iGate announced its acquisition of a majority stake in Patni.
iGate with Apax Partners, will acquire 63% of the company for the final price of Rs. 503.50 effectively valuing Patni, the company at $1.5 Billion. By Indian law, iGate will have to make an open offer to acquire an additional 21% of the company.
With that, a company with revenues of about $200 million in 2009 acquires control of a company with revenues of about $650 million. Even by market cap, iGate is a third smaller than Patni. You won’t see this python-swallows-an-elephant acquisition happen too often in any industry.
What made it possible was the difference in the growth in earnings. Which in turn is because of the difference in how well the two companies are managed (see last year’s stock performance below). Based upon yesterday’s price, Patni’s P/E is around 10 and iGate’s is around 22. The difference is big enough for any private equity firm to drive a truck through.
About a year back I had wondered why the offshore services industry wasn’t consolidating. I had argued the case for scalar acquisitions
But a scalar acquisition strategy – basically bulking up – can make a lot of financial sense. If you are a well managed company with a P/E that is higher than the industry, an active acquisition strategy can make sense.
First, if you can negotiate a price for the target that is somewhere at or below your P/E, you are already looking good.
Second, acquiring a company with a similar business, has fewer integration risks.
Third, this industry, even though it has low entry barriers, is a business of scale. Visibility, brand, lower sales costs and overheads – all come from scale.
When I wrote that piece, I didn’t quite have this python-swallowing-elephant kind of an acquisition in mind. But this is, in fact, a scalar acquisition. Although the integration on this one won’t be easy.
Indian law makes it difficult to outright acquire a company. Mahindra Satyam and Tech Mahindra are still separate companies. Until Patni is fully acquired, integrating management is difficult. Eliminating costs is difficult. Benefitting from having a common brand and go-to-market is not going to be possible. But I’m sure iGate and Apax would have carefully thought through these issues. It’ll be interesting to see how the integration takes shape in the coming months.
Nonetheless, this is a big deal with lots of potential to create value. If there is someone who can pull this off it is Phaneesh Murthy. He’s done superb job with iGate. Congratulations, Phaneesh! And good luck.
Congratulations also to Shashank Singh at Apax Partners for a very significant deal.
Fellow Enterprise Irregular, Bob Warfield calls me out on my claim that software has no marginal cost in my blog post App Stores Galore.
I write about the economics of Information Products often and have used the term marginal costs several times over the years in connection with digital music, e-books and of course the technology industry. So perhaps it is important for readers to understand what I mean when I say marginal costs are zero. In the process, I’ll also examine Bob’s claims to the contrary about the software on an App Store.
Wikipedia’s definition of marginal costs is
…marginal cost is the change in total cost that arises when the quantity produced changes by one unit.
Effectively, when I say that apps on the Mac App Store have a marginal cost of zero, what I am saying is that the next user of Angry Birds or Evernote or Omnigraffle, incrementally costs these companies nothing.
Compare this with Gap jeans. The next pair of Gap jeans sold will cost Gap a pretty sizable portion (maybe 50%?) of the sale price of the jeans.These costs are the material, manufacturing and shipping costs. And maybe a few others as well.
Bob’s rebuttal rests on three types of costs that he says prove that the marginal costs are not zero.
Engineering costs related to updates
Engineering costs are fixed costs. They have no relationship to the units of software sold. Sure, if you sell more units you have more money to spend on engineering, but that is conflating cause with effect. Think of the Gap jeans analogy. Is the next unit of Angry Birds sold going to need any extra cost in engineering? Nope.
Support
Support is a little trickier. If the app you are buying includes support over email or the phone, yes, there is a marginal cost here. But apps, and indeed, most consumer SaaS applications now direct users to their forums. On the forums, they either find the solution to their problem themselves or they post a question and a super user answers it for them. Often, someone from the company’s support team will have to answer the question. And so you might say that as the number of users goes up, the queries on the forum go up and the size of the support team must also go up.
But, there is another dynamic at play here. As users grow in number, the knowledge base on the forum also gets richer. The number of super users also increases. Problems with the software that lead to support queries are ironed out. Does all this compensate for the upward pressure on support costs? I don’t know. Probably not. But for these kinds of apps, after a certain user base has been achieved, incremental costs are not material, in my opinion.
