The custom software and information technology services industry covers organizations that provide computer programming services on a contract or fee basis. Companies in the industry write computer code and offer services such as providing ongoing maintenance and modification of custom software, training, general information technology management, and systems analysis and design.

Industry Overview

The custom software development sector is currently seeing an increase in demand. Corporate spending on computer systems and related software and services rose 11.9 percent in 2004, declined 8.3 percent in the first quarter of 2005, and appears to be once again on the rise. Equipment and software spending rose 11 percent in the second quarter of 2005 and continued gains are expected based on current economic expansion.

The custom software industry is largely supported by corporate spending and is therefore highly susceptible to changes in the economy. As corporate spending for new projects becomes available, demand for the industry increases. When cost cutting measures are put into place, however, new projects are quickly suspended. The industry grew rapidly during the tech boom of the late 1990's. When the economic downturn hit, however, business spending on equipment and software contracted even faster than the overall economy.

Computer hardware is becoming less expensive and more powerful. As a result, IT budgets are finding more money is left to apply to software and support services. This factor should also contribute to continued growth in the custom software industry.

Outsourcing and Market Expansion

While many companies have their own internal Information Technology departments, IT services are often outsourced. IT service providers benefit from long-term contracts while corporations save on the costs of supporting additional staff. Interactive software company emuse technologies, for example, has recently entered an extended service agreement with S4C, the Welsh National Broadcaster, emuse will create interactive applications from digital text, a content management system to enable synchronized voting applications, and a full support structure. The contract runs for three years.

As the amount of business, advertising, and commerce performed online increases, the market for information technology services expands. Burton Snowboards, which manufactures and markets sporting goods, hardly seems like an ideal candidate for custom programming services, but the company recently hired Finnish mobile software company Mind On Move to develop a mobile information service for the company. The service provides information on upcoming events, inside information on Burton Team snowboarders, and a dealer locator.

As companies incorporate modern technology into all aspects of their business operations, new markets for custom programming services will be created. Bank of America, for example, is redesigning its customer relationship management through a computer driven processes that provides customer data to whichever point-of-service the customer contacts. Under the system, a bank teller could be promoted to offer and even authorize a new credit card, while an automated teller machine could offer an equity line of credit. In a similar move, Fifth Third Bancorp is devoting much of its 2006 technology budget on providing an "integrated customer experience," under which ATM's could provide client service information such as reminding the user that a mortgage payment is due.

These innovations are being driven by the fact that customers now contact the banks in a variety of ways - over the phone, through ATM's, over the Internet - instead of visiting bank branches directly. In other words, consumers are taking advantage of a more complex range of technological options, and businesses are being forced to adapt. As a result, demand is created for customized management systems.

The Next New Standard?

Another potential new market for IT services is the ongoing development of new technology standards and platforms. John Palfrey, principal for RSS Investors, LP, stated, "If you think about it, the Internet in the early 1990s was largely driven by email. In the mid-to-late 1990s, it was putting things up on the Web and HTML. By 2000, it was XML." Palfrey predicts the next development is a family of standards and services called Really Simple Syndication, or RSS. Jim Moore, a member of the fund, describes RSS as "the next layer of information technology."

It is interesting to note that as a fund devoted to a new technology architecture, RSS Investors isn't investing directly in the development of the RSS platform. Instead, the fund seeks infrastructure and service companies that will support RSS in operation. "It's like during the California Gold Rush: it wasn't the people mining the gold who made the money, it was the people who sold pick axes," Palfrey explains. "We don't expect to make money from RSS; we expect to profit from related businesses."

Regardless of whether RSS is truly the wave of the future, the implications for the custom software industry are clear. New technology standards will continue to be developed, and as they are they will require IT professionals to support them and integrate them with exisiting systems, creating a demand for customized solutions.

Mergers and Acquisitions

M&A activity in the industry is most clearly visible in the mid-cap sector, as larger corporations providing IT services also provide other products such as computer hardware, prepackaged software, and online services. M&A activity for the sector peaked in 2000, dropping sharply as the technology bubble burst. Deal prices relative to revenues and assets also peaked in 2000. Since then, mergers and acquisitions for the sector have not even come close to the numbers seen in the late 1990's and 2000.

Deal values prior to the end of the technology bubble were highly inflated. Whether today's lower-priced deals are undervalued or reasonably priced is a difficult question. Certainly many acquisitions immediately following the bust took advantage of bargain prices for companies whose fortunes had changed almost overnight. Both the number of deals and the relative purchase prices increased in 2004, indicating a possible recovery in the M&A market for this sector.

Outlook

With corporate spending and dealmaking on the rise, the short-term outlook for the custom software and IT services industry looks positive. The long-term fortunes of the sector will depend on continued economic recovery. The development for new computer applications and platforms should continue to generate new markets for the industry.

Sources: American Banker, Econtent, M&A Insight, Telecomworldwire, Value Line