M&A is seen as a fast track to transformation from IT service to digital service provider
May 4 2021
by Katy Ring, Michael Hill
The COVID-19 pandemic has created a perfect storm for digitization, pushing organizations that have been reluctant to embrace digital technologies to move toward business transformation using those technologies. This is creating a more receptive enterprise market for those service providers offering project and implementation services around transformational technologies such as cloud, AI and machine learning, mobile platforms and applications, and IoT sensor-based systems (as shown in figure 1 in the Context section below).
The 451 Take
Prior to the pandemic, the IT professional services sector was already pivoting professional services revenue toward the new digital services opportunities while still fulfilling existing traditional enterprise requirements. Acquisitions were already part of the strategic development for the players in this sector to optimize business models for the requirements of digital services. However, after a short pause at the onset of COVID-19, the pace of the transaction-paved route to the future for IT service providers has picked up. M&A strategies were expedited by market demands for fast-track digital projects, and most tier 1 global service providers have increased their appetite for acquisitions. Some players such as Atos and Cognizant (both under new leadership) even appear to be bingeing to make up for lost time. We expect the acquisition activity of IT service providers to remain buoyant during the next year.
IT service providers have spent the last decade investing in cloud skills as IT environments have tipped toward the adoption of hybrid public cloud and on-premises infrastructures. Primarily, the opportunity was around infrastructure services, helping enterprises transition toward public cloud adoption while stepping away from on-premises datacenters. IT service providers were sought to assess and migrate application workloads to the appropriate infrastructure environment. This requirement continues, but over the past few years the opportunity has expanded around the development of new applications that take advantage of cloud-native technologies such as containers, Kubernetes, serverless environments and microservices.
For example, 451 Research data finds that cloud native is a particularly acute problem for large organizations; firms with more than 10,000 employees highlight this as their biggest skills constraint. Finance firms highlight limits here as a particular issue, and it's also a similarly prominent issue for both tech leaders and laggards. Cloud platform expertise is another area of acute shortage for organizations with 1,000+ employees.
In order to address these skills gaps, the most popular approach is to train existing staff, but a significant minority (40%) expect to use contractors and consultants to bridge skills gaps, which creates commercial opportunity for IT service providers.
This ever-growing enterprise appetite to innovate and outmaneuver competitors via digital services means, as 451 Research data shows, that demand outpaces new technology skills, and delivery has to be at speed. IT service providers that can transition from providing point services to 'managing transformation' are well positioned to gain influence with, and revenue from, customers tackling digital innovation. Essentially, in the world of digital transformation, there are very few 'one and done' engagements for professional services because the demand is for ongoing incremental improvements. This makes project services (consulting and implementation engagements) a critical success factor for IT service providers because it creates the continuous customer relationship that ensures they are considered for digital transformation projects and that they stay in the loop as these projects mature and new ensuing requirements emerge.
However, ensuring that each IT service provider has consulting skills and technology expertise in a range of rapidly expanding digital areas is challenging. This is where M&A can be a game changer.
Past M&A activity
There have recently been three major deals made by IT service providers. In March, Synnex acquired Tech Data for $7.2bn, Wipro acquired Capco for $1.5bn and in April, Hitachi acquired GlobalLogic for $9.6bn.
Fremont, California-based IT distributor Synnex (which serves OEMs, software publishers and VARs) acquired Clearwater, Florida-based IT distributor Tech Data, creating a $57bn IT supply chain for more than 200,000 technology products from more than 1,500 vendors to over 150,000 resellers and retail customers globally. VARs and channel distributors continue to be challenged by the rise of self-service, on-demand ordering and consumption, as well as the demand for new types of IT services that revolve around concepts like distributed computing, DevOps and the cloud. To add to the disruption, a major new type of entrant to the distribution sector is the managed service provider (MSP), which requires an outcome-based narrative around ease of management and low support costs to produce a more value-based, relationship-oriented sale. Tech Data is arguably more advanced than Synnex in positioning for this type of market and, in combination, the new entity intends to provide innovative integrated stack plays for cloud, datacenters, security, Internet of Things (IoT), 5G and intelligent edge, as well as further developing professional services offerings.
