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TCS poised for strategic purchases in 2020 as peers’ M&A activity slows

Despite COVID-19 pressures, Tata Consultancy Services (TCS) has not shied away from enacting bold initiatives, evidenced by the announcement of Vision 25×25 during the company’s CY1Q20 earnings call. Even in the face of decelerating revenue growth in the first quarter, executives remained optimistic, suggesting that — unlike the broader trend in the IT services industry — TCS is not ruling out investing in M&A if the price is right. For TCS, key characteristics of its business model enable the company to kick the tires in the M&A market and take advantage of favorable valuations brought about by a dwindling number of interested buyers.

Massive scale and healthy balance sheet support M&A consideration

A strong financial model provides the foundation for TCS’ capital allocation strategy and gives the company more flexibility compared to its peers around strategic investments. For example, TCS’ operating margin was 25.1% in 1Q20, far exceeding TBR’s benchmark average of 9.6% and surpassing all of TCS’ India-based peers by over 400 basis points (Infosys’ operating margin trailed closest behind at 21.1% in 1Q20). Additionally, TCS is backed by massive conglomerate Tata Group and has limited long-term debt, putting it in a comparatively lower-risk position even during a time of global macroeconomic uncertainty, provided the company can mitigate impacts to its top line in the coming quarters.

In CEO’s words: “The best time to execute is when nobody else is buying”

Although TCS made two acquisitions in 2018, ending a four-year lull in the company’s M&A activity, competitors with more mature acquisition proficiencies such as Accenture, Cognizant and IBM usually tend to crowd the market and challenge TCS’ ability to gain market share in key areas. For example, Accenture remains committed to carrying out its $1.6 billion acquisition budget in FY20, evidenced by the five AI-centric purchases the company made in CY2Q20. Driving the optimistic viewpoint of TCS CEO Rajesh Gopinathan, however, are opportunities to pick up acquisitions at attractive price points as typically active buyers have lost purchasing power and/or voluntarily corralled investment strategies.

DXC Technology, for instance, remains weighed down by elevated integration costs and restructuring plans following six acquisitions in 2019, including the $2 billion buyout of Switzerland-based engineering firm Luxoft. India-based peer HCL Technologies (HCLT) is in a similar situation, as executives expressed a cautionary mindset while the company looks to complete remaining payments on the $1.8 billion purchase of several IBM software products such as Unica, Portal and Connections in late 2018. As HCLT CFO Prateek Aggarwal explained, “As you can imagine, these are turbulent times, and we don’t want to sort of fritter away the cash at this point in time.”

Previous investments display an audacious mindset amid macroeconomic turmoil

TCS’ acquisition strategy has historically been very selective, with the company opting to build its talent, IP and technology capabilities in-house and normally waiting several years before kick-starting new activity. During its most recent spending pickup, the company has stuck to low-risk and nonintensive purchases such as BridgePoint and W12 Studios in 2018, both consultancies with fewer than 50 employees and with estimated annual revenues of less than $5 million. In mid-2019 TCS also increased its stake in TCS Japan, a 2014 joint venture with Mitsubishi Corp., from 51% to 66%, in what was already a safe bet as the unit achieved double-digit constant currency growth in the two years prior.  

TCS’ last large-scale acquisition came during a risky time for most companies — the peak of the 2007-2008 financial crisis. In the fourth quarter of 2008, TCS completed its acquisition of Citigroup Global Services Limited for $512 million cash and brought on 12,000 India-based employees to provide BPO services in the banking, financial services and insurance sectors. While TBR anticipates the company will likely stay true to its existing strategy around more tactical tuck-in plays versus making a bold large-scale merger, a reflection on the past reminds us that the option — and willingness — exists.

IP will remain at the forefront of TCS’ acquisitions strategy

TCS already touts scale and well-trained talent, leading TBR to believe that the company will focus on obtaining IP, filling portfolio gaps and expanding its addressable market when considering M&A candidates. Because of its selective M&A stance, TCS is often left playing catch-up in the M&A market, reflected in its 2018 purchases of BridgePoint and W12 Studios, which mimicked Accenture’s push around digital design capabilities, and TBR believes this trend will continue.

