India-US Technology Marketplace: An M&A Perspective

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1 Then and Now Outsourcing models have evolved to obtain a high level of maturity over the past four decades. Starting with the In-house units for specialized tasks as was the case in 1960s down to the modern day multi-location global vendor project executions have redefined the mode of business world over more so in the United States. The largest gainers owing to the global outsourcing segment have been the low cost locations world over which have been able to do achieve the same level of the work quality for a far lesser operating cost. Particularly, India as a geographical region has been able to capitalize very effectively on the inherent advantages of low costs, language skills and a fairly vast technical resource pool. Today, India is the largest IT-Enabled Services (ITES) Outsourcing provider in the world with 2007 activity reaching $31.3 Billion 1. While the outsourcing model has become inherent to the business strategy of many organizations, the expected value gain from outsourcing still remains a point of contention. American corporations are looking to maximize savings as well as gain a business edge by involving themselves in the global outsourcing arena; but there is still debate over the preferred mode of involvement in this area. A question, seemingly more pronounced owing the recent activity in M&A in global outsourcing space, which remains to be answered for American corporations is Is the merger or buy-out of an Indian outsourcer/ vendor a viable business decision? The Rationale for M&A There are many aspects that drive the decision towards involvement in Indian outsourcing market for American corporations. The following reasons are worth analysis before a strategic off-shore investment decision is made 1 NASSCOM,

2 More clients are realizing that Outsourcing vendor management is an expensive and time consuming proposition. The definition of success in global outsourcing engagements has been tough to manage traditionally. Also, overdependence on any particular vendor is not an optimal risk strategy. There is hardly any question on the growth potential of the global outsourcing market. It is a high-growth, high-profit volume based business that has shown strong sector growth over the last decade and a half. Indian outsourcing landscape is spread out into many verticals and industry sectors. There is a high possibility that there would be organizations that are complimentary to businesses of a many American corporations. US Technology companies that are product focused have strategic advantages in collaborating with Indian counterparts. Apart from the inherent advantage of reuse of fairly large number of product components it also serves as an outlet to gain competitiveness from the price advantage owing to the Indian presence. Many American firms have adopted the M&A route to make gain a spot in the Indian marketplace and have used the region to provide for their global supply chains. The Alternative Approach Organic Growth Certain organizations have also undertaken a different mode of establishing an Indian presence organic growth. Many multinational corporations have built Indian operations from ground up and are still continuing to hire with very aggressive targets. A sample growth path of multinationals that have largely adopted the organic path to building operations is shown below. Both service companies (IBM, Accenture) and product companies (Oracle, SAP) have registered between 3 to 4 times employee-growth in India Workforce - Indian arms of American Corporations Workforce IBM Accenture Oracle SAP Although this model serves many business needs and achieves a great level of compatibility with the parent organizations, there are various issues in adopting this growth model - 2 -

3 The initial costs of recruitment are considerable. Also it requires recruitment teams who understand the company culture to be involved in the recruitment process to make the process as beneficial as possible. Organic growth means that there would be a gestation period before the offshore unit operates up to a revenue generation mode. This means that there would be a lock-in of a considerable amount of the parent company s capital till that time. Starting afresh in a new unfamiliar terrain would present operational difficulties to the parent American corporation. A considerable amount of research and time would have to be invested in understanding the local issues which may vary from administration, political considerations and infrastructure. To mitigate the risk involved some organizations, for instance HP, have adopted a two-pronged strategy of acquiring an Indian firm and then growing organically from that point. This has also been a successful model although any organization adopting this method would have to take the risks inherent to both approaches of growth in India. Potential Risks and Issues in M&A There are risks involved in mergers between American and Indian corporations. The possibility that issues could crop up, during or after the merger, is high and has been observed in the market in past. The key issues that the merging firms might expect to face are Work Culture Integration Significant work culture differences could exist between firms operating in different geographical regions. There has to be effective integration between the two firms to minimize any potential day-today operational issues. Focus Most Indian outsourcing firms are spread across verticals and industries to minimize business risks. Unless the parent American corporation is large enough to concentrate on building assets across verticals integration could be a bad strategic decision. Retaining Talent This would be an issue faced during both Inorganic and Organic growth in India. More specifically, if the resident work force of Indian company is not convinced about the long-term employability or compensation packages then there exists a danger of loss of talent. New hiring of talent owing to attrition is bound to raise the operating expenses and startup costs. Although there are potential risks in adopting the M&A route to India, careful analysis and study of the target firm would help in minimizing the risk involved. Takeovers Potential Targets? Market speculation over takeovers has always existed. Especially considering the high profile merger activity in the technical space like Oracle Peoplesoft, there have been many speculations about large-scale mergers. Oracle has also bought controlling stock in I-Flex an India based software products firm. While the model is yet to be proven successful it has the potential to redefine the way multinational corporations do business in the sub-continent