Wipro's acquisition of The Capital Markets Company (Capco) is a bold move by the company's new CEO Thierry Delaporte (Capgemini's former COO). Wipro's biggest revenue-earning vertical sector is banking, financial services and insurance (accounting for 31% of revenue), and its largest service line is modern application services (accounting for 46% of revenue). Capco was founded in Belgium in 1998 as The Capital Markets Company NV. It rebranded in 2001 and now has its headquarters in the UK. Acquiring Capco, which serves the banking and payments, capital markets, wealth and asset management, insurance and energy sectors primarily via consulting-led digital transformation services, will make Wipro one of the largest end-to-end global consulting, technology and transformation service providers to the banking and financial services industry. Before Capco, Wipro made three acquisitions under Delaporte. Through 2020, it acquired Salesforce multicloud partner 4C; engineering services company Eximius Design; and Encore Theme Technologies, a specialist in providing cloud solutions in financial services.
Hitachi Vantara, with headquarters in Santa Clara, California, is the IT products and services arm of Japanese industrial conglomerate Hitachi. It is the chief beneficiary of the acquisition of digital engineering consultancy GlobalLogic, which has headquarters in San Jose. The acquisition will strengthen Hitachi Vantara's Lumada digital offering portfolio, bringing in skills and expertise for developing next-generation software. GlobalLogic expands Hitachi Vantara's ability to provide customers with design-led work using an offshore cost model that is competitive for the premium enterprise segment that Hitachi Vantara targets. The acquisition boosts Hitachi Vantara's pivot toward consulting and systems integration services.
While the main macro driver for all these acquisitions is the shift to providing digital services from traditional IT services, a factor is the number of new CEOs taking the helm of tier 1 IT service companies to accelerate this pivot. Wipro is a case in point, as is Cognizant Technology Solutions, which, since Brian Humphries became CEO a year ago, has made 11 acquisitions with an aggregate investment of about $1.4bn in its strategic digital focus areas of cloud, data and AI, digital engineering and IoT. Most recently, it acquired Linium, a cloud transformation consultancy group specializing in the ServiceNow platform and solutions for smart digital enterprise workflows. Since Elie Girard took over as CEO of Atos in late 2019, the company has made 15 acquisitions, many focused on developing its cybersecurity skills and its Salesforce expertise, the most recent being Processia, a Canadian PLM specialist; Ipsotek, a UK AI video analytics expert; German cryptography product company cryptovision and prior to those three, Profit4SF, a Dutch consultancy specializing in Salesforce CRM rollouts.
Although valuations for traditional targets in this space tend to be low, those that trade in more transformational technologies fetch higher multiples. In fact, data from 451 Research shows that the median multiple for IT services and distribution targets over the last three years is just 1x. Conversely, GlobalLogic, Linium, Ipsotek and similar digital services targets have garnered a median multiple of nearly twice that in the same period.
While a 1.7x median multiple may not seem earth-shattering, consider that GlobalLogic alone garnered an 11x revenue multiple in its sale to Hitachi. And, given COVID-19's impact on digital transformation projects, it likely won't be the last double-digit valuation we see. According to our Digital Pulse, Budgets & Outlook survey, 44% of respondents say that their organization's digital transformation strategy has been accelerated by the situation surrounding the coronavirus outbreak.
Pivoting to digital services
451 Research sees the pivot to digital professional services following the three phases shown in figure 3 below. The first requirement is to rethink customer-facing processes, and this has been expedited by the pandemic as digital channels for customer engagement become the most important. The second phase is to work on changing the way that software is developed and delivered by deploying DevOps and agile methods to support this shift toward digital services. And third, once new processes are stable, comes the requirement to further automate and smarten those processes and entrust the running of them to external service providers. In 2021 phases one and two continue to fuel many M&A strategies for IT service providers.
