| Hypothetically asking - who could be credible suitors for Mr. Shiv Nadar's stake in HCLT? | Overweight Price: Rs1,530.20 24 February 2014 Price Target: Rs1,500.00 PT End Date: Dec-14 | |
There is talk among some sections of the media (click here) that Mr. Shiv Nadar, the promoter of HCLT (OW) is seeking to sell his 62% stake, currently valued at just over US$ 10 billion. This would represent a significant transaction for any buyer not to mention the additional outgo associated with the mandatory open offer, which might well make it a transaction exceeding US$ 13 billion (all-in at the current stock price). We are not ascribing any opinion as to the credibility of these reports (the company has denied this) but only trying to respond to a hypothetical question: which company(ies)/entities could be interested in such a big-ticket transaction and more important, possess the financial clout to be able to process it?
· For starters, let’s look at it from the digestion standpoint: HCLT is well beyond what we characterize as the sweet spot of a target. We characterize the sweet spot as between 10,000 and 40,000 employees. At over 85,000 employees, HCLT, in our view, is too large a target that can be smoothly incorporated into the operations of the acquirer. Take the instances of notable offshore-based acquisitions over the past decade (IBM’s acquisition of BPO player Daksh, Oracle’s acquisition of i-Flex, TCS’s acquisition of eServe, Cap Gemini’s acquisition of Kanbay, HP’s acquisition of EDS/majority stake in Mphasis following on from the EDS acquisition). All these targets had less than 35,000 employees at the time of acquisition. The one exception was Satyam, which had 52,000 employees when Tech Mahindra acquired a controlling stake in April 2009. But it was in Tech Mahindra’s interest to phase out Satyam employees in a calibrated fashion in addition to normal attrition (so, within 12 months or so of the acquisition, the employee base of 52,000 sharply shrunk to just over 30,000). The business opportunity cost of employee downsizing was minimal for Tech Mahindra as Satyam had already started losing a substantial amount of business from clients that ejected Satyam from the vendor list following the scandal. In addition, at the time of this transaction, Satyam had many more employees than its true business (actual revenues, not stated revenues) warranted. HCLT, if anything, is in a diametrically opposite situation with little slack in its operating model. It is difficult to optimize further in HCLT without hurting the cause of revenue growth.
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· Next, let’s look at this through the potential buyers’ lens. Who could be interested? IBM and Accenture – the two most potent competitors from the US in the offshore IT services industry have a substantial operating base in India. Even if they were interested, what is to say that they find HCLT desirable in its entirety? There are likely some segments of HCLT’s portfolio such as its infra-management practice that might seem more appealing/desirable as an acquisition candidate. But it would be difficult/infeasible to carve up the firm. That would leave us with HP & CSC – two giants struggling in recent times on the services side. HP has already invested substantially in its India model through its own subsidiary and then through EDS/Mphasis (we reckon that the combination has nearly 60,000 employees). Moreover, HP has a different set of overriding priorities (e.g. hardware) at the global level under CEO Meg Whitman (who took charge in Sep-11), IT Services does not seem to figure among them. Thus, the likelihood that HP would be interested in this is rather remote. With CSC, the strategic rationale is more real given their struggles especially in India and relative slowness in adapting to changes and trends in the outsourcing industry esp. in infra-management. But CSC’s market-cap of US$ 9 billion and positive net debt (its cash of just over US$ 2 billion is dwarfed by its long-term liabilities) might make it financially unviable for it to pursue something of this scale on a stand-alone basis.
· What about the European players? Cap Gemini is settling well in India and is well past the initial hump (as of Dec-13, India accounts for 45% of its global workforce). It has aggressive plans to up its India headcount to 70,000+ in the next 18-24 months from the current 45,000+ and is well poised to do this organically (in other words, it does not need another significant inorganic thrust). Other European players that lack an India base or have a rather small one (such as Atos Origin, Logica acquired by CGI of Canada, Tieto Oyj, Steria) might seem far-fetched prospects but they simply lack the cash or balance sheet strength/capacity to absorb a buyout of this magnitude.
