Will the middleware M&A train stop at Iona next?

Analyst: Dennis Callaghan
Sector: Enterprise Software »»
Date: 25 Mar 2008
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In a year that has already seen middleware vendors large and small acquired, it's no surprise that Iona Technologies (Nasdaq: IONA), a middleware vendor with a sagging stock price and a transitional business, is fielding offers. Such an acquirer would get a maintenance stream, some promising new technology, middleware expertise and a developing commercial open source business model. We think SAP (NYSE: SAP) or Sun Microsystems (Nasdaq: JAVA) would make the best home for Iona, but given the dynamics of the company's business, a private equity buyout cannot be discounted.

Target background

Iona was founded in Dublin, Ireland, in 1991 by Trinity College computer science professors Christopher Horn and Sean Baker. The company brought its first product to market in 1993 and went public early in 1997. Its flagship has long been its CORBA-based Orbix application integration technology, though the company has in recent years introduced software for the more Web services-intensive integration world of today: first with its Artix enterprise service bus (ESB) product, then through acquisition, with its Fuse open source ESB. Iona has also added related technologies through both development and acquisition, like a services registry and repository and data services integration software.

In February, Iona first acknowledged that it had been approached by potential buyers, but not that it had received any offers. Later it announced it had retained Lehman Brothers (NYSE: LEH) to advise its board on any strategic moves, including a possible sale or merger. Iona's low market capitalization relative to its revenue is one reason the company could be an attractive acquisition target. Its market cap now stands at about $140m after the company reported revenue of $77.7m in 2007. Even with its stock price being bid up in recent weeks, it still represents a bargain over this time last year when Iona's market cap was $217m at an almost identical revenue level. Iona's revenue was nearly flat in 2007 and it took a $738,000 net loss, despite generating more than $11m in cash. But product revenue dropped at the company, from $42m to $39m, as declining revenue for Iona's legacy Orbix product, which still accounted for about 65% of the company's revenue, was not offset by revenue from the company's other product lines. Artix accounted for 33% of Iona's revenue in 2007, while the open source Fuse accounted for just 2%.

Iona did move to diversify its product lines in 2007, spending more than $10m to acquire data services integration company C24 and open source integration software provider LogicBlaze, with the latter acquisition accounting for most of the company's new Fuse product line. The company expects those acquisitions to be accretive to earnings this year and projects an overall revenue increase to more than $80m.

Although still based in Dublin, Iona gets the majority of its revenue – $42.9m of $77.7m last year – from the Americas, with EMEA contributing $25.1m and Asia the remaining $9.7m. The bulk of Iona's revenue comes from four verticals: telecommunications, manufacturing, financial services and government. Two customers, Boeing (NYSE: BA) and AT&T (NYSE: T), accounted for nearly 30% of Iona's 2007 revenue.

At the end of January, Iona had 335 employees worldwide – 130 of those in product development. But the company has planned for $8m in cost-cutting measures after its disappointing 2007 financial results.

Recent related acquisitions

The biggest related deal that has presaged more consolidation in the middleware space is Oracle's (Nasdaq: ORCL) $8.5bn acquisition of BEA Systems (Nasdaq: BEAS) announced in January. A much smaller, though not necessarily insignificant deal in relation to Iona, is Workday Inc's acquisition of Iona's Irish rival Cape Clear Software in February for an estimated $35m. Progress Software (Nasdaq: PRGS) made a small deal to buy French integration software firm Xcalia, announced in March but likely completed in January, which is relevant to Iona mainly because Iona bought data services integration firm C24 last year. Progress acquired Xcalia to get its hands on similar technology. Software AG's (FRA: SOWG.F) $546m acquisition of webMethods last year also serves as a bellwether deal in the middleware space.

Selected recent middleware M&A activity

*Official 451 Group estimate. Source: The 451 M&A KnowledgeBase

Potential buyers

Much initial press speculation has focused on Software AG as a potential acquirer, as it has been active on the acquisition front since buying webMethods last year, has stated its intentions to make several acquisitions this year and, like Iona, is a European-based company. There would be parallels between such a deal and Software AG's recent acquisition of Jacada (Nasdaq: JCDA), which it essentially bought for a maintenance stream and to consolidate the legacy modernization space. Buying Iona would also give Software AG a maintenance stream from Iona's legacy Orbix product and would be more of a consolidating move, as Software AG has most of what's in Iona's portfolio. Software AG did, however, indicate its interest to us last year in buying a data integration company. The assets Iona acquired from C24 last year could be attractive to the company. However, we're a bit more skeptical about Software AG wanting any parts of Iona's Fuse assets, though they remain a very small part of Iona's business today.