According to TBR’s 1Q20 IT Services Vendor Benchmark, “The acquisition pace slowed in 1Q20; the nature of acquisitions remained similar to that in 2019 as vendors look to build out emerging technology portfolios, including security and deepened software practices around Salesforce and Workday.” This sets the stage for TCS to follow in the footsteps of its India-centric peers Infosys and Cognizant, which recently completed the acquisitions of Salesforce consultancy Simplus, as well as Salesforce Platinum Partner and digital consulting firm Lev. In TBR’s view, the central component of TCS’ acquisitions strategy will be targeting M&A candidates that can quickly and cost-efficiently add to its IP portfolio, similar to HCLT’s purchase of several IBM software assets in 2018, as TCS has built lucrative services offerings around the success of its homegrown products and platforms, such as BaNCS and Ignio.

Reconsidering TCS’ SWOT assessment: M&A comes alive

In November our detailed report on Tata Consultancy Services’ (TCS) performance and strategy included a SWOT slide with the following item in the Threat category: “Competitors are building assets and scale quickly through acquisitions; TCS retains a conservative M&A stance.” Just a couple of weeks into 2019, we’re seeing a change from the company: a willingness to attack this threat head-on. As noted in our Jan. 10 initial response on the company’s 4Q18 earnings, “TCS’ purchase of London-based digital design atelier W12 Studios will be integrated into TCS Interactive beginning in 1Q19.” BridgePoint, a Georgia-based consultancy, and W12 Studios are TCS’ first acquisitions since 2014, ending a four-year hiatus in M&A for the largest of the India-based IT services majors TBR tracks.

While the acquisitions of BridgePoint and W12 Studios represent a commendable departure for TCS from its traditional aversion to inorganic growth, neither will significantly move the needle for TCS in revenue, added human resources, or market reach. It also remains unclear how much, if any, intellectual property or new client access TCS will obtain from either acquired company. In the digital marketing space, TCS gains no meaningful or material ground on any of its chief peers, particularly Accenture, which generates over $8 billion a year in digital marketing services revenue.

Reflecting these developments, we will update our SWOT slide in the coming full report.

TCS corporate SWOT analysis update for January 2019

We fully expect TCS will continue down the M&A path, particularly in the Consulting & Services Integration (C&SI) and Digital Transformation Services business lines, as both businesses built a war chest for acquisitions and need to enhance their offerings to continue to compete. Our most recent assessment describes the company as having “successfully repositioned, recalibrated and revamped its solution suite to go beyond operations optimization and deliver scalable, digitally based growth and transformation enablement for its global clientele. All of its internal delivery processes have also been completely renovated to support a growing volume of Agile-based projects in the company’s pipeline, while nearly three-quarters of TCS’ workforce has been upskilled in Agile methodologies. Digitally based engagements continue to constitute an ever-expanding share of TCS’ revenue base and order book, driving a strong deal pipeline that is well balanced across multiple geographies and vertical industry sectors.”

Look for our complete analysis of Tata Consultancy Services Feb. 1, 2019.

IBM-Red Hat economic implications: Is disruptive state the new steady state?

IBM’s assets combined with Red Hat’s business monetization models are a good bet to provide a scaled, secure and trusted platform, if IBM can adjust internally and convince its clients to do the same.

The market splash

When a blue-chip bellwether company buys a firm that broke the lock on proprietary operating system dominance something big is afoot. IBM’s market luster has faded somewhat, and the financial sharks are circling with calls for CEO Virginia Rometty’s head and for IBM to be broken up and sold off to warm the cockles of institutional investors’ hearts, who cannot see the market implications beyond 90 days. IBM has been here before, in the late 1980s when Digital Equipment Corporation had a higher market valuation than IBM based on a single architecture and operating system as opposed to IBM’s six or so disparate computing architectures and operating systems. IBM’s first effort to course correct with the 9370 minicomputer was essentially dead on arrival, but its second shot, the AS/400, lives on in server closets to this day as the iSeries.

But this new challenge is different, and IBM knows it. Its executives talk about how “the axis has flipped.” At TBR, we talk of the Business of One as others label this moment as Industrial 4.0. The core revolves around cheap compute. Moore’s law has been the fundamental economic axiom driving the rapid rise and fall of technology vendors for at least 60 years, though some say its effects are waning. Despite the undeniable shift, innovations around cheaper and cheaper compute, storage and networking sources will continue in ways fascinating to fathom, especially as quantum computing nears commercial viability. At once scale means nothing and everything in this Business of One era.

