Public Internet Company Financial Performance

The following article is from Software Equity Group’s 2011 Q3 Software Equity Industry Report.  A complimentary copy of the quarterly report can be downloaded here: http://www.softwareequity.com/research_reports.aspx

Internet providers in the SEG Internet Index closed 3Q11 with a median TTM revenue growth of 20.9%, up slightly from 2Q11’s TTM growth rate of 20.2%.  One out of four companies in the SEG Internet Index posted TTM revenue growth rates greater than 35%.  Considering the median TTM revenue of public Internet companies is $342 million, the largest among our three tracking indexes, the growth rate is especially impressive. Public SaaS companies had median TTM revenue of $187.1 million in Q3, yet only a slightly higher TTM revenue growth rate of 24.9%. 

Equally impressive, Internet companies achieved a median EBITDA margin of 16.4% in 3Q11, modestly less than the 18.4% median EBITDA margin of public on-premise software companies, but considerably greater than the 9.5% median EBITDA posted by public SaaS companies (Figure 17).  The solid profitability of these Internet providers  contributed to very healthy balance sheets, with median cash and cash equivalent balances greater than $130 million, up 25% QoQ and 29% YoY, and a strong current ratio of 2.7 (Figure 16).

The solid EBITDA margins of public Internet companies are particularly extraordinary when taking into account the mashup nature of Internet business models which typically involve significant revenue sharing.  The median gross profit margin of Internet providers was 65.2% in 3Q11 compared to a third quarter median 66.8% margin of public software companies and a median 69.3% margin of public SaaS companies.  Public Internet companies typically compensate by spending less on Research & Development and Sales & Marketing than their on-premise and SaaS software peers.  In 3Q11, Internet companies spent only 9.3% of revenues on R&D whereas their SaaS and on-premise peers spent 15.0% and 13.9% respectively.  Similarly, Internet companies spent only 20.6% of revenues on S&M compared to 33.2% and 24.4% by SaaS and on-premise peers respectively.

Public Internet Company Market Valuations and Financial Performance by Product Category

The following article is from Software Equity Group’s 2011 Q3 Software Equity Industry Report.  A complimentary copy of the quarterly report can be downloaded here: http://www.softwareequity.com/research_reports.aspx

Segmenting the public Internet companies comprising our SEG Internet Index into discrete product categories can provide valuable insight about market trends, sector health, product lifecycles, Internet retail and advertising spending impacts and stock market biases.  But perhaps most importantly, we track this data because the current median valuation of companies comprising a particular Internet category often weighs heavily when buyers value acquisition targets.

The SEG Software Index is comprised of eight Internet product categories:

  • Ad Tech & Lead Generation – Companies that provide key elements in the Internet advertising arena such as search marketing services, software to host and manage ads and a network of websites that run ads.  Representative companies include ValueClick and SINA.
  • Infrastructure – Companies that provide key elements in hosting, communications, storage and content delivery.  Representative companies include Akamai, Rackspace, Digital River and VeriSign.
  • Media – Companies that provide or distribute content online.  Representative companies include Yahoo, Netflix, Pandora Media, Demand Media and Youku (often referred to as China’s Youtube).
  • Retail – Companies that facilitate retail transactions online.  Representative companies include Amazon, eBay and Mercadolibre.
  • Search – Companies that operate search engines.  Representative companies include Google, Baidu and Yandex.
  • Services – Companies that provide various services including, but not limited to, photo sharing, social networking and security over the Internet.  Representative companies include Shutterfly, LinkedIn, Ancestory.com and Renren (often referred to as China’s Facebook).
  • Travel – Companies that facilitate ticketing transactions for the travel industry.  Representative companies include Priceline, Ctrip and Expedia.
  • Video Games – Companies that primarily deliver video games through the Internet.  Representative companies include Netease, ChangeYou and NCSoft.

Enterprise valuations of companies comprising the SEG Internet Index varied widely by Internet category in 3Q11 (Figure 19).  Internet services companies, the only Internet category to experience QoQ growth in median EV/Revenue, led all of its counterparts in 3Q11, posting a median EV/Revenue multiple of 5.1x.  The median EV/Revenue multiple was boosted by Qihoo (26.0x), a provider of online security based in China; by LinkedIn (22.5x), the well-known social media service for business professionals; and by Renren (21.3x), a Chinese social media provider known as the Facebook of China.

