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Well, HP finally did it! After years of showing at best tepid support for its software business, HP finally showed some conviction. HP's purchase of Mercury interactive is a blindingly obvious strategic move with the only question being, what took them so long.

Target: Mercury Interactive

Mercury Interactive was founded as a software quality testing vendor. In simple language, Mercury created software that tested software. Mercury's software stress tested newly developed software products to catch bugs and performance issues before the software was released to the market or installed. Mercury dominated this niche, and still does, but as growth became harder to achieve Mercury was compelled to extend its product scope. Several years ago, Mercury began selling software to manage the performance of applications which were already deployed and running. Today Mercury Interactive competes quite effectively with companies such as IBM, CA, BMC, Symantec, Quest and even to a limited degree HP.

Transaction Terms

Enterprise Value: $4.5 billion ($52.00/share)

Premium to market: 33% above pre-announcement price

Valuation Multiples:

Aggregate Value / 2006E Revenue 4.8x

Price/2006E Earnings Per Share 34.0x

Strategic Rationale

Strategically,this has been one of the most obvious transactions to not get done for years. HP has long had a strong reputation around its Openview product set but it's been perceived as strong at managing the network layer, alright but emerging at managing the systems layer and weak at managing the application layer. Mercury is the leading player at the application layer providing a perfect complement to HP's product weaknesses. Very importantly for HP, they are also acquiring an industry leading team of professionals which we are sure will be an important catalyst to reinvigorate HP software business.

Architect Partners Assessment

Timing is everything. Several events transpired to make this transaction achievable. First, the departure of Mercury Interactive founder, Amnon Landon, last year as fallout from the well described option dating scandal. Amnon was a fighter, not a seller. Second, HP's change in leadership has clearly resulted in a new level of respect for its software business, resulting in corporate resources now being allocated to building what had been an oxygen starved business under Carly's watch. Third, the loss of credibility and uncertainty caused by the senior leadership changes and accounting issues at Mercury Interactive brought its valuation down to earth, making it a relatively affordable acquisition for HP.

This is one of those deals where both sides win. The takeout valuation of Mercury is actually quite good at 4.8x revenues, particularly when one considers that revenue growth was expected to be only on the order of 12.3% from calendar 2006 to 2007 based on Wall Street analyst consensus. Assuming solid execution, not a given, we believe the business will thrive under the HP umbrella making the relatively hefty purchase price quite reasonable.

Here is a take from Vinnie Mirchandani and James Governor and Tony Baer.

Source: HP's Purchase of Mercury: Both Sides Win