For a patient FII or mutual fund, consolidation moves offer a more alluring entry point. For instance, institutional investors have reaped handsome payoffs in stocks such as i-flex or Flextronics by stepping up exposures in the run-up to acquisitions.

Rationale for consolidation

There is considerable diversity in the returns notched up by mid-cap software stocks in 2005. MphasiS BFL, Hexaware, Geometric, iGate Global, KPIT Cummins, NIIT Technologies, Polaris Software and Zensar Technologies were relative under-performers in a bullish market.

At the other end, niche stocks such as Subex Systems, Cranes Software, Geodesic, Nucleus Software and Megasoft, or stocks with sharp turnaround or restructuring stories, such as Infotech Enterprises, VisualSoft, Sonata Software, Mastek or Aztec Software, were stellar performers.

Few stocks have had two straight years of appreciable returns. Dogged by weaker performance, it is the former set of stocks that is likely to be the focus of consolidation. Clearly, three elements are poised to drive this process:

Gaps in vendor portfolio

Large outsourcing contracts are getting broken down into smaller deal sizes and parcelled off to `best of breed' vendors; thus, multiple vendor contracts are slowly becoming the norm.

As average IT contract sizes ($100-500 million) are coming down, mid-sized vendors such as Keane, Perot, Atos Origin or Affiliated Computer Services are beginning to bag a good share of deals that were typically cornered by the leading multinational (MNC) vendors.

Since most outsourcing deals, said to be well over 75 per cent, include an offshore component, there is a compelling need for most MNC vendors to establish a scaleable offshore presence in low-cost locations such as India. Some of the large multinational vendors, such as IBM Global and Accenture (and some smaller ones such as Sapient or Xansa), have organically built their employee base to a competitive size vis-à-vis the Indian vendors.

Some large vendors, such as EDS, and several mid-sized vendors, such as Cap Gemini, Atos Origin, Keane or Bearing Point, have significantly lagged their peers in this respect.

Second, the operating margins of most mid-sized vendors have been in the 6-8 per cent bracket, offering considerable scope to improve them through an India-based presence.

Most of the Indian mid-sized vendors are enjoying mid-to-high double digit operating margins. No wonder, the Chief Executive of the French IT services provider, Cap Gemini has said that it is interested in acquiring mid-sized Indian companies in the 200 to 300 million-euro bracket.

The pressure on Atos Origin, another French IT player, or the US-based Keane has also been mounting on this score. As most of these players are looking to record at least a three-fold rise from their existing offshore employee base of 2,000-3,500, acquisitions may be an inevitable route to quick employee ramp-up and high revenue /margin growth.

Private equity on prowl

High profile private equity firms such as Blackstone, Carlyle, Temasek, Warburg Pincus or WestBridge Capital have been scouting the mid-cap Indian IT space for attractive acquisition opportunities. This has perked up valuations in the domestic Tier-II services space.

Private equity with relatively small equity stakes have the ability to shake up the management, bring other small companies together and set medium-term workable targets for, say, two to three years, to transform existing businesses.

For instance, the re-rating of the VisualSoft stock by over 100 per cent between August, when SAIF-II picked up 14 per cent equity, and December 2005 shows that this strategy has worked well so far. It is now up to the new management to execute and deliver on its promise.

Several private equity deals are said to be in the pipeline. The legendary LBO (leveraged buyout) firm, Kohlberg Kravis Roberts & Co. is believed to be in talks with Flextronics Software to take an equity stake in the company.

It is also rumoured that Blackstone has been eyeing Baring India Private Equity's 35 per cent equity in MphasiS BFL, after the latter failed to sell this equity stake through a bidding process in May 2005. And, with the competitive bar raised by private equity, it is likely that other MNC vendors may also consider a buyout of MphasiS. In the earlier round of bidding for sale of equity stake by Baring in May last year, Temasek and Hinduja TMT had reached the final rounds, with Cap Gemini and Carlyle involved in the earlier rounds.

It is only a matter of time before both the multinational/ Indian vendors team up with private equity funds to put through mergers or acquisitions in the mid-cap software space.

Strategic equity sale

For mid-cap software companies, posting revenue growth higher than the sector average has been a big challenge. If revenue growth slackens, the operating leverage (linked to higher offshore employee utilisation and lower selling and administrative expense) goes awry.

The attempt by these companies to build differentiation in specific verticals such as banking/ financial services or telecom has also been slower than the frontline peers. And, finally, with margin growth almost 5-10 percentage points lower than the majors, the drivers for earnings growth are not firmly in place. Moreover, the promoters of select mid-cap companies may also not be willing to shed their equity stakes in a hurry.

For mid-sized multinational vendors, these margins are still quite attractive. However, as the risks of integration of these acquisitions are fairly high, they may be reluctant to pay the substantial premium for control for complete buyouts.

In this backdrop, probably selective `strategic equity stake sale' by companies such as NIIT Technologies, Ramco Systems, Geometric Software iGate Global or Polaris Software may happen to some of these multinational vendors, paving the way for a buyout later.

Action-packed scene

THE high voltage action in the mega deals space may well be a forerunner for the next phase of change:

Oracle followed this with an open offer for 20 per cent equity at Rs 882.62, which failed to mop up any equity stake.

This was significantly higher than the floor price of Rs 575 fixed by the company.

Using a combination of open offer and secondary market purchases, the company notched up nearly 94 per cent of equity by December. It recently indicated that it will be suspending trading in the stock at the NSE from February 3, 2006.

A month later, Venture Tech Solutions, promoted by Mr Sandeep Reddy and Chintalpati Holdings, held by Mr Srini Raju, acting as portfolio investors, took a combined 8.6 per cent equity in this exercise.

In a bid to restructure the operations of VisualSoft, these equity funds brought AppLabs Technologies and eSolutions to the negotiating table.

Since then, VisualSoft has decided to merge these two companies with itself and focus on the high-growth areas of outsourced product development and testing.

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