The Travel product category followed close behind, with a median EV/Revenue of 5.0x in Q3.  The Travel product category had been the Internet leader in median EV/Revenue for the prior three quarters, but suffered a dramatic 31% drop in QoQ valuation from 2Q11 to 3Q11, the worst among all product categories.  The selloff is most likely attributable to decelerating TTM revenue growth, which declined from 34.5% in 2Q11 to 25.7% in 3Q11.  Despite the drop, the category still boasts two companies with median EV/Revenue multiples greater than 10.0x – HomeAway (17.6x) and Ctrip (10.4x).

The stark contrast in financial performance and market valuation of on-premise vs. online is especially poignant in the video game category. Video game developers that generate the majority of their revenue through on-line gaming are significantly outperforming those that generate the majority of their revenue through retail.  In 3Q11 software companies distributing games through retail channels closed 3Q11 with 0.1% TTM revenue growth rate and a 8.7% EBITDA margin – the lowest among all SEG Software Index product categories.  Predictably, these public software companies had a median EV/Revenue of 1.1x in 3Q11, the lowest, as well, of all SEG Software Index product categories.

Conversely, public Internet providers that host their games online posted median TTM revenue growth of 29.7%, and staggering EBITDA margins of 49.7%.  In response, investors rewarded these Internet game purveyors with a median EV/Revenue multiple of 4.6x (Figure 19), led by Tencent Holdings (11.3x) and NCSoft (9.6x).  We expect the disparity among retail vs online gaming developers to increase, given the growing popularity of more community focused games, smart phone gaming enablement and the wild successes of Zynga and a host of other players that have leveraged the Facebook platform and mobile app stores.

As the result of these favorable market dynamics, the Video Game segment led all other Internet product categories in TTM revenue growth (29.7%) and EBITDA margins (49.7%).  While their revenue performance was not quite as impressive, most other Internet categories reported solid revenue growth, with seven of eight product categories generating Q3 top line improvement in excess of the SEG Software Index’ 14.7% median TTM growth rate.

Profitability varied widely among SEG Internet product categories.  Video Game providers generated the highest EBITDA margins at 49.7% while the Retail product category generated the lowest EBITDA margins of 9.4%.

The stark contrast in profitability is in large part attributable to the high degree of profit sharing inherent in some Internet business models.  Advertising and retail are two product categories heavily reliant on revenue sharing business models, and consequently posted the two lowest median gross profit margins among the eight product categories we track (Figure 20).  Unsurprisingly, both categories also posted median EBITDA margins below the Internet median.

Initial Public Offerings

The following article is from Software Equity Group’s 2011 Q3 Software Equity Industry Report.  A complimentary copy of the quarterly report can be downloaded here: http://www.softwareequity.com/research_reports.aspx

After a remarkable 2Q11, the IPO market slowed dramatically in the early part of 3Q11 before grinding to a halt at the end of the quarter due to whiplashing market volatility.  All four companies that went public in 3Q11 – Zillow, Tangoe, Carbonite and Tudou Holdings – listed in the first two months of the quarter.  Collectively, the four IPOs raised over $375 million at an average of roughly $94 million per IPO, down significantly from the average of $344 million per IPO in the second quarter.  Two anxiously awaited IPOs – Groupon and Zynga – opted to delay their coming out parties. As of the close of the third quarter, 17 companies have gone public in 2011, a marked increase from the twelve that initially listed in the first three quarters of 2010.  Internet IPO volume has been particular strong, with 13 newly listed companies, compared to only one through three quarters of 2010.

By the close of Q3, 2011’s seventeen newly public software/SaaS/Internet companies had a median stock return of -27.3%.  Three of the four companies that listed in 3Q11 fared far worse, off 49.4% or more from their initial IPO price.  Only four of the 17 posted positive YTD stock returns: Zillow, HomeAway, LinkedIn and Ellie Mae.  The best performer was LinkedIn, returning 73.5% by the quarter’s close.  While the allure of investing in social networking was partially responsible, LinkedIn’s 102.4% revenue growth and 13% EBITDA margin was undoubtedly received by investors as proof positive of the company’s value proposition.  Interestingly, the five Chinese companies that IPO’d in 2011 had YTD stock returns at or below the median for the group.  Renren posted the worst result, down 63.6% from its initial IPO price.

In the current climate, IPO aspirants must demonstrate significant market traction, given investors’ demonstrated preference for revenue growth over profitability. The seventeen newly when they listed, well above the Q3 median of public software, SaaS and Internet companies. companies had median revenue growth of 63.9% Five of the newly listed companies achieved TTM revenue growth rates above 100%.  Yet even these outperformers fell victim to the market’s volatility, as only one (LinkedIn) of these overachievers generated a positive YTD stock return as of the close of the third quarter.

