The Shifting Balance of Consolidation in the Offshoring Industry
By Matt Singleton, Associate and Sonny Ajmani, Principal, Opera Solutions
November 27, 2006
Recent acquisitions by global service providers spotlight the imperative of developing breadth and depth of offerings, especially in specific verticals that appeal to western customers
URL: globalservicesmedia.com
While HP’s acquisition of Compaq was significant in size, it was Lenovo’s acquisition of IBM’s laptop division that created a landmark event in the global technology industry. It signified the emergence of a new era of globalization where leading corporations in developing nations have started acquiring a dominating presence in the West. Are we witnessing the beginning of a similar trend in the Indian offshoring/outsourcing industry with TransWorks’ acquisition of Canadian-based Minacs or vCustomer’s acquisition of MCI’s call centers? Is there a pattern in these acquisitions? What is in it for these offshore firms? What does this mean for the likes of western competition such as IBM, Accenture and EDS? What does this mean for customers? Is this a fad or a phenomenon which is here to stay?
To seek answers to these questions, we trace our steps back to the rather traditional waves of industry consolidation in the offshoring industry, which appear to be passing us by at an accelerated pace. The first wave, started in the mid 1990s and was led by the larger Indian IT service providers building scale and diversifying through domestic acquisition of smaller players and launch of joint ventuers (with intent of eventual acquisition). The most prominent examples of this were the Wipro-Spectramind and Infosys-Progeon acquisitions, with many others that took place on the sidelines.
Over the last five to ten years, a strong second wave has emerged. The acquisition of Indian firms by the large U.S. firms was signified with some of the prominent deals such as IBM’s acquisition of Daksh, gaining 6,000 employees in India for $150 million in 2004. Most recently EDS moved this past July to become a majority shareholder in MphasiS, gaining 11,000 new employees for $380 million, which came shortly after MphasiS acquired Princeton Consulting and made itself an even more lucrative target. Many analysts saw this wave as a reactionary step by the large U.S.-based firms to solidify their foothold in the offshoring hotbed.
Even before this second wave of consolidation tapers, a third wave has been initiated by the Indian firms acquiring outwardly. According to a statistic released by the National Association of Software and Services Companies (Nasscom), India, this past February, 70% of M&A activity by Indian companies is with foreign companies. Wipro has already made three acquisitions this year in Finland, Portugal, and the U.S.A. totaling $102 million. On a larger scale, Bangalore-based Subex Systems’ $140 million purchase of U.K.-based telecom firm, Azure Solutions, is a testament to the strength of Indian firms in the global M&A space.
A closer look at this third wave of consolidation reveals some interesting patterns. In this segment of the services industry, typically not known for economies-of-scale, this consolidation shows the hunger and need for global scale. One can see traces of vertical integration, sparked by competition from Western firms, leading to economies-of-scope. This fierce contest has also forced traditional methods of organic growth to be supplemented with acquisitions to achieve the rapid growth, market share arbitrage, and market share capture required to stay competitive. Studying the recent market activity in detail reveals the underlying motivating factors behind these deals:
Climbing up the value chain. The ability to offer a one-stop shop to clients is a desirable end state for any business, and Indian outsource providers are not different. They face competition from many of the foreign players who are able to offer “one-stop shopping” to their clients that not only include BPO services, but higher value-add (and therefore higher margin) activities such as financial research and consulting. For some outsourcing providers like Infosys, who already have an internal consulting arm, organic growth may be the chosen path for expansion in this area. Other firms looking to augment such offerings are trying the acquisition path. In 2005, Satyam acquired two consulting providers: London-based Citisoft and Singapore-based Knowledge Dynamics that offer management consulting and data warehouseing/business intelligence consulting services respectively. Wipro — which already has an established consulting division — acquired California-based consulting firm, cMango, earlier this year in order to further build its depth in this area. Indian firms will need to assess whether in-house growth or acquisitions best suit the desire to grow “vertically.” This choice will have to be made sooner than later — acquire or get acquired is the name of the game!