Figure 3: Phases of Business Development
1. Design thinking for digitizing customer-facing processes
The digital transformation projects of many enterprises today still remain focused on front-office, customer-facing systems to improve the customer experience. This is why the acquisition of Salesforce consultancies remains buoyant. For example, in the past year Wipro acquired 4C Consulting; IBM acquired 7Summits; Accenture acquired Businet; Atos acquired Profit4SF, EdifiXio and Eagle Creek; EPAM acquired PolSource and Infostretch acquired Saggezza. Demand for Salesforce consulting, migration and integration skills to support digital transformation projects continues and so the Salesforce ecosystem of boutique consultancies remains an attractive source of acquisition targets for tier 1, 2 and 3 IT service providers.
Potential targets with US headquarters in this ecosystem include AlgoWorks (Sunnyvale, California, and Noida, India), Ascendix Technologies (Dallas, Texas and Ukraine), CloudMasonry (Chicago), Popcornapps (Fremont, California), Vertiba (Boulder, Colorado) and VRP Consulting (San Francisco).
2. For agile development, cloud-native digital services are required
The second agile development phase involves the building of cloud-native digital services to give form to the requirements of rapid business adaptability using containers, platforms, accelerators, agile methods and DevOps. This is an area where IT service providers are scrambling to ensure they have the depth to support the proliferation of project demand they are seeing. In the past year we have seen Accenture acquire Imaginea Technologies, Olikka and Gekko; Cognizant buy New Signature, Magenic Technologies, Inawisdom, 10th Magnitude and Tin Roof Software; Deloitte bought Hashed In Technologies; Globant bought Grupo ASSA Worldwide; GlobalLogic bought ECS Group (and has itself now been acquired by Hitachi Vantara); IBM bought NordCloud and Instana; Logicalis bought iZeno; NTT Data bought HashMap; Presidio bought Coda Global and Wipro bought Ampion Holdings.
Potential targets in this area include Bulgarian it-economics, German esentri, UK's KDM Force and BJSS, Spanish Xeridia, Belgian Cegeka, Finnish KnowIT, Canadian Gologic and ReactiveStax as well as US-based Nexient.
3. For digital operations opportunities, track supply chain services
When it comes to the next wave of M&A activity in the IT services space, it is always worth keeping an eye on Accenture as a bellwether for transaction trends. Of the 33 acquisitions it has made in the past year, it has made seven acquisitions that fall within the supply chain services domain: SALT Solutions, Zag Limited, Myrtle Consulting Group, End-to-End Analytics, GRA Supply Chain, REPL Group Worldwide and Core Compete.
COVID-19 has stress-tested supply chain management and has generally found the current models and systems in place no longer sufficient. Shippers have very little transparency to see where their freight is once it is in transit, while the modeling of forecasts and management of inventory has been severely challenged by unprecedented peaks and troughs in demand. The urgent need to invest in more robust risk management strategies and plans for supply chains has catalyzed the desire to harness real-time supply chain data and to apply artificial intelligence to enable better decision-making.
All of the tier 1 IT service providers, along with the Big 4 management consultancies, offer supply-chain management transformation services. Potential targets for them would include AB Global Logistics Consulting (Canada), Bristlecone (San Jose), Chainalytics (Atlanta, Georgia) ChainSequence (Barrington, Illinois), Inspirage (Bellevue, Washington), Ion Channel (Washington DC), JBF Consulting (Guilford, Connecticut), Supply Chain Lynx (Oak Ridge, Tennessee), T Exponents (Bellevue, Washington), Tompkins International (Raleigh, North Carolina), TraceRx (Glenn Allen, Virginia), Trinamix, (San Francisco) and in Europe Implico Group (Hamburg, Germany) and Miebach Consulting (Frankfurt, Germany).