Thumbs down to Infy-Capgemini deal

A few months ago, before its entry its into the elite Nasdaq-100 index, the then CEO Nandan Nilekani indicated that the first major acquisition by Infosys could well be in Western Europe or in the BPO space, in response to the oft-repeated query on its acquisitions.

On Thursday, market reports seemed to indicate that Infosys was not only eyeing companies in Western Europe but a player that’s almost thrice in revenues, Capgemini.

Indian IT companies have been trying to break into the high-margin consulting business but without much success. For Infosys, consulting revenues made up just a little over 3% of its topline in FY07. According to estimates of research firm Gartner, the global IT consultancy business today is around $55 billion, and expected to grow at a CAGR of 7% to $71 billion by 2010.

Consulting is an opportunity, no Indian IT firm with global ambitions can afford to ignore. An inorganic growth strategy may prove to be the driver and the impetus that the business needs, since none of the players have been able to crack it so far. Capgemini would provide this to Infosys.

The reactions to whether such a move will actually benefit Infosys have been mixed in the analyst and investment banking community. While the consultancy business and a strong European presence of Capgemini are clear strengths that Infosys will gain from, the likely valuation of Capgemini and the potential hit that Infosys will take in its profitability margins, are getting the thumbs down from i-bankers. Abhay Aima, head of equities and private banking group, HDFC Bank, is being cautious about the deal.

Says Aima, “While in the long term it may be a brilliant strategy, what matters to the investor is what the stock swap and the valuation will be in the short term. That is assuming the deal does indeed happen — right now, both companies have denied it.”

Harit Shah of Angel Broking is more sceptical about the deal and says, “Infosys is growing very well organically at over 40%. When it is growing at such a good rate, it doesn’t make sense for it to acquire Capgemini that is growing at 6%. Also, such a large acquisition would change its balance sheet dramatically.” He advocates that Infosys should acquire a niche consulting company in the US and Europe, if it wants consulting capability. But there are some who believe that this might in fact be a good idea. One investment banker we spoke to told ET, “It makes sense for them to acquire a consulting organisation. This apart, it also gives them a local presence in Europe.”

If Infosys were to go through the deal while it might acquire a bigger presence in the consulting space and gain a footprint in Europe it won’t be a bed of roses. It will need to address some core issues pertaining to the existing operations of Capgemini, apart from integration and cultural issues.

Capgemini’s employee base is almost as large as that of Infosys, so Infosys could well be looking at potentially laying off a significant number of people. Also, Capgemini’s operations emerged from the red only in 2005 and its margins are still at 5.8% at the EBDITA level, compared to Infosys’ 31.6%.

Some experts, though, believe such blips are only temporary. Investment strategist, Gul Teckchandani, says, “Downloading functions from the western world into India has largely been accepted. This will definitely allow for decent offshore arbitrage for the Indian companies.”

Infosys to acquire Capgemini ?

Indian tech behemoth Infosys Technologies now moves the international bourses. A spate of rumours on the trading floors of Europe that Infosys is mulling a bid to buy Europe’s largest IT services giant, Capgemini, lifted the mood on Euronext, Paris, and pushed Paris’ CAC-40 index up by 3.58 euros. This at a time when the buzz surrounding Infy looking at a big inorganic move — read a marquee acquisition — gathered pace.

Both sides strongly denied any such move. European market reports across agencies quoted traders, as rumours that Infosys is mulling a bid for the consultancy emerged. At 10:00 pm IST, on France’s CAC-40 benchmark index, Capgemini gained 4.6% to a two week high of 53.78 euros. “There is no possibility of it acquiring Capgemini, and nor were there any preliminary discussions," persons closely involved with Infosys said. An official spokesperson for Capgemini, Europe told ET: “We do not comment on speculation.”

Whether it does or not, the story isn’t so much about Infy acquiring Capgemini.

It’s about the fact that European investors were happily mopping up Capgemini shares, and pushing up its relatively languishing scrip in the belief that Infy can, and will. Infosys is “big enough and none of the large Indian players has made a large acquisition in Europe,” reported AFX, citing a Dresdner Kleinwort analyst.

Now, an Indian contender is fast becoming de rigueur in any deal story overseas. It’s yet another sign of India Inc’s rising clout in the global M&A market. On any given day, European markets swirl with rumours of bid talks for at least a dozen companies.
Now, suddenly, traders on equity floors are throwing in — almost as a routine — the names of Indian companies into the melee, and share prices of target or acquirer companies are dancing to the India tune.

Market reports also quoted analysts assaying, "margins are very high in consulting business as compared to other commoditised business Infosys has. If the deal with Capgemini actually happens, Infosys will be able to successfully compete with other biggies in the consulting space... it will fit in very well."

If such a merger were to happen, the combined strength of the two companies in terms of turnover would stand at around $14 billion, still some way behind global leaders IBM, EDS and Accenture. The consulting business for Infosys is still on the investment mode, at 1.3% of total revenue, and suffered a loss of Rs 111 crore with a topline of Rs 213 crore in FY07.

However, the financial fundamentals of both the IT services giants throw up a very diverse set of numbers. The operating margin of Infosys stands at 27.57% while for Cap Gemini it is at 5.8%. For FY07, Infosys registered revenues of $3.09 billion, while it was $10.3 billion for Capgemini in calendar 2006. Even the outlook for the ongoing fiscal shows diverse projections. Infosys said it is looking at achieving a topline growth of 28-30% (in dollar terms) for FY08, while Capgemini has projected an 8% growth in 2007.

Though Infosys has publicly stated it would be looking at acquisitions if it brings certain niche capabilities or newer markets, sectoral analysts believe that in the case of Capgemini, it seems highly improbable.

Capgemini has itself been in acquisition mode. Last year it acquired Kanbay for $1.25 billion and has barely completed the integration of that merger.

Capgemini, however, is a scrip that seems to attract bid speculation. Just last week, there was speculation that it would make a bid for rival Atos. In 2000, it had acquired the consultancy arm of E&Y and had reportedly faced integration issues. At that time, media reported the company as saying it was in “no mood for further restructuring, having just finished one merger."

But according to a professor at Wharton Business School who has advised frontline Indian software firms, their consulting businesses have not quite achieved traction so far. This may have prompted software majors to reassess their approach to the consulting business. A stronger consulting business is likely to chivvy up valuations, he added.

On the other side, for Capgemini, a company that has just returned to the black, this may be the time to capitalise on its consulting business value, which accounts for 11% of its total revenue. Observers say, in the face of sedate growth projections in the medium term, the company may not be averse to hiving off its consulting business. However, they do not rule out the possibility of the company being open to a total sell-out as well.

For Infosys, which has never scripted a significant inorganic growth story, an acquisition of this size would seem a tad far fetched. Officials at Infosys have earlier said that any acquisition of a large company will have look into multiple and complex issues, especially the cultural fit between the organisations.

But, as the Wharton professor said: “In the event of a full-scale merger, Infosys faces its biggest challenge in managing the issue of cultural integration. After all, people are at the heart of any IT acquisition and any loss of key personnel can completely upset the calculations.”

Back home, the Infosys scrip ended at Rs 1925.05 on the National Stock Exchange, lower by 0.53%. On the Nasdaq, at the time of going to press, it was quoting at $51.15, up 0.61%.