M&A spending in the IT services sector this year dropped by more than half from 2007. As we wrapped up the year, we hit the lowest point of that yearlong downtrend for IT services deals, which means that 2009 is likely to be a challenging year. If this trend is going to turn around in 2009, it will likely be up to the industry leaders. With financial buyers missing in action, it will be the strategic transactions that make or break the M&A deal flow in 2009. We expect that more deals like Hewlett-Packard/Electronic Data Systems will happen in 2009.
Services operations strove to broaden skill bases and vertical expertise, extend geographic reach especially into emerging markets, and acquire customer relationships. Changes to customer requirements and the fact that companies increasingly prefer to work with as few IT partners as possible are creating ever-tougher global competition for IT Services providers. This competition is particularly evident between IT consulting and service providers, but can also be seen between national and regional providers. The result is a clear consolidation of the market and difficult times ahead for the smaller IT services firms.
As we look at the IT M&A trends from 2008, we are faced with a bittersweet reality. Deal volume was up while the multiples for this sector took a sharp decline. As revenue multiples only moved from 0.85x in Q1, to 0.70x in Q4, the more painful multiples to look at are those of EBIDTA – the primary valuation metric for IT Services. Coming off a successful high in 2007, EBIDTA multiples in Q1 were trading at 12.80x. By the end of Q4 we saw numbers get chopped to an average of 5.36x.
Where we go in 2009 will be greatly dependent on:
1. The contract models of the larger IT firms
2. The strategic positioning of the smaller firms
3. The immediate effects of global, national and regional political initiatives
4. The various catalysts for a deeper consolidation cycle.
1. Just as subscription and SaaS models have taken hold in the software arena, IT vendors will also be adjusting their price and contract methods to reflect the pay-as-you-go model which makes better use of resources and cash during a volatile market. Whereas most of the previous contracts were signed under a fixed price/output scenario, IT firms - particularly those from India expect these new strategies to help incentivize sales and keep development projects offshore.
2. Meanwhile, the smaller, more flexible IT firms (often near shore) will be leveraging against India’s increase in standard developer wages coupled with an economic situation that will be less conducive to spending on new projects, but more conducive to integration and management of processes, applications, and platforms. As the small firms become “mid-sized”, expect the acquisitions to continue as the larger IT companies try to build out their offerings with vertical expertise and regional presence.
3. We are still unsure as to what the Obama effect will be on the offshore model. Promises from the new president mean that major tax incentives and corporate compensation will be introduced to keep development and integration on US soil. Generally speaking, significant enactments like this tend to have a ripple effect through Europe – assuming this trend catches-on, there may be some interesting changes in IT sourcing over the next 18-24 months.
4. As is the case of any depression, fortunes will be lost and won. Last week’s meltdown of Satyam is one of many we expect to be revealed during the months (daresay, “years”) ahead. When a major reputable player dissolves, it creates tremendous opportunity for competitors (near and far) to acquire resources, expertise, client base, and regional footprint. We expect the consolidation cycle to continue… while some deals will be made out of desperation, others will succeed in remaining strategic.