Perhaps another German software company would make an even stronger candidate: SAP. The companies surely have plenty of customers in common. In fact, Iona's two largest customers, Boeing and AT&T, are both SAP reference customers as well, and AT&T became a strategic SAP hosting partner this year. So, large customers could drive such a union. And Workday's acquisition of Cape Clear has created some precedence for a deal like this between an application software provider and an integration software provider. It would also be a way for SAP to counter Oracle's acquisition of BEA, without scrapping its own NetWeaver application integration strategy. Buying Iona could give SAP integration assets and expertise that could be absorbed into NetWeaver, something that would be harder to do if SAP bought a larger integration firm, like Tibco Software (Nasdaq: TIBX). Even the Fuse assets shouldn't be a deterrent to SAP, as they would give SAP the chance to experiment with open source without affecting its core application software business. Another connection between the two companies is Business Objects, which SAP acquired last year and which serves as a key ISV distributor for Iona.

We could also make a pretty strong case for Sun Microsystems buying Iona. Sun's integration technologies today are mainly based on its acquisition of SeeBeyond Technology in 2005. Those products give Sun strong technology for Java-messaging-based integration, business process management and composite application development, whereas Iona's software revolves around Web services integration. Iona could also give Sun a services registry/repository and data services integration technology. In addition, Iona, like Sun, has embraced open source – Sun is making all its products open source. So there are a number of synergies we see between Sun and Iona. Buying Iona would also raise Sun's profile in the overall middleware space, as the company is still predominantly associated with server and application development technology today.

Red Hat (NYSE: RHT) cannot be discounted as a suitor either, as the company has made its intentions known to consolidate the open source middleware space. Buying Iona would remove an open source middleware competitor for Red Hat's JBoss division, though 98% of Iona is closed source technology today, which Red Hat might not want to bother with. We doubt Iona's board would go for a deal that saw the company carved up and spun out into multiple pieces.

Potential public acquirers of Iona

A private equity buyout is still a possibility, too, as Iona remains in a transitional stage: trying to replace declining revenue of its legacy Orbix business, which is falling faster than its Artix and Fuse business revenues are growing. This could mean future declining revenues and earnings impacted by restructuring costs until the Artix and Fuse businesses mature enough to offset the Orbix drop-off. So leaving aside takeover rumors, Iona's value on the public market isn't likely to change much in the foreseeable future, and the company remains somewhat undervalued, trading at less than 2x revenue, even with the price bid up by acquisition expectations over the past month.

Peninsula Capital Management appears to be Iona's largest institutional investor. It has acquired nearly 570,000 shares of the company this year, giving it more than six million shares in Iona, about a 17% stake – by far its largest declared holdings in any company. Iona cofounders Baker and Horn own about 3.5 million shares between them. Failing a substantial takeover offer, going private could be an attractive option for the company, though PCM, a hedge fund, is increasing its stake in Iona in expectation of such a bid rather than planning a private equity buyout of the company.

Given Iona's reliance on a handful of large customers, a customer buyout is not out of the question either. However, we think it's more likely that large customers would broker a deal between Iona and another strategic vendor they deal with, such as SAP, rather than acquire Iona themselves.

Competitive landscape

Iona sees IBM (NYSE: IBM), Oracle, Software AG and Tibco as its primary competition today. We would add Progress Software's service-oriented architecture (SOA) infrastructure and DataDirect groups to that list, though neither company has ever really identified the other as a presence on prospective deals. Red Hat-JBoss, MuleSource and Sun are competitors, especially as Iona seeks more of a presence in open source middleware. With Iona trying to increase its presence in SOA governance, it figures to challenge point competitors like SOA Software and Hewlett-Packard's (NYSE: HPQ) Systinet technology, which it picked up when it bought Mercury Interactive.

Looking ahead

From the announcements Iona has made to this point, it's clear that the company is fielding takeover inquiries and taking them seriously. That said, Iona is generating cash and projecting revenue growth this year as its acquisitions of the past year begin to make top- and bottom-line contributions. We wouldn't discount Iona's long-term growth potential either, as the company has taken steps to modernize its business, even as its Orbix business for now is contracting faster than its newer product lines are expanding.

So in other words, Iona doesn't really need to sell and will likely hold out for a strong multiple, at least 3x revenue. Recall that BEA got a 5.2x multiple from Oracle – we don't think Iona will command that much – while webMethods got just 2x from Software AG, which we think Iona can beat. But with a hedge fund holding nearly 20% of Iona, a deal will likely get done by the second quarter. We wouldn't rule out any of the companies we mentioned above or a private equity buyout, but we think this deal makes the most sense for SAP and Sun, in that order.