4 The big three of Indian Outsourcing space Infosys, TCS and Wipro, at least in the foreseeable future, can be targets only with heavily fought hostile takeovers. Chance of any of these three companies being taken-over is minimal. Each of these organizations has unique ways of keeping a check on the take-over risk. Infosys keeps its share price high by adopting strategies like publishing conservative profit targets so that exceeding them gives shares prices a boost. The board of directors of Infosys does not take home a large salary; rather the earnings are made though bonus payouts on shares of which the board members own a considerable percentage. This works in a two-pronged manner to keep the market confidence high about the organization and also keeps the share price high. Wipro does not figure as one of the big bellwethers on the Indian Tech stock landscape primarily for the reason that there is not enough floating stock around. CEO Azim Premji owns about 80% of Wipro, thereby negating any large volume share transactions. TCS is the software arm of the business conglomerate Tata Sons. It went public only recently and is governed by the Tata Sons board that would not let a large percentage of controlling stock out of sight. Also, considerably large investment needed to take control of a firm like TCS would be potentially a deterrent to any multinational corporation. While these three firms are not the best candidates for merger purposes, there are a wide variety of Tier II/III players who could be potential targets in the future. More specifically, the smaller India-based firms that are more product focused are ideal for mergers should the business parameters of the parent organization align itself to such an action. An indicative analysis of firms within the IT sector from a takeover viability is presented below: The bull-run on the Indian stock exchanges has pushed up the prices of most stocks to a very high price to earnings ratio. This makes merger a risky venture since there would be doubts about the market valuations of firms. With valuations beginning to stabilize in the Indian market it is time for global organizations to be assessing the - 4 -

5 market for good deals. Thus, a careful evaluation of the long-term roadmap must be made before adopting the M&A route in the Indian scenario. The Other side Buyouts of smaller US Consulting firms While US corporations are scouting for potential acquisition targets in India, an interesting reverse process is also slowly catching hold. Indian corporations are acquiring smaller US consultancies. For instance, Cognizant Technology Solutions bought Fathom Solutions a Chicago based Telco consulting firm in April 2005 and Wipro bought Nervewire Inc. a Massachusetts-based business and IT consulting company in June These mergers, although few at the moment, demonstrate the interest Indian corporations have in integrating American corporations into their folds. The rationale behind these acquisitions Move up the value-chain paradigm that almost all Indian Outsourcing firms are playing for. Increased billing rates by providing a high value service is a definite avenue for increasing revenues for these firms. Most IT Outsourcing business comes from North American geographical region. It makes strategic sense for the outsourcing companies to have local high value assets in the region. Most Indian IT companies have traditional fiscal management, thus are cash rich. Effective means of investing this surplus capital is always an attractive option. While this trend has not caught the attention of firms across the board, it is a fact that all of the big Indian outsourcing companies are looking for smaller high value consulting firms that could help them in expanding their consulting offering in the North American market. Given the potential gain for the Indian outsourcing firms in engaging in this activity the market may see more activity in this space. Which Approach fits where? The kind of approach that a firm adopts vis-à-vis India depends on the nature of the firm, risk taking aptitude and strategic fit between the parent firm and the target. The table below demonstrates, in a generic manner, what would be the best course of action when different kinds of organizations try to enter the Indian market

6 A structured evaluation of the needs of the parent firm and capability to resolve the work culture differences that may crop up during the process is essential to any merger decision especially so because in this current context this means a merger between two organizations based out of entirely different geographical locations. Future Trends While the future trends in the M&A space in this segment are hard to predict since each organization makes decisions based to variety of factors including the stock market, work culture and debt servicing capability, there are some common trends that would shape the industry in the years to come: Consolidation Formation of Big Ten of IT Outsourcing on the lines of Big Five in late 90s is a possibility over the next decade and a half. Market drivers will ensure that once bullishness from the market tapers away, consolidation is the only way of survival for the sector. Although, niche players in specific segments like Telecom or Medical transcriptions would continue to operate. Geographical Diversification Outsourcing corporations with wide spread geographical units and a multi-center control chain would evolve due to market consolidation. New Outsourcing Markets India, despite in leadership position in near term, would gradually give way to China, Latin America and Eastern European based outsourcing companies. M&A activity in these regions over the next decade would increase. More High Value services Traditional India based IT Outsourcing firms would ramp up value offerings over the next decade. This would present a direct competition to incumbent high value consulting firms in United States and Europe. It is essential for both American and Indian corporations involved in outsourcing that at the end of the bullish market sentiment that is currently driving firm valuations, there the organizations that would remain standing are the ones with the critical market capital

7 Actions for any organization looking into this sector Any firm looking into expanding Indian operations or entering the Indian market needs to look at a variety of factors before making any decision. Whether being directly involved or not, outsourcing has impacted the way all organizations do business. Thus, it is important to evaluate the pattern M&A activity in the segment would take to understand the impact on the vertical as a whole and on practically every single business organization. Some of the essential actions that need to be undertaken are: Strategic Evaluation Evaluation of mode of expansion best suited to the needs of the organization. To Partner or not to partner in Indian landscape is a question that is not easy to answer. Risk Mitigation Even if there is no coherent move towards M&A with Indian Outsourcing companies an India-strategy in this segment will help analyze and mitigate any future risks. Re-visit Vendor Relationships regularly Regular revisit of Outsourcing vendor relationships and having an independent advisor examine organizational outsourcing strategy are best practices. Potential M&A Evaluation Waiting too long for valuations to come down may be detrimental to becoming competitive in the short term. Evaluation of potential targets and understanding compatibility must be undertaken continually. The mode of doing business has undergone drastic changes over the last four decades and the rate of change would only accelerate with the rapidly changing economic conditions. It is essential for any organization to analyze and understand the future trends in this segment to remain ahead of competition. About the Author Deepak ( mailto:deepak.bharathan@gmail.com) is a strategy consultant working with PA Consulting Group. He has conceptualized and implemented transformational business strategy initiatives for Fortune 500 clients across three continents. His clients have included majors from diverse verticals like Private Equity, Telecommunications, Media, Manufacturing and Life-Sciences. He currently lives in the Washington DC metropolitan area