In-Depth

Breaking Consolidation's Spell

Software-industry innovation isn't dead; it's just sleeping.

The Next Big Thing in software—the disruptive technology that will change the face of a stagnant industry and goose thousands of new businesses into being—has yet to announce itself this decade.

In the 90s, it was the Internet and the Y2K bug. In the 80s, it was the mainframe. These days, "there isn't anything compelling that says, 'You've got to move or else,'" says Gartner analyst Tom Eid. However, the growth of service-oriented architectures, open source software, regulations, and standards (to name just a few) will act as drivers for new business opportunities that will begin heating up around 2007, according to Gartner research.

A quick glance at the headlines shows that the industry is still solidly in a consolidation phase. Microsoft continues to devour promising niche players; over the past two years it has acquired Sybari Software, GIANT Software, and technology from GeCAD to shore up new antivirus and anti-spam security capabilities. Mature software companies, even ones of considerable size and market share, are getting swallowed up by even bigger companies. PeopleSoft and Siebel both fell to Oracle in the past year, while smaller acquirers such as Symantec and EMC have recently snapped up security and storage software providers such as Sygate, Veritas, Legato, and Documentum.

"If you go back to the 70s, 80s, 90s, and now, there's a downturn at the beginning of the decade, a bottoming-out period around the third or fourth year, the recovery starts around the fourth or fifth year, and then a growth phase occurs around the sixth or seventh year that then carries it to the start of the next decade," Eid says. Barring some unforeseen historical anomaly—for example, another terror attack, or an energy crisis—we can expect the pattern to repeat itself.

How Did We Get Here?
Of course, there's more to the current situation than just usual business-cycle ups and downs. Dwight Davis, vice president and practice director at technology research provider Summit Strategies, cites dynamic computing as a big driver in industry consolidation.

He explains that infrastructure and application software are merging to create a hybrid by the ungainly moniker "applistructure." "A lot of application functionality is being standardized and put in the middleware layer," he says. Whereas a company might once have relied on an application-specific security model, for example, it will now have a standards-based security model in the middleware layer that works for all the applications running on top of it.

As a result of this blending, more application providers are moving into the middleware space. SAP has done just that with NetWeaver, while IBM, Oracle, and Microsoft are all making their own inroads to applistructure.

Combine this phenomenon with the increasing prevalence of standards and diminished buyer interest in proprietary solutions, and you'll see why "it's removed some of the lock-in factor and differentiation of those applications," according to Davis. Once-thriving standalone applications end up in the suites of large vendors, who purchase smaller organizations to fill in functionality gaps and position themselves as true one-stop providers.

Proprietary applications might also be bested by powerful competitors in the same niche. "The natural tendency seems to be to consolidate to one or two players in a particular market," observes Peter Pawlak, senior analyst for server applications at independent research firm Directions on Microsoft.

Take the photo editing market, for example. Anybody who isn't Photoshop will have a very difficult time finding customers. "It has to do with file compatibility and the skills that people have in these products," he says. A user trained in Photoshop has very little incentive to buy, let alone learn how to use, a different proprietary application.

Pawlak concludes, "There's no need these [established] products don't really fulfill, so the only thing anyone can do is say, 'We'll do it cheaper.' But established players can drop price, too, because the cost of producing the software is already behind them." New entrants risk being shut out not only on capabilities, but on production margins as well.

Where Are We Going?
All of this points to a future in which a few monoliths rule the greater software market and smaller companies live on crumbs. Ambition and true innovation are rewarded with acquisitions and product phase-outs. "If your dream is to have the next Lotus 1-2-3 or Pagemaker, the chances of that are low. Real low," says Pawlak.

But take heart, software entrepreneurs. Look again at the bottom of that chart, where 2007 kicks in.

The forces driving integration and interoperability make it that much easier for new products to work in concert with established ones (even if they also make it easier for established companies to incorporate new ones). And there will always be safe harbor in highly specialized, expensive niche markets that don't move enough units to attract global giants' attention—geographic information systems, for example, or surgical simulation software.

New concerns about regulations, compliance, and corporate governance have given rise to "this whole new software market that wasn't there three years ago," says Eid. The same goes for instant messaging software: a market that barely existed several years ago now has, by Eid's estimate, 50 or 60 vendors competing with IBM and Microsoft in the space.

And there's always open source, now that the technology (and its supporters) has matured past the "religious fervor" phase into the mainstream. "Open source doesn't mean free," Eid points out. "There is software money to be made with Linux and open source. It's not purely a service opportunity."

John Andrews, president of Evans Data Corporation, also sees room for growth in virtualization, service-oriented architectures, and companies that offer software as a service. He predicts that a few years from now, merger and acquisition activity will slow down because "there's only so much capability out there that large companies are going to need to address."

Eid agrees. "[Large companies] will compete head-on against each other, but at the same time that leaves definite opportunities for smaller, nimbler vendors to come into play," he says. "There are always new things happening, always opportunities for growth, and the pace of that growth is always quickening."

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