Channel Insider content and product recommendations are editorially independent. We may make money when you click on links to our partners. Learn More.

There is nothing like a sinking stock market to make investment fund managers jittery and start them wondering whether they will ever rediscover the ability to make money again. That is exactly what has been happening this year, particularly in the technology sector.

Most of the major indices continue to be down, year to date. The S&P 500 Index has lost 3.4 percent so far this year, the Nasdaq composite is lower by 9.6 percent, and the Morgan Stanley Technology index is in bear-market territory, down 11.7 percent for the year.

Investors have responded to the pummeling of technology stocks by steadily withdrawing assets from technology funds for the last 16 weeks in a row.

It is at times like this that we batten down the hatches, get closer to our companies to better understand industry trends and focus on key emerging issues to find money-making ideas.

In this spirit, we have been examining the consolidation occurring in the software industry and the implications for channel and investors alike.

What happened to the good old days? Back then the software industry was churning out 20-percent growth, or better, every year. Well, according to the U.S. Bureau of Economic Analysis, the last year U.S. software capital expenditures grew at more than 20 percent was in 1999. That seems like light-years ago.

U.S. software capital expenditures actually declined in 2001 and 2002 before showing low single-digit growth in 2003 and accelerating in 2004.

During the first-quarter earnings season, we have been deluged with announcements of weak sales from software companies such as Siebel Systems, BMC Software, Compuware, IBM, Borland and many others. This is similar to the many “blow-ups” we saw in the software business during the second quarter of 2004.

Furthermore, excluding the positive effects of currency translation gains, there has not been a lot of growth in the software business over the last three years.

The reasons for this marked slowing in the software industry’s growth rate are many and varied. Some claim the size and maturity of the software business preclude the heady growth rates of the past.

Others, as NetIQ Corp.did in last week’s earnings release conference call, blame poor sales execution, “difficult markets” and competitive pressures from the likes of Microsoft in the application and vulnerability management space.

Many in the industry just feel there is a lack of innovation, and as hardware prices have come down, budgets for software have also declined because some companies will only spend a fixed percentage of their total allocations on the software component.

Whatever the reasons for the anemic growth in software sales relative to historical norms, the sector is in the early stages of consolidation, as we have seen with Oracle’s purchase of Peoplesoft and Retek, IBM’s acquisition of Ascential Software, Adobe’s buy-out of Macromedia and Symantec’s pending merger with Veritas.

We expect merger and acquisition activity to accelerate in the months ahead as clients trim their software vendor rosters to streamline their procurement processes and enforce more homogeneous deployments of their Information Processing strategies.

It appears to us that under this scenario, the main acquirers will probably end up being companies such as IBM, Microsoft, SAP, Oracle, Hewlett-Packard and Computer Associates. Potential public company acquisition targets often mentioned by industry insiders include BEA Systems, Borland, BMC, Lawson Software, Novell, and Sybase.

From the channel’s perspective, it seems to us that as the software publisher base becomes narrower and more concentrated, offering suites of applications and not just “best-of-breed” products, the need to add value through vertical application focus becomes more acute for long-term survival.

The channel must partner and give its allegiance to software vendors committed to maximizing channel profits and reducing channel conflicts with software manufacturers’ direct sales forces.

Finally, software integrators and VARs must diversify their customer bases to minimize the risk of buying from an ever more concentrated set of suppliers while selling to a small group of large customers and thus increasing the opportunity for a profitability squeeze. This implies even tighter attention by VARs to the vibrant and profitable small and midsize business marketplace.

Benny Lorenzo has more than 30 years of business and technology experience and is currently General Partner at Aspira Capital Management of Fort Lee, N.J. He has held various positions with AT&T and IBM. He was also portfolio manager at P.A.W. Partners and served as senior vice president of Equity Research at Dillon, Read & Co. Inc., general partner at Volpe, Welty & Co., and vice president at LF Rothschild & Co. Inc. Benny Lorenzo can be reached at