Scale: Vital and trivial at the same time

Scale means nothing amid the development of new ideas.

Scale means everything when it comes time to ensure business commerce can leverage the new ideas in ways that protect brand, customer privacy and regulatory compliance.

IBM understands this as well as, if not better than, any of its competitors. The challenge for IBM is the same one faced by Satya Nadella when he took over Microsoft: how to change a deeply ingrained and highly successful corporate culture to align to these new, seemingly contradictory market realities. A lot of economists get lost in the buzz of hypergrowth for scaled public cloud revenue. Public cloud, at its core, is nothing but a commodity utility offering. It has never been the IBM play, and it ought not to become its play now. The company’s domain is enterprise IT, not easy storage of family photos or digital music. Amazon, Azure and Google (“Amazurgle”), and emerging regional rivals, can meet these demands, especially when such companies derive the bulk of their revenue elsewhere through advertising or e-commerce.

What IBM has to learn is how to compensate the management layers on companywide execution rather than on siloed execution. You cannot hold firm on razor sales when to lose that sale means risking a lifetime of highly profitable razor blade sales.

The technology assets IBM stands to gain in the acquisition are well documented, particularly in a recent commentary by TBR Senior Analyst Cassandra Mooshian. But TBR has covered IBM and Red Hat for years, and after one particular Red Hat analyst day, TBR summed up Red Hat CEO Jim Whitehurst’s business strategy as “deja vu all over again.” Essentially Red Hat aimed, and is still aiming, to do in the PaaS layer what it did in the enterprise operating system layer. Red Hat’s success with this strategy would prove a boon to IBM, and IBM’s long working history with open-source communities should allay many (but obviously not all) of the concerns within those communities around the business following the proposed acquisition.

Digital and Compaq: A cautionary tale for IBM and Red Hat

Big mergers bring big risks: Compaq and Digital Equipment Corporation, a tragicomedy

Compaq proved in the early 1980s you could buy non-IBM hardware and not get fired in the process by creating a portable PC that could be lugged around by weightlifters. Ultimately, Compaq struggled trying to move up the stack into the peer-to-peer networking space, as Dell and Gateway undercut Compaq’s undercutting of IBM PC price points, and made a big acquisition of Digital Equipment Corporation to buy enterprise server direct sales and services. But culturally, Compaq choked off the very assets the company desired by imposing volume business sales cost controls onto an enterprise-selling organization. In the end Compaq wound up being absorbed by Hewlett-Packard Co. (HP), which has acquired many hardware companies over the years.

What are the lessons learned for IBM-Red Hat?

IBM has decided to invest one-third of its market cap in acquiring Red Hat for $34 billion. Essentially IBM bought the ecosystem engine necessary to create the flywheel effect of IP services and support. There are synergies, to be sure, on the support of open foundations that have accelerated product commoditization in ways that benefit customers and pressure technology vendor business models across the entire technology spectrum. At issue will be which pieces of two different cultures and business best practices prevail, for, as Peter Drucker famously said, “Culture eats strategy for breakfast.”

What can IBM learn?

Red Hat pioneered the business model of monetizing services around free products. This stands diametrically opposed to the best-in-class blue suit selling model made famous by IBM and increasingly less relevant in the digital economy. Red Hat generates 75% of its revenue through the channel. Given that scale matters less, IBM has to improve its downmarket selling motions. Red Hat best practices should be imported into the current IBM selling motions as quickly as reasonably possible.

Red Hat also has near-zealous support among the developer community. Again, allowing Red Hat leadership to help shape new developer programs, run the Red Hat way from the wealth of IBM assets, will be critical lest those supporters migrate to another Linux distro such as Suse or Canonical.

What can Red Hat learn?

IBM has enterprise trust to solve critical technical integration problems soundly and securely. It likewise has access to more CxO decision makers in the enterprise. Success of the proposed acquisition will be as much adding more product to an existing sales channel as it will be to tailor messages to the decision makers while preserving the uniquely ardent support Red Hat has with the teams writing the code.

More to follow from TBR

A more extensive TBR Business of One special report, IBM-Red Hat economic implications: Is disruptive state the new steady state?, will be out shortly, written with Professional Services Practice Manager Patrick Heffernan. Recent commentaries are also available by Cassandra Mooshian, Big Blue opens its arms, and its wallet, to Red Hat; and Michael Soper, Red Hat can save CSPs from themselves.

