The Hindu Business Line : Frenzy to continue

It looks like there's no stopping the merger and acquisition momentum driving the software sector. But it is likely that this time around, most of the action, the spin and the whirl, will be from the middle-rung companies.

AS the curtain comes down on a frenzied year of mergers and acquisitions in the software services sector, the crucial question uppermost in everybody's mind is: Will 2006 offer an encore of 2005 on the M&A (merger and acquisition) front?

Given the fragmented nature of the sector, industry analysts and observers predict that the pace of M&As is set to rise sharply. The dynamics that are driving the consolidation wave within the sector are quite straightforward.

On the one hand, the sustained flight to scale by Indian frontline companies is widening their revenue gap with the mid-rung peers. On the other, multinational players are stepping up the employee base and getting their offshoring act together.

Caught between these two are the middle-rung companies, both domestic and multinational, that are under increasing pressure to scale up and deliver industry-leading growth.

On the contrary, quite a few of them have been passing through turbulent times in the past few quarters, forcing them to re-examine their business models. How will it play out? These trends reflect that most of the action on the M&A front will probably be in the mid-cap space.

"We are actually at the start of an M&A revolution," says Noshir Kaka, principal, McKinsey & Company. Opinions, however, differ on whether these will be big bang acquisitions or multiple `tuck in' acquisitions of which we have seen an enormous number this year.

eWorld examines several key aspects that are likely to drive M&As in the sector:

Big bang not for now

The acquisition activity among frontline companies has only recently picked up momentum.

In a matter of three months, Tata Consultancy Services put through three acquisitions, starting with the operations of UK insurance major Pearl, the Australian banking product company FNS and the Chilean BPO firm Comicrom.

Since its NerveWire acquisition more than two years ago, Wipro recently announced that it has snapped up Austrian chip design firm New Logic for 47 million euros in an all-cash deal.

Over the last couple of quarters, Satyam Computers has also announced two small acquisitions of the UK-based Citisoft and Singapore-based Knowledge Dynamics.

Infosys Technologies has been the only one to stay quiet on the acquisition front, since its last acquisition of Expert IT Services in Australia in end-2003. Infosys believes that it can grow organically, except for filling in strategic gaps.

Most of the recent acquisitions by frontline companies are intended primarily to fill strategic gaps in their portfolio or foray into a new service line.

And in most cases, the financial outlay relative to their size has been insignificant. This trend is likely to continue, as the frontline companies are clocking growth rates ahead of the industry and are hardly facing any problems in building up scale vis-à-vis their multinational peers.

As the recent ABN AMRO deal shows, unbundling of large-sized deals will be playing to the advantage of the frontline companies. In the near term, there appears to be no compelling reason for frontline companies to resort to big bang acquisitions.

The picture, however, is bound to change over the next couple of years, as IBM and Accenture emerge as a potent threat and other players such as Affiliated Computer Services, EDS or Sapient get their act together.

Changes in the third-rung pecking order

A lot of action over the past six quarters has been in the third-rung companies in the software value chain. Several Indian promoters that had reached a certain size decided to cash in their chips by selling out to mid-cap peers.

Take, for instance, Pawan Kumar, former President of IBM, selling out his company vMoksha to Helios & Matheson or Chandra Kumar and his team ceding their equity stake in Linc Software to MindTree Consulting. In the same vein, B.V. Venkatesh, former CEO of BFL, let Majoris Systems, a firm founded by him in 2000, be acquired by French-headquartered Valtech, and Aztec Software, an outsourced products company, bought out the Pune-based Disha Technologies to get into the testing space.

As Chandra Kumar, founder of Linc and now a Vice-President at MindTree, post sell-out, says, "It would have taken us a pretty long time to attain a larger size, which would not have made any sense. That's when we decided to merge with a larger firm and the decision was not taken in a hurry."

Linc had always been operating in the IBM AS 400 category, considered a niche segment. "We wanted to stay focussed in this niche segment so that our customer base was protected." These sell-outs are a clear reflection of the fragmented nature of the industry. There are said to be nearly 3,000 companies at last count in IT and M&As are expected to offer a good option for these players to stage an exit.

"It's a virtuous circle. Like in Silicon Valley wherein the start-ups get acquired and then there are new sets of start-ups emerging every year, we see that happening in India as well," Kaka says.