Server side costs of processing, storage and bandwidth
Even if the software downloaded is simple desktop software with no SaaS component, there is the matter of the first download and subsequent updates. And presumably, the traffic created by polling to see if an update is required.
I understand that these costs, for an additional user, are not zero. But there is something called materiality. Is this particular cost material compared to the revenue from the next user? I doubt that Angry Bird or Omnigraffle worry about it. Evernote perhaps does, but how many apps do you know that users regularly use to scan and upload documents to?
Two endnotes
In software, there is always more that can be done. More products, more features, better performance, better customer service. The only thing holding it back is the money available to do all this. As a company grows in customers and revenue, it expands its engineering and customer service teams. Because it can. But this is not because of marginal costs. The causation is the other way.
Marginal costs is a construct used in Economics. In real life, you can never really parse out marginal costs from fixed costs with any certitude. Nor should you waste your time doing it. Managerial decision making, most of the time, doesn’t need numbers to be precise. So when I say, marginal costs are zero, but they turn out to be 2% of the unit price, it is not going to result in a different decision on whether one should be on the App Store or not.
The Mac App Store launched yesterday and saw more than 1m downloads on its first day. Evernote, a note taking productivity app, saw 40,000 downloads because of the Mac App Store. Clearly, a nice first day.
Nowadays, it seems everyone is launching an app store. Google Chrome has a Web Store. Amazon.com announced an App Store for Android Apps, that will compete with Google’s Marketplace. And of course, there’s the big daddy of app stores – App Store on iOS for the iPhone and iPad.
For the App Store owners the motivation is straightforward – an additional revenue stream. Apple charges 30% to App developers plus a registration fee. For everyone this is an additional way to monetize users and a platform.
But what’s in it for users? Quite a bit, I believe. Which is why I think App Stores will succeed for mobile devices, consumer apps and enterprise apps.
Is the 30% cut of revenues too much? It depends on how much you expect your revenues to go up by. After all, software has no marginal costs. Every dollar of incremental revenue is a dollar of incremental profit (before taxes).
For small app developers its a no brainer. For established players like Omingraffle, if a significant portion of their revenue stream gets diverted to the Mac App Store, they will need to make up for what they pay Apple in App Store fees in the form of incremental revenues. I suspect that will happen. In any case, they don’t have an option. They have to be available on the Mac App Store.
I see App Stores taking hold and becoming a fixture. Which means that making a platform successful (Force.com, Google Docs) suddenly became worth a lot more.
A very happy new year to my readers.
A couple of years ago I had posted a New Year’s Wish “Less”. Instead of a Wish List, which is mostly about wishing for things that you don’t have, I thought that I would ask for less of things that we have too much of. (no money is not one of those things!)
Fewer natural disasters in parts of the world that can’t handle them
Less irresponsible government spending
One word – Greece
Less than 24 hours of news coverage from 24 hour news channels
If they can’t do that then can we get them to have fewer talking heads on the screen at the same time. CNBC, I’m talking to you.
Fewer pages in the US Tax Code
Unfortunately, every change that is deficit neutral, hurts somebody who goes and lobbies their senator who filibusters until the bill is killed. Either that or the tax accountants will kill it. Simplification reduces billings. Hmmm…that’s true about IT Services too.
Less complexity in our cell phone bills, banking fees, utility bills…
I eagerly await Bank Simple
Fewer Amitabh Bachhan ads
I propose a public service ad that has Amitabh Bachhan say “I endorse all products sold by all manufacturers”. The ad loops from 2am to 4am on all TV channels. When we want to see Big B, we go to the movies. Oh wait, when did he do his last movie?
And while we are on the subject of TV ads, can we have fewer ad minutes per programming minute in India?
Less disrespect for its readers from Times of India group websites
ET and ToI start video ads with sound, as soon as you land on the website. On the other hand, I click less and less on links from ToI.
Less corruption in India
It’s not like I am hopeful or anything, but this is a Wish List after all.
Less religion in politics. Less religion in education.
Leave science alone.
My personal resolve for 2011
Spend less time with the Web of Infinite Information and more time with friends and family.
@labnol’s resolve for 2011
…type less and spend more time with speech recognition…
I have been looking for any personal finance software that can help keep track of my investments. So far, I have come up with zip. Maybe someone else has had a better experience.