Ten software companies filed S-1’s in 3Q11, bringing the U.S. software IPO queue up to seventeen (Figure 22).  The IPO pipeline consists of a healthy group of software companies across the on-premise software, SaaS and Internet sectors.  Internet companies in the pipeline are much larger and growing considerably faster than their on-premise software company counterparts, with median TTM revenue of $127 million (vs. $66 million) and a median revenue growth rate of 201% (vs.32%), and only slightly less profitable when measured by median EBITDA margin (7.8% vs. 8.6%).  If the GDP begins to grow and investors regain their appetite for newly listed companies with strong revenue growth and growth potential, Internet IPOs should continue to outperform their software counterparts.

M&A Deal Volume and Spending: All Industry Sectors

The following article is from Software Equity Group’s 2011 Q3 Software Equity Industry Report.  A complimentary copy of the quarterly report can be downloaded here: http://www.softwareequity.com/research_reports.aspx

Globally, the third quarter’s 12,142 M&A transactions across all industry sectors eclipsed the previous post recession peak of 11,722 transactions set in 1Q11.  3Q11’s tally represents a 23% YoY increase from 3Q10’s 9,872 M&A transactions, and a 5% gain over 2Q11’s 11,515 M&A transactions.  Despite the record number of worldwide M&A transactions, the total spend of $606 billion in 3Q11 was 10% lower than 2Q11’s $671 billion, and 12% off 1Q11’s post-recession peak of $691 billion.

Domestically, 4,089 M&A transactions were announced across all industry sectors in the third quarter of 2011 (Figure 23).  The 3Q11 U.S. deal total was down slightly from 2Q11’s 4,202 transactions, but up 21% year over year.  Mirroring the rapid pace of transactions internationally, domestic M&A transactions are also heading for record volume this year.  In 1Q11, there were more than 4,000 domestic deals, the highest domestic deal volume we’ve reported since we began tracking this metric in 2001.  The second and third quarters each exceeded 4,000 transactions, as well. Perhaps as important, buyers loosened their purse strings over the past year.  In 3Q11, acquirers’ spent an aggregate $304 billion on 4,089 transactions, a whopping 35% more than 3Q10’s total price tag of $225 billion.  Average deal size also jumped, reaching $75 million in 3Q11, up from $67 million in 3Q10.

There were 622 worldwide leveraged buyouts in 3Q11, totaling $20.8 billion, compared to 658 worldwide LBOs worth $32.1 billion in 2Q11, and 695 in 1Q11 aggregating $25.5 billion.  The number of U.S. LBOs dropped to 213 in 3Q11 from 240 in 2Q11 and 233 in 1Q11.  The total spend on U.S. LBOs in the third quarter was $15.3 billion, down from $17.3 billion in 2Q11 but still considerably greater than the $13.1 billion total spent in 1Q11.  The drop in deal volume suggests PE buyers may be having a difficult time finding attractively priced targets in the face of rising valuations.  The largest LBO in 3Q11 was Apax Partners’ $5.8 billion acquisition of Kinetic Concepts, at 2.7x TTM revenue, a relatively high valuation of for a financial buyer.

Software/SaaS M&A Deal Volume and Spending

The following article is from Software Equity Group’s 2011 Q3 Software Equity Industry Report.  A complimentary copy of the quarterly report can be downloaded here: http://www.softwareequity.com/research_reports.aspx

To date, there were 405 reported software M&A transactions in 3Q11, virtually the same as in the second quarter (409) and third 3Q10 (407) (Figure 24).  Since M&A data for the quarter is often revised and released well into the following quarter, we anticipate the final deal tally for 3Q11 will exceed 420, the highest quarterly tally this year.  M&A deal volume has been above or very near its historically healthy level of 400 for six of the past seven quarters, following five consecutive quarters of sub-400 M&A transactions (4Q08 to 4Q09).  In the first three quarters of 2011, there have been 1,242 software M&A transactions, up 1.7% YoY for the same nine month period, and 30% higher than the 957 software deals reported for the first nine months of 2009.

