"Damned if you do, damned if you don't" - this largely seems the story of big-ticket M&A in the Indian IT/BPO industry ::JPMorgan

 “Big-ticket” M&A in Indian IT ordinarily have several objectives, but
three are most often articulated: (1) introducing or raising growth profile in a
distinct, altogether new function (vertical/horizontal/geography), normally the
more immediate payoff; (2) cross-synergizing, which is selling the acquired
capability into the broader base of the acquirer’s existing clients and the
acquiring firm’s existing capabilities into new clients from the acquisition to
boost the acquirer’s organic growth prospects; and (3) achieving sufficient,
scalable offshore flow-through (or downstream) over time to scale and break
even on margins (this applies to acquisitions made onsite). Items 2 and 3 are
typically longer-term aims, much harder to realize, as well, as they entail
integration of the target into the acquirer’s mainstream. This has proved a
torturous agenda, as integration can easily undermine the culture,
processes and identity of a target, which defeats the logic of the acquisition.
 We find that most, if not all, large M&A fails at Items 2 and/or 3. Highprofile acquisitions that have delivered significantly below expectations, in our
view, include Info-crossing (acquired by Wipro in Aug-07 for US$600mn),
Oracle’s acquisition of i-Flex (stock price of Oracle Financial Services
motivated more by technical factors such as delisting) and, to a lesser extent,
Axon (acquired by HCLT for US$658mn in Dec-08). Info-crossing has not
consolidated Wipro’s then-leadership in infra-management (if anything,
TCS/HCLT has taken over leadership in infra-management in the last two
years). The financial products business at OFSS has been languishing for a
while now, growing at just single digits in percentage terms. AXON has not
helped HCLT grow enterprise solutions (SAP/Oracle solutions) ahead of peers,
though AXON has helped HCLT sell its core infra-management services to its
(AXON’s) clients.
 In an attempt to preserve the distinctiveness of the target and also as part of
learning from the shortcomings of previous M&A integration efforts, many
acquirers are delaying the integration of targets into the mainstream, which we
see as prudent. This might postpone the synergy gains, but if doing so minimizes
risk of the M&A going wrong, it might be well worth it.
 Historically, the market has been initially skeptical of larger mergers of
listed entities, especially mergers involving a company merging into a
smaller/comparably sized one (e.g., Patni-iGate or Tech MahindraSatyam). We find that it can be 12-18 months after a merger announcement
that tangible value emerges (if it happens) for the investor, as the acquirer
sets about tackling the initial burden-of-proof (we have seen this with the
TechMahindra-Satyam merger, for instance). Investor interest in stocks of
companies involved in a merger emerges only at very reasonable valuations,
when merger/acquisitions risks are more than adequately priced in. Such a point
may be reached after a period of significant stock underperformance following
the merger announcement.
 We would temper buoyant expectations of significant acquisition(s) or
merger(s). The feel-good factor that the prospect of a large acquisition
sometimes induces may be more psychological and may not square with the
subsequent track record, as our analysis suggests

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Infosys seems to have started off on the wrong foot with its Lodestone acquisition.
That such a miss at Lodestone should come in 4QFY13, barely two quarters
after the acquisition was made, raises some questions including the eventual
viability of large M&A activity in the Indian IT/BPO space. Few studies have
been done on large mergers/acquisitions in this sector. How many of them have
worked out (at least partially) for the buyer over the medium to long term? How
many have been disappointments and ended up being only a dissipation of good
resources (money, people, management bandwidth). How many still have potential
despite early disappointments and therefore bear patient watching?
Our thematic report explores the performance of large M&A activity in the
India IT/BPO industry. We recognize that a large acquisition should be viewed
relative to the size of the acquirer (a consideration value amounting to a reasonable
percentage of an acquirer’s market cap could be a large acquisition for the acquirer).
We have studied almost every M&A instance in the industry since 2005 (of
consideration value at least US$500 million). The takeaways are sobering, to say the
least.