Here is what I am looking for:
Schwab, of course, has nothing even close. They are so scared of making errors that they throw up a warning window every time I try to download a csv file. Can’t trust them to venture out this far.
I like mint.com for keeping track of expenses etc. but their investment management totally sucks. Pretty charts that are all horribly wrong, worthless or both.
A friend told me that Quicken takes care of all of these requirements. Unfortunately, Quicken gives the Mac platform short shrift. The last version for the Mac is from 2007 and the reviews are not good. No 30 day trial, so I passed. If someone has used this version and thinks it works, leave a comment.
iBank from iggsoft was supposed solve this very problem. The poor cousin treatment that Mac owners get on software for personal use. Tried it out. Couldn’t even set it up. No way to upload a csv! At least I couldn’t figure it out. For the transactions I could upload it seemed like it didn’t meet my criteria.
So my search continues. In the meanwhile, I put together a Google Spreadsheets solution, which meets all my criteria, except the windowing. Google allows you to call the price on a stock as a formula which is quite neat. The only problem with this is that transactions must be downloaded from the brokerage account and cut pasted into the worksheet every once in a while. I don’t trade much, so my solution works for me, kind of. At least until someone comes up with exactly what I want. But does that ever happen?
Infrastructure Management Services or IMS is one of the fastest growing services for IT Services companies. But computing infrastructure is what the Cloud will impact first and foremost. Is the fast growing IMS in jeopardy, then?
There are good reasons why the Cloud is a big trend. Enterprise IT loves the pay per use, “utility” model of provisioning computing power and storage. The infrastructure and the headache of managing it, both belong to someone else. Someone who can drive down costs tremendously through scale and automation in a way that the company on its own, never can.
But there are issues too. Since data will be outside the company firewall, information security is a big issue. Also, there are billions of dollars invested in data center infrastructure. Its all very well to say convert your investments into variable costs, but whose going to take those investments off the company’s hands? Not the cloud services vendor. In the meanwhile, virtualization technology like VMWare’s is helping companies achieve some of those savings in house.
The migration to cloud infrastructure is going to be gradual. Startups who don’t have anything invested will go straight to Amazon Web Services or a similar provider. But big business, which is where IT Services companies get the lion’s share of their revenues from, will take its time in migrating to the cloud.
Change is always an opportunity for a services company. Whether a company wants to try out the Cloud or implement a “Private Cloud” in house, they need advice and migration services.
Traditional IMS may also see a boost in the short term. A Fortune 1000 company may not shift much of its infrastructure to the Cloud, but between that and implementing a Private Cloud, the change will be significant – the pain of which they may decide is not worth bearing themselves. Often, this will lead to outsourcing decisions.
In the long-term how will the Cloud impact the IMS opportunity? There are some reasons to be concerned, but on balance, the impact will be positive.
The Cloud, by definition, reduces the workload on infrastructure management. But Private clouds retain a lot of the infrastructure management workload of legacy data centers. And as we have noted earlier, it will take many years before large companies will completely jettison their data centers, which will also need to be managed. Thus, the addressable space for IMS will shrink, but gradually.
While the pie might shrink somewhat, the slice of the pie that IMS gets could increase rapidly. Infrastructure management has been one of the laggards in the offshore services world. Some of it was because it required significant investments in NOCs (Network Operations Centers) by service providers, which slowed down progress. But it was also because clients have been less eager to offshore. The risk-benefit tradeoff for IMS is not as good as it is for Application Services. New technologies like virtualization will reduce the risk of outsourcing critical infrastructure management. The Cloud might just be the catalyst that gets more companies to outsource more aggressively.
But while there is opportunity ahead in IMS, service providers will have to change directions to take advantage of it. An advisory service to help clients understand the costs and benefits of migrating to the Cloud and/or a Private Cloud, should help position the service provider early in the decision cycle. A Private Cloud implementation and ongoing management service could be a money spinner, if not immediately, perhaps in a year or two (for which one would have to be offering it right now). In the future, there could be opportunities to resell third-party white-label Public Cloud services with a layer of IT management tools, although margins here are likely to be slim.
Photo Credit Kevin Dooley
