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July 27, 2006updated 19 Aug 2016 10:09am

Mercury Falls as Temperatures Soar

For all of the talk of Hewlett Packard's acquisition of Mercury Interactive for $4.5bn being about giving HP much-needed capabilities in the area of IT governance, it's clear that Mercury was acquisition fodder the moment it went public with news

By Jason Stamper Blog

For all of the talk of Hewlett Packard’s acquisition of Mercury Interactive for $4.5bn being about giving HP much-needed capabilities in the area of IT governance, it’s clear that Mercury was acquisition fodder the moment it went public with news of its financial shenanigans in November last year.

If any company could possibly survive such a revelation — and the SEC has said there are 80 companies still being probed about possible stock option irregularities — it was not Mercury, which for several years had been explaining how its IT governance software could help with “visibility and control”, “transparency”, and to “lower the cost of compliance with regulations such as Sarbanes-Oxley”.

One need only to have looked at the case of Peregrine Systems, a so-called business service management software purveyor that was rocked by its own accounting scandal back in 2002 after a run of revenue-recognition irregularities, two changes of auditors, and the purging of all its top executives. Incoming CEO John Mutch did what he could to restore confidence in the firm, but he was fighting a losing battle and by September 2005 it had been acquired — by HP no less.

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While Mutch oversaw a new slogan for the company, “Evolve Wisely”, and even talked about making acquisitions of its own, he was honest enough to concede that it is rather difficult to regain confidence after an accounting scandal.

Asked in an interview with me last year whether his primary objective was to steer the company back out of Chapter 11 bankruptcy protection and sell it, Mutch was honest enough to hint: “It would be disingenuous to say that an HP or an IBM might not look at us and say ‘you are now a great $200m company’ and think about acquiring us. We’re a public company.”

That wasn’t the case at Mercury, which despite its apparent loss of face continued to argue that it would make a go of it as an independent company and come through the scandal intact.

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Speaking to me during the aftermath of the stock options scandal announcement in late 2005, Mercury’s chief marketing officer Christopher Lochead was adamant that being acquired was not in the game-plan: “The executive team doesn’t want to sell it,” he said. “People can speculate but we are absolutely not for sale.”

But by the beginning of May the business press in Israel, where Mercury has its roots, was full of the news that the company was conducting a “discrete auction” that had, at that time, elicited a $3.5bn bid from HP. Later rumours that a bid from EMC had pushed the price up were later denied by EMC itself, but the final figure HP is paying, $4.5bn, suggests at least one other party may have tabled a bid.

Either way, it was the accounting scandal that turned Mercury into a target. On the news of the scandal its stock dropped from $34 to $23 on Nasdaq, giving it a far-reduced market capitalization of $2.4bn.

Since Mercury is still in the process of restating a number of financial reports it’s difficult to draw conclusions about HP’s eventual purchase price of $4.5bn, and whether it represents good value to HP shareholders. But I will persevere.

Mercury’s stock had recovered to the $38 mark prior to its acquisition, giving it a market cap in the region of $3.3bn. Add to that the cash and equivalents of over $1.3bn that Mercury is understood to have had in the bank and the purchase price of $4.5bn appears to represent the market value of the company. Some of those questioning the 33% price premium over Mercury’s stock market valuation appear to have failed to take into account that cash in hand.

We also know that Mercury announced sales for fiscal 2004 of $685.5m, and in a limited filing about its 2005 results due to ongoing restatements, said that sales for 2005 were up around 22%. That gives the company sales for 2005 in the region of $836m, so HP’s purchase price (excluding Mercury having around $1.3bn in the bank) represents around 3.8 times its most recent fiscal sales.

On the face of it that’s a relatively low price-sales multiple, but one must take into account the fact that Mercury had been rocked by the accounting scandal and delisted from Nasdaq’s main market to boot.

There will be much pondering, too, as to whether Mercury’s software will be a hit at HP. We have already been contacted by one former disgruntled HP executive who ended up at the company after his software firm was acquired, and who noted that: “Their track record in everything related to software is disastrous: eSpeak, SoftBench, Bluestone, Verifone, etc. Nothing that they have done in this millennium would lead me to believe that they have learned anything from these previous fiascos.”

It is true that HP’s track record in software is poor to say the least. This is particularly true in the middleware space where its strategy was to build its own, then partner with BEA, then buy Bluestone and continue to partner with BEA, then shut Bluestone and partner with all of the major middleware vendors instead.

But for all of its software shortcomings its OpenView systems management suite still has a good reputation in the systems, network and IT service management spheres, and has remained a reliable competitor to the chief rivals IBM, CA and Compuware.

What it lacked though was the overarching management framework that provides a view not only of systems and network management but that offers senior IT personnel a dashboard view of all of their projects, and crucially tallies cost and time budgets with delivery.

This is what Mercury brings to the table. Sceptics would argue that HP has waited too long and so paid the price: Compuware bought IT governance with its $100m purchase of ChangePoint in May 2004, and CA bought into IT governance with the $350m purchase of Niku in June 2005. Even the beleaguered Borland saw the value in IT governance some time back, buying the admittedly small project portfolio management outfit Legadero in October last year.

But while IT governance is clearly one of the big reasons for the acquisition of Mercury, one should not forget that it was only a small part of its portfolio. Its bread and butter was automated software testing tools, to which it had gradually added application performance and availability management, moving from pre-deployment technology to applications that optimised applications after they had been put into production.

These technologies, added to its IT governance technology, were well marketed under the umbrella it called “Business Technology Optimisation”. Not only had it successfully managed to diversify beyond its testing tools roots while many of its rivals fell by the wayside (Segue’s acquisition by Borland being the latest example), but it did a relatively good job of educating the market about the importance of “quality” in software development and deployment.

It wasn’t for no reason that the company had become a Wall Street darling before its accounting scandal, consistently delivering exemplary revenue and profitability growth. As the firm’s chief marketing officer Christopher Lochead told me earlier this year, “We love our technology and we love beating the s**t out of our competitors.”

With its acquisition of Mercury, HP says it will almost double the size of its software business. But whether it is able to retain Mercury’s apparent passion for its BTO vision — let alone replicate Mercury’s exemplary marketing of that same vision — is a big question considering HP’s software acquisition history.

On a conference call to discuss the acquisition, HP chief financial officer Bob Wayman acknowledged that the ongoing restatement could potentially leave HP open to some liabilities: “We frankly cannot fully protect against some potential liability,” he said. From where we are standing, the question is not what liability Mercury poses to HP. The question is what liability HP poses to Mercury.

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