For investors hoping the soft-ware industry would rebound quickly from a dismal 2001, the quarter ended March 31 was a reality check. More than a dozen software makers missed Wall Street expectations by as much as 15%, and many reduced estimates for the rest of the year. Even companies that breezed through last year’s mess-such as business-software maker PeopleSoft Inc. and security specialist Check Point Software Technologies Ltd. – came up short. "Customers are much more conservative about how they spend," says Check Point CEO Gil Shwed.

The dashed hopes have sent stock prices and private valuations tumbling throughout the sector, setting the stage for a long-awaited consolidation. There are bargains aplenty to be had, and many of the industry’s bigger, more stable companies need to fill out their product lines. As a result, analysts and executives predict that half of the 200 or so public software companies could disappear through acquisition or bankruptcy within the next two years. "The shakeout that hit hardware a decade ago is hitting software now," says

Clark H Master, vice-president and general manager of Sun Microsystems Inc.’s enterprise-systems products.

History backs that idea: Major consolidation in the software industry tends to lag the rest of the economy. The number of software merger-and-acquisition deals, for instance, jumped 45% in 1992, the year after the last recession ended, according to Thomson Financial. Current conditions look ripe for a repeat. Last year, big software companies were busy managing the rapid downturn. Now, many feel they have a better grasp of market conditions, and they have begun to look for acquisitions to bolster their arsenals.

In part, that’s a reaction to the slump in tech spending: Many simply want to add products that will increase their share of the few dollars now being spent on software. But large companies are also preparing for a maturing industry in which fewer big players will dominate. "Five to ten years from now, there will be room for only a dozen or so very large software companies," says Bob Eatroff, a managing director in Morgan Stanley Dean Witter & Co.’s technology M&A practice. "As the industry matures, customers want fewer suppliers."

Peoplesoft, for example, says it’s looking for a niche company that can help it gain ground in the market for software that manages supply chains. Analysts speculate that could mean i2 Technologies Inc., a Dallas software company that is already No.2 in the market. IBM Corp. wants to beef up in so-called middleware technology, which helps integrate corporate-information systems. One possible target, according to analysts: See Beyond Technology Corp., a Monrovia (Calif.) company with $42 million in first-quarter revenues. It may lack the size to compete on its own. And business software leaders, such as SAP and Siebel Systems Inc., are looking for data-mining and customer-management software makers such as Epiphany Inc.

For buyers, the price is right: Software stocks have been hammered. The Goldman Sachs Technology Industry Software Index is down by 77% from its peak in March, 2000. Share prices of desirable companies such as E.piphany and i2 have sunk to just $6 and $4, respectively. That’s well below their highs of $211 and $110 back in 2000. The typical asking price for private software outfits is a fifth of what it was a year ago, say several executives. "It’s almost like a permanent Thanksgiving sale," says Stephen Kelly, chief executive of customer-management software maker Chordiant Software Inc., which paid $12 million for privately held OnDemand Inc. on Apr.1

For now, deals remain limited to the small fry. Net-software maker BEA Systems Inc., for example, bought five companies last year. But each was under $50 million. "The bigger deals are very hard to do" because they can be so dilutive to earnings, says CEO Alfred S Chuang.

Still, not every shaky little software company can count on a bailout. Take Commerce One Inc. Just five quarters ago, the e-commerce-software maker had revenues approaching $190 million per quarter. But in 2002’s first quarter, the company says it pulled in about $30 million. "It’s death by atrophy," says Bob Austrian, analyst at Banc of American Securities LLC. True enough. Many others, though, are hoping for salvation in the form of a shopping spree.

By Jim Kerstetterin San Mateo, California, with Steve Hamm in New York in BusinessWeek. Copyright 2002 by The McGraw-Hill Companies, Inc