A total of $23.8 billion was spent on 3Q11 transactions with announced price tags, 13% higher than 2Q11’s $21.0 billion, and the highest software M&A spend since 2Q07.  Software mega deals are in large part responsible, as nearly half of the total spend in each of 3Q11 and 2Q11 came from transactions greater than $500 million: In 3Q11, HP acquired Autonomy for an enterprise value of $10.3 billion; in 2Q11 Microsoft acquired Skype for an enterprise value of $9.1 billion.

Considering the irregular fluctuations in total M&A spend each quarter, YoY comparisons of TTM data are a more reliable measure to discern M&A spending trends. And the trend over the past year is encouraging.  On a TTM basis, total software transaction dollars aggregated $70.6 billion at the close of 3Q11, 49% greater than the $47.4 billion spent on software M&A deals at the close of 3Q10. Similarly, on a TTM basis, the average deal size increased for the sixth consecutive quarter to $42 million (Figure 25).

Software M&A Valuations

The following article is from Software Equity Group’s 2011 Q3 Software Equity Industry Report.  A complimentary copy of the quarterly report can be downloaded here: http://www.softwareequity.com/research_reports.aspx

The software industry’s benchmark median exit valuation fell to 2.2x TTM revenue in 3Q11 from 2.5x in 2Q11, but remained notably higher than the median 1.9x TTM M&A multiple reported for 1Q11 and 4Q10 (Figure 27).  The 12% drop in median exit multiple, combined with record software M&A volume, suggests that while buyers are still actively shopping for acquisitions, lingering uncertainty about the economy has made some more circumspect and is putting more pressure on valuations.

Lest every software entrepreneur who reads this report multiply his/her company’s TTM revenue by 2.2 to determine current fair market value, we must emphasize that the 3Q11 median exit multiple for software and SaaS deals is simply that – a median – the midpoint of a very broad range of exit valuations.  Perhaps more useful is our calculation that in 3Q11, 44.4% of M&A deals with reported EV/Revenue exit multiples had a 2.0x EV/Revenue multiple or less.  By contrast, 13.9% of M&A deals with reported EV/Revenue exit multiples had a 5.0x EV/Revenue multiple or more (Figure 28).

Since very few software transactions publicly identify a private software seller’s TTM EBITDA, we lacked sufficient data to ascertain the median EBITDA exit multiple paid in 3Q11 for private software company sellers.  We did, however, determine 3Q11’s median exit multiple for public software company sellers was 15.7x TTM EBITDA, a healthy improvement over 2Q11’s 14.7x and 1Q11’s 13.9x TTM EBITDA exit multiples (Figure 29).

Software M&A Valuations By Ownership

The following article is from Software Equity Group’s 2011 Q3 Software Equity Industry Report.  A complimentary copy of the quarterly report can be downloaded here: http://www.softwareequity.com/research_reports.aspx

While a variety of factors impact exit valuation, one important driver is the seller’s equity structure.  As a result, we analyzed all 2011 year-to-date (YTD) M&A transactions with ascertainable revenue multiples to determine how exit valuations varied by type of equity ownership (private vs. public company).

Public company sellers received a median 1.8x TTM revenue exit valuation, while privately held software company sellers commanded a median of 2.5 x TTM revenue multiple (Figure 30).  The higher exit multiples paid to private sellers continued a trend that began about four years ago when larger software companies and private equity firms virtually exhausted the supply of highly leveragable public software company targets with lots of cash and recurring revenue, and focused, instead, on private targets that were often venture-backed, growing rapidly and, consequently, expensive.  The latest examples are Riverbed ’s acquisition of Zeus Technology ($140 million, 7.5x TTM revenue) and Compuware’s acquisition of dynaTrace software GmbH ($231 million, 9.9x TTM revenue), both in Q3.  The high multiples paid for Zeus Technology and dynaTrace, providers of application delivery and application performance management software, respectively, demonstrate how expensive private companies competing in rapidly growing and transformative software categories can be.

As a next step, we separated public and private software company buyers to ascertain any difference in median purchase price paid in 3Q11.  Historically, public buyers have paid higher exit multiples than private buyers: 2.5x vs. 2.0x TTM revenue in 2007; 2.0x vs.1.7x in 2008; 1.9x vs.1.2x in 2009; and 2.4x vs.1.8x in 2010.  In 1Q11 we saw a significant expansion in premiums public companies were paying (3.3x vs. 1.5x), corresponding with a spike in their own public market trading multiples, which continued into 2Q11.  The trend moderated somewhat in 3Q11 as public valuations declined.  In 3Q11, public buyers paid a median 2.4x TTM revenue multiple, while private buyers pad a median 1.9x TTM revenue multiple.