· The Japanese players are stronger contenders but have displayed modest globalization ambitions so far. NTT Data, Fujitsu, Hitachi, NEC, Mitsubishi are notable Japanese players that hold fort in an extremely local, significant Japanese IT Services market. Their presence in India is marginal. With a near-zero cost of capital, they can take a much longer view of the acquisition break-even period than others (longer investment return horizon). The flip side is that Japanese IT system integrators (with the mild exception of NTT Data) have so far displayed/professed little aggression in their globalization agenda. Some of these companies have figured in earlier buy-out speculations – in particular, pertaining to Patni (a much smaller company than HCLT) when Patni was on the block. But the Japanese companies can summon the capital and tolerance better than most others.
· Finally, looking away from the pure corporate to a private equity consortium or a combine of a private equity consortium and a corporate. We saw this structure at play in the acquisition of Patni for US$ 1.22 billion by iGATE backed by funding from Apax Partners in Jan-11. But a buyout of Mr. Shiv Nadar’s stake in HCLT of this size will likely require several private equity players acting in concert with/without possible involvement of a corporate who takes operating responsibility. What adds to this complication is that the 12-month forward valuations of HCLT (16x on 12-month forward earnings, Dec13-Dec14) is not likely to be attractive to a typical private equity player unlike in Patni’s case whose forward valuations at the time of acquisition were ~11x (on forward P/E).
· Are we taking a narrow, traditional view by restricting the consideration list to just the IT Services/system integration players? How about taking other segments of the IT universe? For example, would any predominant software player (such as Oracle/SAP), facing the prospect of challenge to some of its traditional business in the age of mobility, cloud etc., be eager to extend the business model beyond software to embrace IT Services? The software + services piece is threatening for HCLT’s peers from both ends ‑ a potential acquirer (e.g., SAP/Oracle) could direct more downstream implementation to the target. Software companies inherently are rather acquisitive but have tended to make only software acquisitions either to enhance/extend their own software capabilities, adapt to new software trends (such as cloud-based software or as-a-service-business models) or simply to kill competition. Besides, software is culturally and rhythmically a very different business from IT Services. Hence, the thought of a combined Software + Services proposition within the same entity though appetizing is really a long-shot, in our view.
Not just software, some IT Product/hardware companies too can join the fray; their motives for acquiring IT Services plays are not hard to seek, namely:
(a) Stability of higher-margin cash flows.
(b) Position product players in the right area of IT spending which seems to be migrating fairly quickly away from commoditizing hardware and towards services & software.
(c) Better end-to-end positioning for total IT budgets which helps forge closer links to C-level executives as they seek integrated solution providers.
(d) Discretionary pricing power enabled by bundling
In this context, two notable non-traditional acquisitions by IT product players of IT Services/BPO players come to mind - Dell acquiring Perot Systems and Xerox acquiring Affiliated Computer Services (ACS).
· Conclusion: The sheer size of the HCLT transaction being speculated is a stringent, limiting factor that militates against serious overtures from suitors.Some of the more patient Japanese firms might be able to pull it off financially. A clutch of major private equity players possibly in concert with a corporate might also be likely contenders but are HCLT’s current valuations attractive enough for private equity players is the moot point. European interest seems quite unlikely particularly as limited cash levels and balance sheet strength leave very little room to carry off a transaction of this magnitude. We can dream up an appetizing scenario of a software powerhouse (SAP/Oracle) thinking of a big foray into IT Services through this opportunity but that seems a long shot. We do not outright rule out some interest from other non-traditional, non-Services players challenged on the core business (e.g. hardware players) looking to diversify into relatively stickier, higher-margin/ROIC IT Services.
Investment Thesis
HCLT has consistently delivered on revenue growth over the last several quarters primarily driven by its strong positioning in Infra management space. Along with solid revenue growth, HCLT has shown strong margin performance (particularly gross margins) as well over the past 7-8 quarters. This suggests that management has complete control over cost structure. Also, HCLT’s operating cash flow performance continues to be robust. Therefore, we believe the company is performing on all fronts. Our only concern is the lopsided nature of revenue growth as infra-management has driven growth solely over the past few quarters, while the software service business has continued to struggle (except in 2Q FY14). However, HCLT reported deal wins of more than US$ 1 billion in each of the last four quarters, which provides near-term (CY14) visibility on revenue growth.
Valuation
Our Dec-14 price target of Rs1,500 is based on a one-year forward P/E multiple of 14.0x. Our target multiple embeds a one-year forward valuation discount of ~25% to TCS, which we believe is fair and warranted, given the weaker margin profile and return ratios of HCLT. Notably, our exchange-rate assumption is Rs60/US$ for the next two years (FY15 and FY16).
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