Jan 30, 2009 (07:01 PM EST)
Indian Outsourcers Warm Up To Acquisitions

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When HCL Technologies clinched an $811 million takeover of the United Kingdom's Axon Group in December, outbidding rival Infosys, the transaction set a record for the largest IT acquisition to date by an Indian outsourcer. Also in December, Wipro Technologies announced plans to buy Citi Technology Services for $127 million, the second acquisition of a Citigroup offshore subsidiary by an Indian outsourcer. Tata Consultancy Services completed its $505 million purchase of Citigroup's business process outsourcing unit that same month.

The top Indian IT companies historically haven't been big deal makers. Why acquire when organic sales growth was running at 30% or more a year, as it did until the recent slowdown? Also, India's business culture just isn't as geared toward acquisitions; if the Indian outsourcing industry existed in the United States, it would've seen 50% to 70% consolidation already, estimates Partha Iyengar, a Gartner outsourcing analyst based in India.

But there are a number of factors that could drive more deals: slowing organic growth, the pressure to provide specialized skills, the need for overseas growth, and a financial scandal that put one of the big four Indian firms, Satyam, in play. 2008 saw a surge of M&A activity among IT outsourcers, and the trend may continue in 2009, as the largest, healthiest Indian outsourcers--the ones that have built cash reserves in good times--snap up smaller players. Consolidation among the very top Indian firms looks unlikely, however.

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KR Lakshminarayana, chief strategy officer at Wipro, says the economic downturn is an opportunity for his company. "This is the time when assets that would normally not be available now become available," he says. Globally, many competitors are "strategically challenged," while Wipro still has the cash--almost $800 million in its most recent quarter--and the access to credit needed to execute acquisitions, he says.

chart: Benefits Of Indian IT Services
At the same time, while there are more companies available to buy, the recession has made it more challenging for companies still able to do acquisitions. Wipro's selection criteria has gotten "that much tougher," as it's forced to be pickier about the firms it's considering acquiring, Lakshminarayana says. Wipro IT services revenue grew just 3.5% in constant currency in its third quarter, ended Dec. 31.

HCL, too, is planning to aggressively pursue acquisitions, says Ram Krishna, the head of the company's Enterprise Technology Services division and point person on its M&A strategy. "We basically accelerate when there's a slowdown," Krishna says.

The company followed a similar growth strategy during the economic slowdowns in 2001 and 2002, he says. In particular, HCL wants to invest in industries in which it has established specialties, such as IT services for engineering firms.

"We know where we want to go, but it's not always possible to grow those capabilities organically," Krishna says. When the company wanted to build a practice serving the banking industry, it bought a captive services group owned by Deutsche Bank. It took a 51% stake in Deutsche Software in 2001 and later acquired the rest of the company, taking in a few hundred employees as the nucleus of a group that now employs more than 10,000 people. The recent Axon acquisition brought 1,600 employees to help HCL grow its presence in the SAP consulting services market.

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Acquiring niche outsourcing firms makes more sense for HCL than buying one of its major competitors, since in services, scale isn't a great differentiator, Krishna says. "You need a certain scale to demonstrate an ability to execute and a variety of skill sets," he says, "but once you're there, it doesn't matter much to your customers whether you're a $5 billion or a $7 billion or a $10 billion company." HCL had $1 billion in revenue the first half of its current fiscal year.

Having the right technical skills is critical for outsourcing firms. Asked what benefits they get from Indian outsourcers, 31% of customers cite "access to technical skills we don't have," second only to lower cost, in our InformationWeek Analytics survey of 346 IT pros whose companies have hired Indian IT outsourcers (see chart, "Benefits Of Indian IT Services").