Mainframe Software Makers Have Seen The Future--And It's Rugged

Information Processing

As The Computer Slump Trickles Down, They'll Be Taking Refuge In Mergers

Anne R. Field in New York
With Barbara Buell in Boston, Zachary Schiller in Cleveland, and Jim Hurlock in Dallas
Business Week

December 23, 1985

The high-flying mainframe software business is coming down to earth. Since 1980, both International Business Machines Corp. and the dozens of smaller companies that supply the non-IBM third of the $4.5 billion market have thrived as total industry sales grew at 17% a year. A handful of the industry's major independents grew at 40% annually. But reverberations from this year's computer slump have finally hit the software business: Annual sales growth is heading for single digits, prices are falling, and major consolidation seems likely. Says Stephen T. McClellan, a vice-president at Merrill Lynch & Co.: ''The software industry is in a state of structural change.''

The opening salvo in this restructuring took place in November, when Ameritech Corp., the Chicago-based regional Bell telephone company, bought Applied Data Research Inc. for $215 million. ''Ameritech is just the first,'' says Dennis J. Yablonsky, president of Cincinnati-based Cincom Systems Inc. He expects not only buyouts but a growing string of joint-marketing agreements and other alliances. Says Richard G. Sherlund, a Goldman, Sachs & Co. analyst: ''It's a classic case of an industry in a maturation process.''

The transition is creating both short- and long-term problems for the industry. The collective revenues of seven major software producers targeted by a recent Gartner Group Inc. study, for example, are rising only one-sixth as fast this year as last. Combined with unrealistic assumptions about continued high growth, this has had a major impact on earnings. ADR, for example, planned its 1985 budget of $183 million on the basis of its stellar 42% growth in sales the previous year. But this year's rate of increase slowed to a disappointing 24%. The company lost $2.3 million in the nine months ended Sept. 30, and Ameritech moved in.

For many years, high-growth assumptions were perfectly valid. Though IBM holds between 60% and 70% of the market, its mainframe software products are largely operating systems that control the basic functions of computers. The independents have thrived by targeting two other segments. They've captured 40% of the market for data-base management programs used to retrieve information from banks of data. And they've won most of the market for applications programs, used for such jobs as accounting.

'MAJOR WARFARE'

But the rapid growth that turned some of the independents into big companies sowed the seeds of basic problems that now cloud their future. When they were small, these companies could react quickly to changes in demand. Their products also were cheap enough that they didn't fall prey to cost-cutting campaigns of their customers. Once they ballooned past the $100 million mark, however, the reaction time of many independents slowed. As the markets for data-base and applications programs have become saturated, most of the major companies have tried to grow by invading each other's turf. ''There's major warfare going on,'' says Paul Cubbage, senior industry analyst with Dataquest Inc. Three years ago, for instance, Cullinet Software Inc. didn't sell mainframe application programs. Now it has 17% of the business.

Moreover, the independents have found that it's not as easy to peddle software when the price gets high. Customers are demanding ever more sophisticated--and expensive--products. For example, they are buying suites of interrelated data-base management and applications programs that can cost up to $1 million. Such purchases are being scrutinized by higher-level executives, and approvals are taking longer. Even after careful deliberation, suppliers say, sales are harder to close.

IBM, which still owns the market for operating systems, has avoided such problems. But companies selling data-base and applications software with top-end price tags of $200,000 to $1 million per copy are hurting. Cullinet, the bellwether of the industry, announced a 39% decline in earnings, to $3.6 million, for the second quarter ended Oct. 31. That followed the previous quarter's 23% decline, to $4.2 million--Cullinet's first year-to-year drop in 29 quarters. Management Science America Inc., the leading applications company, lost $3.4 million during its last quarter ended Sept. 30, compared with a $1.7 million loss in the same period a year before. Software stocks tell the tale: Cullinet fell from 31 in May to 16 on Dec. 9.

The future could be even darker for the data-base companies, as IBM moves aggressively into their territory. Last April, Big Blue introduced a $40,000 data-base program, DB2, to compete with the key products of many independents. Although analysts say the program does not perform as fast as others, many customers are delaying purchases until they can get ahold of DB2 and test it.

GETTING CHEAPER

All of this is leading to projections of lower industry growth (chart, page 69). Software shipments should decline from a compound annual rate of 17.4% from 1980 to 1984, to 6.9% between 1985 and 1989, according to Dataquest. Even rapidly rising sales of IBM's new mainframe, popularly known as Sierra, won't be enough to prop up orders: Sierra can use much of the software made for earlier IBM machines.

Faced with intense competition and new buying patterns, software companies have been forced to rely on price-cutting to boost sales. Until recently, their sales depended primarily on the merits of their products and on the extra support they could provide. But to differentiate their products further, analysts say some companies are cutting prices by as much as 40%.

Prices can go only so low, however. Inevitably, many companies will follow the lead of ADR and find a merger partner. Aerospace, media, and defense companies may buy software outfits to gain both easy entry into the software market and technology that can be used to develop their own new products. Industry observers say that even IBM may acquire a software company to expand its tiny share of the market for applications programs. Some good may come from this trend. Merging with bigger partners means the software companies would no longer have to worry about pleasing stockholders with short-term gains. This would free them to devote more resources to research and development. And it would be easier to convince customers of the software maker's long-term viability. ''IBM has been selling on the strength of the company, the usual 'uncertainty' technique,'' says John R. Bennett, ADR's chairman. Now that Ameritech is behind ADR, ''we feel confident that we can go head-to-head with IBM.''

But for those who don't merge or enter into corporate alliances, the going will be rough. Slower growth will require more cost-cutting that could mean big cutbacks in R&D--the key to any software company's long-term survival. For these companies, coming down to earth may mean a rough landing and a lot of bruises.

Graph: SLOWER GROWTH FOR MAINFRAME SOFTWARE