Indian Outsourcers Warm Up To Acquisitions

Jan 30, 2009 (07:01 PM EST)

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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").

Trouble At The Top
Among India's top six outsourcing companies, Satyam is the only one looking vulnerable to a takeover, having hired investment banks to find and sort through potential suitors. The recently revealed accounting scandal has left the company on shaky financial ground, having to deal with executive turnover, a government investigation, and the possibility of investor lawsuits. Dubbed "India's Enron," it began with former CEO Ramalinga Raju admitting to inflating revenue and profits and falsifying about $1 billion of cash on the company's books. The former CEO and other former top officers face criminal charges, and the government has seized control of the board of directors.

"The extent of the inherent damage is still unknown," says Gartner's Iyengar. Infosys has said it isn't interested in acquiring Satyam, and no big players have publicly shown much interest. "But Satyam is still a reasonably sized provider with a strong value proposition," Iyengar says, so when things settle, other buyers may emerge.

For the most part, the large Indian IT services firms are more interested in expanding on their own or by buying smaller players than by merging with each other.

In addition to cultural resistance to acquisitions, the larger Indian outsourcers tend to be fairly evenly matched in the skills and services they offer, making it hard to find big, complementary acquisition targets, Iyengar says. So instead of looking at each other, they tend to seek out boutique consulting firms and niche outsourcers that bring with them existing customers and revenue streams. Buying the Indian operations from would-be customers--"captive" operations--will likely continue to be one of the most popular ways to get both industry-specific knowledge and a top customer.

That was the case with the two units Citigroup recently sold off. They were particularly attractive because they came with built-in revenue streams from having Citigroup as their first customer.

Indian outsourcers also may want to buy their way into greater onshore presence in the United Kingdom or the United States, says Ross Tisnovsky, IT outsourcing analyst at Everest Research Institute. Wipro did that with a major deal for Infocrossing. But the only reason to merge big players like Tata and Wipro would be to get bigger, and "that by itself is not usually a reason to acquire," Tisnovsky says. There might be some consolidation among some of the small to midsize outsourcing operations, he adds.

Midsize Indian outsourcer Patni, with revenue of $542 million through its first three quarters of this fiscal year, has been pursuing a strategy of "very selective acquisitions" to gain entry into markets where it wants a stronger presence, says Tony Viola, VP of marketing at Patni Americas. It bought into IT services for life sciences with the 2007 acquisition of New Jersey-based Taratec. Patni has also acquired a telecommunications specialty with the acquisition of Logan Orviss, based in Monaco, and Cymbal in California, and it moved into product engineering with the purchase of Massachusetts-based ZAiQ, all since 2004.

Acquisition Disruption

5 Big Deals
Recent Purchases
Of Note
1. HCL Buys Axon
The $811 million purchase of U.K. SAP consultancy closed in December and is the largest buy to date by an Indian outsourcer.
2. Wipro Buys Infocrossing
The $548 million purchase of the U.S. data center operator in 2007 strengthened Wipro's infrastructure offerings.
3. TCS Buys Citigroup Unit
The $505 million purchase of the Citi BPO unit in December let Citi shed 12,000 employees, while hiring TCS as a contractor.
4. Wipro Buys Citigroup Tech Services
For $127 million, Wipro gets Citi's offshore IT group, along with a six-year contract worth at least $500 million to provide services back to Citi.
5. Patni Buys Taratec
Patni's 2007 $27.2 million purchase of life-sciences IT consulting firm follows other vertical IT buys in telecom and product engineering.
For customers, the potential for disruption from a takeover depends largely on the nature of the relationship. A big customer of a small firm can exert a lot of control over that firm. That influence is diluted when it's acquired, says Gartner's Iyengar, citing Capgemini's acquisition two years ago of Kanbay, a Chicago consultancy with offshore operations in India. "The deeper the relationship and the more entangled your business is with the provider," the more likely an acquisition will bring significant change, he says.

If you judge the risk and consequences of your supplier being acquired to be significant, then you need to have a contingency plan, he says.

Mergers and acquisitions among outsourcers can have positive consequences for customers, too. Businesses that outsource work to augment their staff benefit from the larger pool of resources that an acquisition makes available, says Everest's Tisnovsky. Companies looking to outsource work also might find that the range of services an outsourcer can offer expands as the result of an acquisition.

What's Ahead
While they may not be targeting each other, the major Indian outsourcers have been competing aggressively for the best acquisitions. To make the Axon acquisition, HCL outbid Infosys' initial $753 million offer, a rare bidding war for the industry.

Worldwide, M&A activity among IT services providers has been accelerating: There were only 13 acquisitions globally by multinational IT services providers in 2004, Everest says, compared with 27 in the first three quarters of 2008. The larger Indian IT outsourcing companies accounted for eight of the 27 acquisitions in the first three quarters of 2008, compared with two of the 13 in 2004.

Tisnovsky expects acquisitions by Indian firms to continue as these companies get more mature and find it increasingly difficult to grow organically. With profitability declining, he says, Indian outsourcers "are going to need to turn some of that cash into operational improvements, and there will be forces inside of these companies competing for cash." But the strongest are likely to selectively acquire as well.