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.

Offshore Services: Whither Consolidation?

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.

Funny Chart

Andrew Biggs compares spending on veterinary services and healthcare spending in the US. The case he makes is that the issue with healthcare is not the rate of growth of spending but the absolute amount of spending. He presents this chart as evidence of both. But it is a totally inappropriate way to represent the data.

The first thing that the chart hits you with is that the ‘slope’ of both lines is roughly the same. And the fact that Biggs’s conclusion is that the growth rate over the period is roughly the same for both might lead you to think that they are connected. But they aren’t. The lines are on different scales and so a comparison of slopes is meaningless. If you interpolate the data points, you get growth rates over the entire period of 267% for healthcare and 261% for vetcare. Close enough that the conclusions don’t change. But that’s not the point.

A chart of this kind (Y1/Y2) is the wrong choice to show similar growth rates. I could take any two time series and design the Y1, Y2 scales in such a way that they appear to be growing at the same rate. The right way of doing this would be an indexed chart such as is used to compare the performance of two stocks or a stock against an index.


Satyam – the Larceny Scenario

Investigators looking into the fraud that has been called India’s Enron have found a “maze” of about 300 companies related to Mr. Raju that were used to “siphon” as much as $1 billion in cash from Satyam, said a senior official involved in the inquiry, who was granted anonymity to discuss developments in the case.

A New York Times report indicates a simple answer to what happened to Satyam’s missing billion dollars – larceny. The performance of the company – revenues, margins – were not systematically overstated over many years as Ramalinga Raju claimed they were. Instead, the promoters were stealing. This simpler explanation is something I have suspected all along.

Ironically, if this is true, this is good news for Satyam. On many fronts.


Satyam Operating Margins Look Real


I pulled this chart together on our very own research platform just to see if there were any signs in the operating margins that Satyam was managing earnings. I found none.

The comparables to Satyam (SAY) are Infosys, Wipro and Cognizant. Satyam’s range of the operating margins is just fine. The seasonality caused by the annual influx of trainees through campus hiring is also there. I couldn’t figure out why the dip was a quarter later than Infosys but there is probably a rational reason for that.

Also present is the uptick in margins in the last couple of quarters, which is presumably because of the favourable movement in exchange rates.

Managed earnings should leave some fingerprints. I couldn’t find any. So either Raju and co were very, very careful with how they were managing the earnings. Or, they weren’t managing earnings at all and the money has actually gone missing.

Satyam Next Steps

India’s regulatory authorities have made a great start on the Satyam accounting fraud scandal. The two bodies that would have regulatory oversight over such a situation – the Ministry of Company Affairs and SEBI – are both playing this on the front foot. The Raju brothers the CFO have been arrested and remanded to judicial custody. The Satyam board has been sacked and very quickly a new board is being assembled. So far so good.


More on Satyam

We are where we are. The biggest corporate fraud in India’s history was disclosed by its perpetrator yesterday. Where we go from here, as I wrote yesterday, this is a test of our regulators. How they handle this crisis will determine how investors see the Indian market in the future. Frauds happen everywhere. But if in India, fraudsters go scot free or with just a slap on their wrists, we will damage the trust that investors – both within India and outside – must have to get back into Indian markets when things start looking up.

I find it hard to believe that this fraud was committed to inflate earnings. If that were the case, the Rajus would have sold at least some of their stock. Did they believe that this was going to continue forever? As others have pointed out, a 3% operating margin is very hard to believe. The downward pressures on rates in IT Services simply isn’t enough to cause that, assuming that salaries were on par with other IT Services companies. So the question is, where did all that money go?

I think Raju is doing a Madoff – taking the fall for the rest of the family. It is impossible to cook the books of a large company for this long without half a dozen people being complicit. That includes their auditors by the way – PriceWaterhouseCoopers – who must be held to account.

The way this investigation is carried out and its outcomes will be closely watched. The net must thrown wide to catch everyone involved. Follow the money and you will find them. The court cases should not drag out. Justice must be expedited with its proceedings as open to the public as is permitted. And along with the due punishment under law, we must seek disgorgement of ill-gotten gains. It would be a downright shame if at the end of this, just one person gets a light sentence and $1 Billion, or whatever part of it is truly missing, is never recovered.

I understand Merrill Lynch resigned the Satyam account. That doesn’t change the fact that they were advising Raju on the Maytas acquisition, which stank to high heaven.

I wonder what’s going on in the heads of Satyam’s clients? Well for one, every CIO of Satyam’s client companies will be wondering if the people from his company who were involved in the selection of Satyam did so entirely on the merits of their proposal. Next, he’ll be worried about business continuity. A major service provider that’s been delisted on the stock exchange doesn’t exactly give you the confidence that your systems are in safe hands.

On the other hand, this could be a great opportunity for a dirt cheap acquisition. If only we knew what their true accounts looked like.

What an amazing destruction of a company, its shareholders practically wiped out, dispirited employees who would be heading for the door if there were jobs out there and customers who are ruing the day they hired Satyam. And for what! Truly, greed has no limits.

Questions re Satyam

While I was out of circulation and not blogging (business trip and vacation) the Satyam saga was unfolding. I remained abreast of what was happening but didn’t post anything on it. It’s been well covered by other bloggers and the media in general both in India and abroad. So I won’t bother adding my opinion except to say that if India Inc. is to redeem itself, what happens from here on out is what matters. The Rajus, on the other hand, cannot redeem themselves. Nor can the independent directors, unless they publicly say that critical information was withheld from them.

But I have several questions about the whole affair. Some of them are rhetorical, others are real questions. So if you know the answers or where I can read up on material, please let me know.


Outsourcing Captives is Not an Acquisition

About a year ago, I had written about why offshore IT captives don’t work [link]. Now I hear that the companies that had set up captives in India are rushing to get rid of them. Except that there is a curious twist. They want to be paid to rid themselves of their mismanaged captives.


The IP imperative for IT Services or How to Beat the Recession

The Indian IT Services industry is going to feel the pain of the US recession which is likely to spread to other major markets as well. This recession is going to be different as I have said before.

What do you do, when you are faced with a near certain slow down? You can try and squeeze whatever juice you can out of your as-is business, but that will take you only so far. Or you can choose to breathe some new life into your value prop and perhaps change the trajectory of your company.