Short term AiMs for small cap Software and IT Companies

Small Cap Software and IT Companies, especially those on AiM are feeling the pain. This comes from the macro economic environment, being public where there is no liquidity, little praise for good news and a lack of interest in smaller companies. The sector remains US led with only two European companies featuring in the global top 15 IT companies by market cap. These larger companies are on the prowl and are ready acquire undervalued companies. Many of the European and certainly UK software companies are niche market players which make them attractive targets so that others can build scale or add complimentary products. For those companies with deep pockets consolidation is most certainly the name of the game for the industry over the short term.

Fewer brands in fewer hands

Further evidence (following recent declines in growth rates) of a mature market is that the number of UK main market listed IT companies has halved in less than 3 years, a trend dominated by global consolidation. The AiM market currently has 112 software companies with £3,029m of market capitalisation. The  low average valuation continues to highlight that many came to market to secure venture funding when it was not available elsewhere and the equity currency, which may have been envisaged, has not materialised. There is no reason to suggest that the AiM market will not befall the same fate as the main market, albeit the reduction in companies may come from UK centric consolidation or public to private transactions. Unfortunately, coupled with this there are also likely to be some casualties in the current economic climate. The landscape of the UK IT and software industry may look very different by 2010.

Bargain-hunting by the big boys

Central banks across the world are reducing the cost of capital in a bid to stoke up demand. This will further weaken sterling and attract foreign shoppers, looking to invest in companies where they consider the market has underpriced the business. Companies listed on AIM tend to be less well established and have weaker balance sheets than companies on the main exchange. The current lack of credit in the market is likely to be felt most by companies that do not have proven products and whose balances sheets do not have tangible assets. Assets in the software sector are predominantly intangible, and valuations of these tend to be more susceptible to swings caused by market conditions. In the search for investors it is essential that software companies can present the value in their product clearly, making the best use of hard facts such as sales to date, the length of contracts, customer credit ratings, the number of customers and historic renewal rates.

Tips to ride out the recession rollercoaster

In the current period of macro uncertainty, it is critical for companies to focus on the fundamentals and return to basics: -

• Targeted cost effective innovation is very important for small cap IT companies. Software or service that addresses security issues or is a cost saving proposition for organisations is likely to be more successful.
• Cash is king - valuations will increasingly focus on company's free cash flow. Don't underestimate the value of quality of management. They must really understand how their technology works and more importantly be able to convey this to the market.
• Licensing products or services for defined terms as opposed to perpetuity will give the buyers more flexibility and more certainty over their commitment. This will result in a slower but less volatile growth for companies in this sector.
• Given the mature state of the industry, strategic partnership(s) with a large vendor(s) could be the key to success.

The months ahead may well be defining for a number of the companies as they battle with tough economic conditions, weaker demand and a lack of funding. We may be about to see a fundamental shift in the market place, such that the sectors is more concerned about survival than product innovation. The reality is that the market has matured and developments such as Open Source, software as a service, and outsourcing have to a large extent been the true drivers of the squeeze on IT spending for a number of years, rather then the more recent "credit crunch." The fact remains that IT is the backbone of many (if not all) organisations and as such too critical for large scale cutbacks, as such there will continue to be winners and losers.

Finally, it remains critical that the industry remains focused on exploiting the innovation which exists in the UK and others, including the government, need to help, to ensure the UK remains competitive.