Is Offshore Services a Scale Business

Earlier this week I wondered why Indian Offshore Services companies weren’t “bulking up” – basically acquiring companies just like themselves – just smaller and with perhaps lower P/Es.

A reader left a thoughtful comment :

I guess one of the common reasons for M&A (to add bulk) is to achieve economies of scale. Indian IT outsourcing is services business. In services industry, (compared to manufacturing industry) the economies of scale flatten out relatively fast. The profit/revenue per employee for a 10,000 employee company may not necessarily be better than a company with 5000 employees. After all its all about humans, not machines.
So a large company (Infy,Wipro etc) doesn’t gain much by acquiring a smaller size company. Their own brand name is already so powerful, that they don’t need much help in that department.

The comment makes a lot of sense and it would be hard to disagree with the fact that the IT Services does not have the economies of scale that a steel manufacturer does (ergo, Mittal acquiring every company in sight). But there are important economies of scale at the top of the range. Let me explain.

If you look at the financial metrics of an IT Services company, it is almost entirely a variable cost business. Both capital intensity (capital investment required to produce a unit of revenue) and fixed costs are low.

Also, IT Services revenue tends to be sticky. Especially, if the revenue is of the kind that “runs the company” rather than “changes the company”.

So you have an industry where you can get into business with very little capital. You breakeven fast because the fixed costs are low. And the revenue you have is relatively immune to competition. Which explains why you have so many small companies in the industry.

But you also have giants in the industry – IBM, Accenture, Infosys, TCS. There must be something that makes the giants grow faster than the guys at the bottom of the range.

There are indeed. Some things like Overheads and Sales costs could both be more efficient (lower % of revenue) and more effective (cover more industries, more countries in the world) with size. But these aren’t that major factors. The important one is the economies of scale related to branding.

Outsourcing large scale IT or BPO, more often than not, comes down to a matter of trust. A C level executive at a Fortune 1000 company is making a huge bet that can make or break his career and perhaps even a few quarters for the company. And while a part of that trust is derived from the service provider’s representatives working on the deal. A big part of it comes from that intangible – the brand.

And when it comes to branding, size matters. It’s not just that you can spend much more on advertising if you are bigger (like IBM or Accenture). Your brand automatically benefits from your larger presence. You have more client references (who have hopefully had good experiences with you). The analysts know you, the deal consultants know you. You are public. You are in the news. You are automatically on every short list.

Branding also matters at the other end of the value chain – in hiring. Employees like to join large established companies and will often forgo a higher paying job at a smaller company. (Silicon Valley may be the one exception to the rule and even here, things have changed). So Infosys is basically getting the cream of the crop at a lower cost than their competitors. Is that worth a few points on the margin? You bet.

Here’s the nub. There are several companies around $1B that are well run companies, but they run the risk of becoming marginalized, of losing the mindshare game to the big guys. In a market where growth may be harder to come by, they will have to compete harder against bigger brands, if they want to keep shareholders happy. Inorganic growth (acquisitions) can be one plank of your strategy in such companies. Obviously, it can’t be the only thing you’re doing.

That said, gaining economies of scale is not the only reason to bulk up. It has to make financial sense. Relative stock valuations, cash on the balance sheet – those are the table stakes.

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7 Responses to Is Offshore Services a Scale Business

  1. rajiv gupta says:

    Centuries ago India gave ZERO to the western world , and since histroy repeats itself its again time we give ZERO again to the western world .

    In my prediction Indian companies can literally acquire any company in the world in next 4-5 years and make them Zero – Atleast the inflated egos will be reduced to zero :-))

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  2. Basab, the relationships with individual client buyer (and the overall brand with the client) go hand in hand. IT Services is a B2B business, and in this business relationships and record matter a lot. Almost all companies in this business will get a majority of their revenues from a small fraction of their overall client base. The more business you do with a client, the more you're likely to get new business with them (provided the business isn't screwing up on delivery). Why buy then?

    I guess it would make sense to buy around relationships- either buying companies that have similar brand/positioning but complementary clients, or buying companies that help deepen a specific client relationship.

    One could propose buying for the employee base or, good Lord!, even intellectual property. IT services businesses are largely about the headcount (people x time x rate = revenues), and there frankly isn't much new intellectual property going around to pay revenue multiples for. Buying for employees would make sense only if the client base is complementary. Otherwise, the acquirer could be spending years trying to unravel the bad relationships from an acquisitions.

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  3. Anon says:

    With great size, comes great angst…check out the anti infy tirade by seeming insiders on economictimes website! ("promotions strictly for performers"). This, for an award winning company with a culture to die for! What would be the state of employee engagement in companies that aren't as respected?

    Why would companies invite more employee ire by acquiring companies and merging the two operations? Acquisitions in this industry are certainly not for the faint hearted.

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  4. Vikram says:

    These large IT companies will go anywhere to sustain their branding. Like winning “The Best Employer” when almost every employee in the organization is wondering “how the heck?”

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  5. Madhu says:

    In the services business, scale = strength. Beautifully explained, thanks for the great article !

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  6. Ram Medury says:

    The only reason to buy, would be to touch that holy grail of non-linear revenue stream. Strong IP bought along with clients can then be scaled by revving up the delivery engine. An interesting proposition and I am right in the middle of such a thing!

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  7. Alok says:

    Basab, acquisitions should be done only to scale your current capabilities but to add new ones too. IT organization need to learn more complex businesses and talk their language in working on large and complex deals. Acquiring companies in domain expertise would add capability and credibility to their kitty and help them grow businesses faster.

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