Cognizant’s 3 new acquisitions enhance digital and global reach

Cognizant has made seven acquisitions since the beginning of 2017, adding between 2,200 and 2,300 employees and over $500 million in acquired revenue (by TBR estimates). The company’s acquisition spree continued in recent months with three additional purchases. In August Cognizant bought SaaSfocus, a Salesforce consultancy based in Noida, India, with operations in Delhi and Mumbai, India, as well as Sydney and Melbourne, Australia. SaaSfocus has completed over 1,500 Salesforce engagements in India and Australia with clients across the financial services, insurance, manufacturing and automotive sectors, including Audi, Baxter and Holcim. SaaSfocus has also forged strategic integration, application and industry-specific partnerships with companies including Informatica, Jitterbug, MuleSoft, DocuSign and Cloud Lending Solutions. TBR estimates SaaSfocus will add between $3 million and $4 million in new revenue and over 350 employees (about 280 are providing service delivery from India).

In September Cognizant announced the acquisition of Kansas-based Advanced Technology Group (ATG), further expanding its advisory capabilities on the Salesforce platform, specifically around the management and implementation of quote-to-cash (QTC) solutions: configure, price, quote (CPQ) software; multiplatform contract life cycle management and billing; and automating QTC processes. ATG operates delivery facilities in Kansas, Missouri, Ohio and Montana and has IBM, Subaru and CenturyLink on its client roster. We estimate ATG will add between $2 million and $3 million in revenue and about 280 employees to Cognizant after it is fully integrated.

Finally, in early October Cognizant announced it would acquire Austin, Texas-based Softvision. Financial terms were not disclosed, but Cognizant was expected to pay as much as $550 million to acquire Softvision’s 2,800 digital product and design engineers working in 27 studios across 11 countries (though the majority of digital product development will be in North America). TBR estimates Softvision will add between $160 million and $180 million in inorganic revenue to Cognizant beginning in 4Q18.

Cognizant’s latest purchases deepen its digital engineering capabilities, particularly around Salesforce technologies, but short-term margin erosion can be expected as Cognizant integrates its latest buys. Even as enhanced Salesforce competencies position Cognizant as a leading cloud CRM, marketing and platform vendor, integrating three additional employee bases into a workforce already beset by high turnover may exacerbate Cognizant’s struggle to control attrition. Still, Cognizant’s newest acquisitions will further enable the company to fulfill its overarching strategy of driving digital to the core of client enterprises.

TBR continues to view Cognizant as a leader among the India-centric vendors, and the company certainly separates itself from peers with its aggressive acquisitions. Executing on integration remains the key, and TBR will closely watch (and report on) progress.

Legacy’s last gasp: SAIC, Engility and the importance of skills over scale

SAIC’s planned purchase of Engility combines federal contractors with business models similarly disrupted by the march of technology

Themes of consolidation continued to pervade the U.S. federal government IT and professional services market on Monday, Sept. 10, with SAIC (NYSE: SAIC) announcing it will acquire peer Engility (NYSE: EGL). The proposed deal would combine two legacy providers of systems engineering and technical assistance (SETA) and ITO services to U.S. defense, intelligence, civilian and space agencies. The combination makes strategic sense for both parties as the commoditization of labor-based services compresses margins, compelling companies to look for scale advantages to optimize cost structures and maintain competitiveness to capitalize on the federal market’s current upswing.

The proposed deal would add to the lengthy list of market-shaping acquisitions and divestitures over the past five years. SAIC can be viewed as an instigator of the trend, as the company split from its former parent company, now Leidos (NYSE: LDOS), in 2013. Engility has also played a role in the industry’s consolidation through its acquisition of TASC in 2015. In the few years since, Leidos purchased Lockheed Martin’s (NYSE: LMT) IT services business, CSRA briefly gained independence before combining with General Dynamics IT (GDIT) earlier this year, and another new company, Perspecta (NYSE: PRSP), emerged from the combination of DXC Technology (NYSE: DXC) U.S. Public Sector assets with Vencore and KeyPoint Government Solutions.

While scale motivated all of these moves to varying degrees, SAIC’s planned purchase of Engility may represent the beginning of the end of this trend. As rapid technological change disrupts legacy business models, TBR believes the importance of scale will diminish. The deal will help SAIC in the near term, but what the company does next will determine its long-term survivability in the Business of One era.