Watch For Mergers and Acquisitions, and Big Gains, In This Sector

Mergers and acquisitions (M&A) are among the events that move markets. But, M&A activity tends to be unpredictable. The recent acquisition of Dr Pepper Snapple Group, Inc. (NYSE: DPS) shows both the unpredictability and the potential rewards.

The announcement of the deal was a surprise. However, it was a pleasant surprise to share holders of DPS who saw the stock price rise by more than 32% on the morning the deal was announced.

Because of the possibility of outsized gains like that, some analysts are always on the hunt for potential deals. One analyst recently tapped the software industry as a potential source of M&A deals in the next few months.

Deal Making Could Soar

Deal making tends to go in and out of fashion. The reason for that is simply the potential for profits. Right now, conditions appear to be turning more favorable for deals.

One reason there could be more deals is simply because there is likely to be more cash available to complete the deals. Under the tax reform law that was passed at the end of last year, companies are repatriating cash from overseas.

The companies will get a lower tax rate on the cash that comes back but there is no longer an incentive to allow cash piles to grow to large levels. Before tax reform, holding cash was a tax avoidance strategy. That incentive no longer exists under the new rules.

One of the sectors that has the largest cash piles is the tech sector. Analysts are looking at software companies as a potential source of deals.

But, cash is not the only reason to expect M&A activity. A rising interest rate environment may temper stock market trading gains, making target companies look more affordable, says RBC Capital Markets. And, large software companies will aim to acquire promising technology or software designed for specific industries.

“Less multiple expansion, (overseas cash) repatriation and innovation tailwinds could drive a bigger M&A year,” said RBC Capital analysts in a report.

This would mark a reversal in the software industry. M&A slowed among software companies in 2017 as a booming stock market sent the trading multiples of possible targets higher, and as some looming buyers, including Microsoft (Nasdaq: MSFT), Oracle (NYSE: ORCL), Salesforce.com (NYSE: CRM) and privately held SAP, consolidated earlier acquisitions.

Oracle recently raised $10 billion in the bond market, giving it cash to tap for acquisition, noted Terry Tillman, a SunTrust Robinson Humphrey analyst in a report.

“Oracle has made its strategic intentions well known publicly and it includes maximizing growth opportunities associated with SaaS, Platform-as-a-Service (PaaS) and Infrastructure-as-a-Service (IaaS),” said Tillman in a report.

Adam Holt, analyst at MoffettNathanson, has some specific targets in mind. He believes some large companies are likely to acquire capabilities they lack right now instead of developing every software tool in house.

Holt identified Microsoft, Oracle and Adobe Systems (Nasdaq: ADBE) as companies that fit into category. He also believes VMware (NYSE: VMW) as another potential deal maker.

Dell Could Make a Deal With VMW

According to CNBC, Dell Technologies could emerge as a public company through a reverse-merger with VMware. The reverse merger, whereby VMware would actually buy the larger Dell, would then allow Dell to be traded publicly without going through a formal listing.

It would also likely be the biggest deal in tech industry history, giving investors who backed Dell’s move to go private in 2013 as a way to monetize their deal, while helping Dell pay down some of its approximately $50 billion debt.

VMware’s stock fell sharply on the news but could be attractive after the sell off.

The stock now trades at about 22 times next year’s expected earnings and that doesn’t include potential benefits of a deal.

Watch the Hottest Companies

Some analysts noted that for many buyers, the focus is expected to be on fast-growing software-as-a-service, or SAAS, companies. The customers of SaaS vendors purchase renewable subscriptions, rather than one-time, perpetual software licenses. Customers receive automatic software updates via the web.

The SaaS software market rose 23% to $43 billion worldwide in the first half of 2017, according to data provided by market research firm IDC. The overall software market will grow 8.5% in 2017 and 2018, says Gartner, another market research firm. This means SaaS companies are gaining share overall.

While some SaaS markets are maturing, such as human resources and customer relationship management, SaaS companies are expanding into analytics, IT services, financial and other areas.

While revenue growth has been the strong point of many SaaS companies, Goldman Sachs says some could face top-line pressure going forward, making them more amenable to being acquired at the right price.

“Our view is that the wave of M&A is slowly beginning to build, and we would expect to continue to see a healthy dose of best-of-breed vendors consolidated into both legacy software vendors like Oracle and SAP, as well as ‘born-in-the-cloud’ vendors like Salesforce and Workday,” said a Goldman Sachs report.

Goldman Sachs says targets could include Zendesk (NYSE: ZEN), Cornerstone OnDemand (Nasdaq: CSOD), or HubSpot (NYSE: HUBS).

Holt, the MoffettNathanson, analyst, believes that Workday (Nasdaq: WDAY) and ServiceNow (NYSE: NOW) are on “several wish lists” but their valuation soared in the first nine months of 2017. Both stocks have been market leaders and remain richly priced.

Workday sells software for human relations, payroll and other business functions. The company has expanded from the human capital management (HCM) into financial software.

Salesforce.com, a pioneer in SaaS, is also a potential target according to some analysts. The company sells software that helps businesses organize and handle sales operations and customer relationships. Salesforce.com has expanded into marketing, customer services and e-commerce.

Salesforce.com has forecast organic revenue growth over 20% through 2022. But, it could be a buyer, according to analysts at William Blair.

“There is the potential for a mega SaaS tie-up (Salesforce/Workday being the granddaddy of them all), though our sense is the odds are greater for acquisitions to be driven by the on-premise (Microsoft, Oracle) vendors,” said a William Blair 2018 outlook report.

One trend that could accelerate M&A within the software industry are partnerships with cloud computing vendors Amazon Web Services, Microsoft and Alphabet-Google.

AWS and Microsoft’s Azure service rent computing power and data storage to large companies via the internet. They’re also moving into software-related “PaaS”, or platform as a service, which involves selling apps that run on cloud infrastructure.

More large companies are shifting business workloads from private data centers to cloud computing services.

“PaaS is disrupting traditional enterprise software much faster than most realize,” said a Cowen report. It estimates that the PaaS market jumped 50% to $8.5 billion in the first half of 2017.

Acquisitions could deliver quick gains and investors should consider companies cited by top analysts as potential buys.