Our finding is that most large-scale M&A do not meet many of their objectives,
some, in fact, quite badly. There is no single or common reason for this. It could be
a medley of reasons, including any of the below:
(a) Inability to preserve the distinctiveness of the target (especially of onsite
firms) as the acquirer attempts the integration process sometimes hurriedly
(especially true of overseas/onsite acquisitions).
(b) Little incentive for target management to stay, especially if a fairly large
portion of the consideration value is paid upfront, with modest future earnout(s) in the total package. In higher-value targets, such as consulting, it is the
on-the-ground consultants who tend to have the relationships and noninstitutionalized knowledge. This is unlike an outsourcing firm, where
relationships tend to be more concentrated in a very narrow population of client
partners, account managers and divisional heads, but also where firm knowledge
is more institutionalized. Undesired attrition of key resources in onsite-centric,
higher-value (or domain-centric) acquisitions undermines acquisition success.
(c) Hacking away too much of the muscle of the target firm, instead of the fat.
Onsite firms tend to have onsite-centric administration costs that can be almost
immediately rationalized by an acquiring firm with little risk. Sometimes,
trouble arises when sales and marketing teams are streamlined, especially if it
proves difficult for the acquiring firm’s sales and marketing managers to duly
appreciate the skills/process/methodologies ingrained in the sales and marketing
processes of the target firm.
(d) Inability to take a strategic view of offshoring and/or reluctance to embed
offshore penetration-linked goals in the KRAs of global, senior managers of
global firms acquiring in India. This factor has relevance to the phenomenon
of overseas global firms acquiring India-based firms to establish an offshore
beachhead (e.g., CSC acquiring Covansys, Cap Gemini acquiring Kanbay). We
still await success indicators (even after six to seven years since these US$1+
billion acquisitions have been made). Rather than see the India entity as just one
arm of the company and one among several acquired companies in the parent’s
portfolio, what seems lacking is priority in defining how integral offshoring
must be to the overall strategy of a firm and, accordingly, setting the KRAs of
senior managers. Do overseas firms incentivize the senior managers to embed as
much of the offshore arm as possible in selling overall firm capability? Is there
enough representation of Indians in the overall global leadership of these
companies?
Looking at the track record of these acquisitions (such as Kanbay,
Covansys, Oracle Financials Software), we suspect that answers are not in
the affirmative. CSC and Cap Gemini are still struggling to improve margins at
the overall company level in the past five to six years.
In contrast, Accenture’s (covered by J.P. Morgan US Analyst Tien-tsin Huang)
ascendancy in the past three to four years is almost wholly (if not wholly)
attributable to outsourcing (not its legacy consulting). So, we view Accenture as
a test case of how global firms can reposition their large, legacy business models
to establish thriving offshore beachheads integral to their remodeled business
propositions (not without intense teething pains, of course). Of course,
Accenture has grown its India presence taking a largely low-risk, organic
approach, in contrast to CSC and Cap Gemini.
Clear success stories are present, but few. We believe TCS’s acquisition of eServe is a notable success story amid a rubble of disappointments elsewhere. The
Satyam-Tech Mahindra combination has potential, in our view, now that Satyam has
stabilized, cost synergies having substantially played out, as reflected in improved
margins, but revenue synergies accrued from cross-leveraging respective company
strengths have to still play out for the combination.
MphasiS, under the ownership and patronage of EDS, also had a good business run
in FY07 and FY08, but this was not sustained after HP (covered by J.P. Morgan US
Analyst Mark Moskowitz) acquired EDS. Under HP, MphasiS’s core performance
has considerably weakened in part due to HP’s issues, in part due to competition with
HP’s fully own subsidiaries in India, which compete with MphasiS for the offshoring
pie.
Conclusion. Large mergers/acquisitions in this sector, much more often than not,
don’t live up to the expectations of the acquirer. “Damned if you do, damned if you
don’t” – this phrase seems to epitomize the large-scale M&A action in the Indian
IT/BPO outsourcing space.