Setting the stage for action in mid-caps

As the revenue gap widens between frontline and middle-rung companies, the focus will increasingly shift towards revenue and the post-tax earnings growth of each company relative to industry growth.

Signs of this are already evident in the premium price earnings multiple being enjoyed by the frontline companies vis-à-vis their mid-rung peers.

The third-rung companies have also raised the bar for middle-rung companies, setting the stage for possible consolidation within this space. As Kaka says, "I certainly see global majors coming in and acquiring Indian Tier II (middle-rung) firms. I see more activity on that front in India, especially next year."

This opinion stems largely from the recent statements made by the senior management of Cap Gemini and Atos Origin, the two leading European IT vendors.

They have announced that they are actively scouting for acquisitions in India, with Cap Gemini exploring the acquisition of a euro 200-300 million player. At present, they significantly lag their US peers such as Accenture or IBM in building an offshore back-end.

In order to cater to some of their large outsourcing contracts at a competitive cost, they are considering an acquisition seriously. With the operating margins of these two companies in the 3-8 per cent range, the need to shore up margins is also a key business imperative.

At the same time, Indian players such as VisualSoft Technologies, Four Soft, MphasiS BFL or Scandent Solutions have also been actively involved in the M&A scene to build the necessary scale in their operations. Recently, the Hyderabad-based VisualSoft announced that it plans to merge AppLabs (engaged in testing services) and eSolutions (enterprise solutions) with itself.

This is expected to broadbase its portfolio of offerings and enhance its revenues from Rs 200 crore to Rs 330 crore.

Similarly, the Bangalore-based Scandent Solutions, a $75-million services firm, has decided to merge with the $200-million Cambridge Services Holding LLC, its BPO arm, to create a new entity named Cambridge Solutions. The combined entity will have revenues of $275 million (Rs 1,200 crore).

There are hardly stray instances. Practically, every single mid-rung company ranging from KPIT Cummins, Geometric Software, Zensar Technologies, Subex Systems, Aztec Software to 3i Infotech is making or actively pursuing acquisitions to fill strategic gaps in its portfolio, widening its range or offerings or expanding presence in specific geographies.

Though indications are that M&As will happen at a feverish pace, two key factors could impact the intensity.

The prevailing high valuations commanded by mid-rung companies are hampering M&A activity in India, says Amar Chintopanth, chief financial officer of 3i Infotech, formerly known as ICICI Infotech. 3i Infotech recently concluded three deals by acquiring two US-based firms and an Indian firm.

"We negotiated with almost 25-30 firms in the past nine months before settling for the three which we acquired recently, as high valuations dragged the process," says Chintopanth.

However, Vivek Pandit, partner, McKinsey, begs to disagree stating that there's no question of valuations impacting the M&A process. "The valuations are as per the economics in India," Pandit says, adding it did not prevent Oracle from acquiring i-flex solutions, nor IBM from buying out Daksh.

"In the grand scheme of Indian valuations being high, the fact is that the impact that these companies have on the economics of global IT is significant.

While these deals don't seem accretive at first glance, a number of these deals bring in cost savings that make them accretive more quickly. Over a two-year period, some of these high-value companies have returned the investments made in acquiring these companies," adds Pandit.

The second factor is the challenge of integrating acquisitions successfully. The playing field in the software arena is changing so rapidly that the risks associated with people and cultural integration are quite high. Take, for instance, the Polaris-Orbitech acquisition in 2002. From being a pure software services company till 2002, Polaris put through a `make or break' merger with OrbiTech, a Citigroup subsidiary, to enter into the BFSI (banking, financial services and insurance) products space.

After going through the pains of integration for two long years, Polaris is still struggling to establish its `Intellect Product Suite' as a product of choice at the higher end of the banking market.

With Oracle picking up Citigroup Venture Capital's 41 per cent equity in i-flex solutions in early August this year, and the strong order book built by the Swiss-headquartered Temenos, the banking products scene has become highly competitive. The next three-to-four quarters of earnings performance for Polaris will be crucial to see whether its business model yields successful results or not.

Since scalability is expected to remain a key challenge to growth in this sector, the willingness to take that risk will be high. As Pandit says, "I see three to four deals of the IBM-Daksh or Oracle-I-flex scale over the next few quarters." In a highly fragmented industry, those who are not in the top 50 will have to either grow into that league or sell out, he adds.

vishwa@thehindu.co.in

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