In the last 18 months the markets took a deep dive and then recovered. Valuations in the Offshore Services industry yo-yoed, business prospects sank and then recovered. Yet amidst all this, the pace of acquisitions didn’t go up much. Apart from the Satyam acquisition by Tech Mahindra, deals have been small and infrequent.
The question is why? From the industry structure it would seem like the Offshore Services industry is ripe for consolidation. It has a few major companies that have scale, geographical and service breadth and brand names both in the market and the talent pool – companies like Infosys, TCS, Wipro, Genpact, Cognizant. And then you have companies distributed across the revenue spectrum. There are mid-sized companies, small companies and tiny companies. Shouldn’t the market be consolidating?
Not necessarily. First there is the timing issue. Valuations are back to being on the high side – which makes the buyer skittish. More importantly, growth is back. When the industry is growing, sellers don’t see a reason to sell. The companies that are growing don’t want to sell because they think they’ll get a better price next year.
But is growth evenly distributed in this recovery? It doesn’t seem so. I haven’t looked at the data, but my sense is that recovery of growth has been spotty for smaller companies. Which should mean that larger companies with a high P/E should be happy to bulk up with, but that isn’t happening.
I think the reason is the quality of revenue. Acquiring companies are looking at quality of revenue – acquisitions that bring them geographic penetration, domain expertise or a wider service footprint. And because these acquisitions are complementary the companies being acquired can be quite different from the acquiring company. Company culture, business operations, core skills may be different enough that the acquiring company is afraid of biting off too much. Which is why the acquisitions are small. “Pearls in a necklace” as Wipro has called it in the past.
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.
I think the Satyam acquisition is going to be a big test case. If the merged operations of Tech Mahindra and Satyam are successful as a single company, it will prove that large acquisitions can work and can work financially, if the price is right. As growth in the industry slows down, especially for undifferentiated mid-size companies, acquisitions should pick up pace.