6 am pacific

Horses for Sources has a post on the rumored merger discussions between Cognizant and Genpact. Financial Express reported on it first. I disagree with the premise of the post and wrote a long comment which for some reason did not post to the blog. So I am reproducing it here at the end of the post. (Note to self: always write long comments in a notepad before you post them.)

First let’s look at what could be the rationale for an acquisition in the Offshore industry. To my mind there are four models that justify an acquisition. They are not mutually exclusive and most acquisitions may be classified under multiple models.

1. Acquiring Offshore Capability

The legacy model of IT Services and BPO is no longer viable. Whatever remains is crumbling under the weight of offshore economics. It has taken over a decade to do so, but most of the major players – IBM, Accenture, Cap Gemini, Unisys – have all set up, with varying degrees of success, India and other low cost country capabilities. On the way, some of them took the opportunity to acquire an Indian company. IBM acquired Daksh and EDS acquired Mphasis. I see acquisitions in this model continuing as promoters in smaller Indian companies becoming more willing to deal.

2. Market Footprint expansion – Geo, Vertical

These will typically be small, tuck-in acquisitions. You could be buying a point presence in a geo or a vertical where you see potential but don’t have a foothold. Infosys’s acquisition of Expert Systems in Australia would be in this category.

3. Service/Solution expansion

TCS’s acquisition of Citi Global Services gave them a solid capability in BPO in Financial Services. HCL’s Axon acquisition would be in this category as well.

4. Scalar expansion

Acquiring a company similar in most respects to your company would fall under this category. Tech Mahindra’s acquisition of Satyam and Caritor’s acquisition of Keane would be called scalar acquisitions. I call them scalar, because the rationale behind them is to scale the company. I believe that there hasn’t been enough of this kind of consolidation and that this is coming soon to the industry. My earlier post gives the reasons why.

One model that is conceivable but I don’t hold out much hope for is where an Indian services company acquires a major consulting led company. I just think the integration is too tricky and the risk of flight of talent is very real. HCL Axon approaches this model, but Axon while reasonably large was a very focused SAP consulting and services company and SAP was never HCL’s strong suit. So they can effectively carry on doing what each of them was doing pre-merger and avoid any integration whatsoever.

This may look like the same combination as 1) above, but it is not. If a major global player acquires a mid-sized Indian company they will operate it purely for offshore capability. All market based roles and leadership roles in the company will be retained by the acquirer. But when an Indian services company acquires a consulting company, it is not clear who will lead and who will follow. And that is what will lead to trouble.

Onwards to the possibility of a Cognizant-Genpact combination. Why might this be a very good combination? Here are my reasons:

The businesses are very complementary. Genpact is less than 15% IT Services. Cognizant is 5% BPO. The lack of overlap means a few things, all of them major factors:

• In one stroke Cognizant as the acquirer becomes one of the largest and most sophisticated BPO service providers. In addition to already being a large high-growth IT Service providers.
• One of the worries in Services acquisitions is that you will end up offering the same services at the same clients at different rates and then the client will move all services to the lower of the two rates. That overlap is going to be minimal in this case.
• The senior teams of both companies will find homes in the combined company. In the medium term they should not have to merge leadership of business units.

Horses for Sources (HfS) says that the BPO culture is quite different from the IT Services culture and that will not bode well for a merger. I can’t see why they would think this. Both companies have a dynamic, growth-oriented culture and have professional management.

HfS thinks that Indian companies have used cash for acquisitions and Cognizant doesn’t have enough cash to acquire Genpact. Indian companies have used cash so far for acquisitions because they have enough cash – actually more cash than they know what to do with. This cash expands the balance sheet and lowers investors’ return on capital. Companies like Infosys have done several special dividends to reduce cash. Nobody in their right minds would use stock to acquire when they have that much cash sitting around.

Does that mean that they won’t use stock when they have to? Absolutely not. I don’t think Genpact’s investors would have any problem accepting CTSH stock.

Also, on a related matter, both Genpact and Cognizant are listed in the US with no float in India. This makes things easier. Acquiring a company 100% in India is a little messier, procedurally.

The fact that GE is 40% of Genpact’s revenue is known and will be priced in to the acquisition price, post due diligence.

The rumor may or may not be true and even if it is true, the deal may or may not happen. But on the face of it, it makes sense. The combined company will be on target to be the second largest in the Offshore industry after TCS within less than a year based upon projected growth rates. And in this industry size matters.

The US and Western Europe account for the lion’s share of the market for Offshore services. In the medium term they are expecting slow or no growth and at least in the US, high unemployment rates.

In such a scenario, we should expect that the public opinion will turn against offshore. Naturally therefore, the anti-offshore rhetoric in the media and from politicians will ratchet up.

