30 more Californian programmers and hired replacements in Noida. "I don't think the company would be here if we hadn't made these moves," said Phillip Cavallo, Lumenare's CEO.

When starting up new companies, entrepreneurs and venture capitalists are making overseas outsourcing part of their business plans right from the start. Start-up companies continue to incorporate in the United States in the hopes of winning American customers, accessing US investment capital, and going public on American stock exchanges. But once these companies develop their technology products, the cost of readying them for the marketplace frequently forces young companies to turn to international resources.