Acquiring industry specialization. With the commoditization of basic application development and maintenance, offshore providers are working rapidly to build industry specializations. Firms are now supplementing their IT offerings with underlying technology platform with related BPO services, to grab a larger share of the back-office outsourcing pie. One example of this type of efficient investing is ICICI OneSource’s acquisition of Pipal Research, a company with only $1.5 million in revenue. This allowed ICICI OneSource to expand its existing offerings in the financial services into the growing financial research field. Under similar circumstances, Wipro purchased mPower Software Services for a very palatable $28 million in December 2005. With this acquisition Wipro gained entry into the lucrative payments-systems market. TCS’s acquisition of Chile-based Comicrom for $ 23 million in November 2005, further strengthens the hypothesis that firms are constantly looking out to gain a stronger foothold in a specialized industry, in this case banking. This acquisition enhances TCS’ platform based BPO competencies in banking in the lucrative Latin American banking-technology market. Several other acquisitions can be found where Indian firms have taken over financial services, health -care specialists, and other nontraditional segments for Indian BPO vendors. For example, Transworks’ acquisition of Minacs allowed for expansion into customized BPO solutions in the financial services as well as the automotive industry. Similarly, in a desire to strengthen its presence in health care, Godrej Global Solutions acquired U.S.-based Outsource Offshore. that specializes in health care transaction processing and data capture solutions.
Creating instant shareholder value. To date the Indian firms, who enjoy rich market valuations of ten times revenue, have been able to acquire western firms at a much lower valuation of 1.5–2.5 times revenue. Thus by making smaller “tuck-in” acquisitions that do not need to be reported separately every quarter, the offshore suppliers are able to quickly get the higher valuation for this newly acquired revenue. Recently, NIIT acquired the U.S.-based learning and development firm, Element K, at an incredibly low 0.5 times revenue multiple, quickly achieving sizable returns on the newly added revenue. As many Indian firms are already seeing 30%-40% margins on existing operations that are taken into account in their valuations, there is little value in making large acquisitions that would dilute this advantage. As a result, many such acquisitions to date are on a smaller scale despite the healthy cash reserves and tremendous buying power of the larger BPO conglomerates.
Optimizing delivery networks. We are beginning to see the larger offshore providers build global operating models for themselves. While their delivery networks are being built both organically and inorganically in emerging countries such as China and the Philippines where labor is cheap, acquisitions in the west are targeted at building the onshore operations to facilitate the acquisition of local clients. Such a client acquisition network enables a more seamless transition of processes from the client to the onshore delivery center and eventually to the offshore network. This smooth transition enables clients to offshore without bearing the upfront re-structuring cost of laying off their employees (in the near term) or facing any perceived taboo related to sending jobs offshore. For example, a New Jersey-based financial-services organization, with a low desire and readiness to lay off employees and transplant positions 10,000 miles away, can outsource its operations domestically even though it is to an Indian entity. Such a transaction can include an agreement with the service provider to retain the outsourced staff, and sometimes real estate for a period of 18–24 months before sending it offshore. This approach increasingly allows the offshore players to compete more aggressively with the traditional domestic outsourcers such as IBM and Accenture. One of the most recent example of global delivery enhancement is Genpact’s acquisition of MoneyLine in July to further expand its international presence in the mortgage servicing business. In a press release immediately following the announcement of the acquisition, Evan Gentry, President and CEO, Genpact Mortgage Services, claimed, “We are providing the ultimate outsourced mortgage solution, utilizing the best of onshore, global delivery, scale and global resources to address the outsourcing needs of large mortgage producers worldwide.”
Buying a brand-name client. When vCustomer acquired MCI’s call center or when Wipro acquired mPower Software Services that had MasterCard as a flagship client, it added another brand name to its customer portfolio — something critical to establishing credibility with western customers. Similarly, in an effort to further its reputation in the financial services (focusing on the mortgage services sector), WNS acquired Trinity Partners, which included a $60 million contract with First Magnus Financial Corporation — a top 15 wholesale lender. Also an added benefit, a western brand-name operator that has credible audit policies, data security and proven onshore execution can give regulators and management committees of future clients increased confidence in delivery capabilities of these vendors. WNS’ acquisition of Trinity Partners no doubt assisted in gaining credibility within the U.S. Mortgage industry, which has a smorgasbord of complex regulations.
Buying liquidity through western securities markets. As the offshore providers are racing against time to grow as fast as they can, gaining access to future investment capital is critical. While the larger firms are listed in India and enjoying healthy investment interest due to their ADRs, some of the smaller players are starting to acquire publicly listed western firms to tap into western securities markets. In addition to providing a future source for investment liquidity, such a move can also assist these firms in onshore branding. However, there are very few such examples at this stage.
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