In the past, the polemic against “offshoring of jobs” at the national scene has generally focused on China and the loss of manufacturing jobs in the US. The reasons for this are:

– The impact of Chinese manufacturing on US jobs preceded Offshore services outsourcing by almost a decade. The magnitude of the impact was also much larger.

– Loss of manufacturing jobs is a union issue. The Dems are extremely sensitive to union issues, especially in the Rust Belt (which became rusty because of Chinese outsourcing).

– The early impact of Offshore services was on IT workers. And for a while the impact was softened because of the growth in the IT sector. The employment in the sector grew so much till the tech bubble burst, that it easily absorbed both domestic workers and outsourcing.

– IT Workers were typically better educated and higher paid. If they failed to find another job, they had a college degree and would be able to find some other form of employment. Probably lower paying but they wouldn’t be without a job for too long.

But things are different now.

Chinese manufacturing still has a much bigger impact. Which is why there is so much angst in the US about China’s pegged currency rates (which is deserved, IMO). But there are other things that are different this time around.

First, the impact of Offshore services is slowly veering away from IT workers to regular white collar workers – from customer service to business analysts. Many of them don’t have a college degree and don’t have flexible skills.

Second, while the US was losing manufacturing jobs to China, the service jobs were picking up the slack. Over a couple of decades, the composition of the US workforce shifted dramatically to where services jobs accounted for the bulk of the workforce. Now as services jobs slowly start leaking out to India, there is no mega trend to rescue it. To make things worse, unemployment is expected to stay close to 10% for a while.

As you might expect, the backlash has begun. There was the Borders Bill. Then state governments, who are incidentally running budget deficits, have started barring government outsourcing to include any offshore component.

From the NY Times article on the Border Bill

“I’m thrilled that these companies are complaining about having to hire more Americans,” said Senator Claire McCaskill, Democrat of Missouri. “That is the whipped cream and cherry on top of this sundae.”

Indian services companies run the risk of becoming punching bags for American politicians. Unless they do something about it.

The first thing you need to do if you are responsible for your company’s response to the backlash, is to be clear about your own position. Offshore services may be called outsourcing. It may be that you can point to the guy in India who took away a specific American’s job. But despite all this, Offshore services is no different from trade in merchandise of any kind. Offshore is trade in services. Keep repeating that sound bite. If people attack Offshore, they are anti-trade.

This is not about twisting facts to make a bad situation look good. It is in fact exactly right. Which is why no economist worth his salt will stand up and say that the US should place restrictions on Offshore services. Because it is trade. And unlike Keynes, there are no economists contesting Ricardo.

Next, talk about all the American goods that Indians consume. From Nike shoes to Cisco routers. I haven’t confirmed this yet, but someone I spoke to today said that India-US trade ran a deficit on the Indian side after accounting for services.

Then, talk about the fact that there is a shortage of IT workers in the US. Unemployment may be at 9%, but that doesn’t mean that unemployment among college educated software engineers is anywhere close to that. This does sidestep the issue of the impact of BPO but if you had the aggregate numbers I am sure one could craft a response there as well.

Finally, craft a coordinated PR plan through an industry body. Don’t just sit back and let the media and politicians control the message. Some of this seems to be happening as is evident from this article in the FT where both Infosys and Cognizant are quoted.

The action above should be happening in the media and in meetings with clients and, importantly, employees. Employees who are onsite meeting clients are often asked these questions by concerned client managers. If they are armed with the right messages and data, they can handle these questions much better.

Another important area of action is to influence governments. I doubt if lobbying US legislators is going to go too far, at least in this charged atmosphere. But it does help to at least have industry body representatives get their point of views in front of legislators.

On the other hand, lobbying the Indian government to take action is likely to be very effective. India and the US have a special relationship. Neither side will want a trade war and will work to avoid a situation where India does a tit-for-tat targeted tax on consumer products from companies which are majority owned by a US company.

Lastly, the best friends of Indian Offshore companies are American corporations. They like the cost, flexibility and availability of talent in India. They are global corporations and believe in open markets. They would love to do more business in the Indian market. And they have leverage with US lawmakers.

Outside the US market, the UK market is going to follow a similar pattern. Outside the US and the UK, the stakes are anyway smaller. The environment is going to get tougher and more unfriendly to Offshore over time if things don’t improve unemployment wise. It’s important to stay focused on this matter and be proactive. Damage control after a bill like the Borders Bill, achieves very little.

[Update: For completeness’ sake, I must mention that the most important action point perhaps is to actually hire more Americans. Or Britishers. There are Indian companies who seem to be doing that with some success. An earlier post on local hiring.]