HCL Technologies has been trying to manoeuvre in choppy waters through a series of acquisitions and alliances. The recent acquisition of HCL Infosystems’ software business is a pointer to the future direction of the software services industry. Consolidation of strengths is the key today and the deal emphasises this fact. Srikanth R P analyses the deal and its impact

While billing rates have been coming down across the industry, in many cases they have been compensated for by growth in volumes. While Infosys, Wipro and Satyam have all recorded declines in margins, in the case of HCL Technologies, the fourth largest player in the Indian software services space, the impact has been felt from both ends. The company’s focus on technology R&D meant it faced pressure on two counts—pricing pressure, accompanied by a rapid fall in volumes. To overcome this problem, the company embarked on a risk management strategy through a series of acquisitions, alliances and joint ventures.

The strategy seems to have paid off as some encouraging signals have started to appear. Revenues through the inorganic initiatives have been constantly growing and now account for 24.1 percent of total revenues in the second quarter.

The company continued with its aggressive acquisition philosophy when it acquired the software exports division of another Shiv Nadar-promoted company, HCL Infosystems. According to the terms of the stock-swap deal, shareholders of HCL Infosystems will get two shares of HCL Technologies for every nine shares held. Though the acquisition looks like just another addition to HCL Tech’s burgeoning shopping bag, it is an important step in present times where consolidation of strengths is the key to survival.

Three Shiv Nadar group companies have been operating in the software space—HCL Infosystems (HCL Insys), HCL Technologies (HCL Tech) and NIIT. At a time when the size of a player is increasingly becoming an important factor when it comes to winning huge offshore deals, the group thought it prudent to leverage the synergies of the two companies. Company sources say that HCL Tech’s size combined with HCL Insys’ niche expertise is a win-win combination for both.

Currently, a significant portion of HCL Tech’s revenues come from the technology R&D segment, with
the applications segment contributing close to 38 percent of revenues. Most analysts believe that while the applications segment is a steady growth driver for Indian software companies, the technology R&D segment—where HCL Tech has a major focus—is cyclical and highly prone to a technology slowdown. This is where the HCL Insys deal could add impetus to HCL Tech’s inorganic strategy by increasing revenue contribution from the applications segment where it lags behind its peers.

Says Kawaljeet Saluja, IT analyst, Motilal Securities, “HCL Tech had a weak package implementation practice. Package implementation has been a major growth area for the Indian IT services sector in the last year. HCL Tech’s lack of presence led to a situation where the company was missing out on a significant growth opportunity. The acquisition of HCL Insys’ software export business corrects this significant anomaly. HCL Insys has a strong presence in package implementation services, with a strong SAP practice (225 professionals). Besides, post-merger, this business will be supported by better financial backing and management bandwidth and has the potential to establish for itself a larger scale of operations, which would have been difficult to achieve if the business remained with HCL Insys.”

Adds Pankaj Chopra, CEO, wow-india (an investment advisory firm), “Thanks to this deal, HCL Tech will get about 10 percent in revenues (Rs 170 crore) and about 4 percent addition to net profits. The company also gains by getting horizontal skill sets in ERP, system integration, supply chain and CRM, along with clients such as i2, GM, Novartis and Cadence.”

In a sluggish market, the move of transforming focus from a technology standpoint to an enterprise focus seems to be a move in the right direction. But despite the encouraging signals, most analysts we spoke to were not bullish on the strategy of the company. The reasoning is simple: Though acquisitions have boosted HCL Tech’s top line, operating margins have continued to remain on the lower side. And with each acquisition, the probability of margins getting depressed increases. For instance, take the HCL Insys software business acquisition. HCL Insys being predominantly known as a hardware company commands lesser margins than HCL Tech does. This is the one of the biggest challenges that HCL Tech has to overcome. Moreover, analysts warn that too many alliances and acquisitions could increase costs and dissipate management attention.

The recent announcement also brings up one more interesting fact. While previously companies simply floated software companies so that they could garner as much software business as possible, the technology slowdown has meant that a reverse route is now being thought of. The same business groups that floated different software companies are now looking at consolidating their operations. As mentioned earlier, this is in sync with current times, where size of a company plays a large role in influencing contracts.

Impact on HCL Infosystems
With the decision to sell off the software exports division to HCL Tech, HCL Insys will focus aggressively on the call centre market. Apart from this, the company would be looking at playing a bigger part in the Indian IT services space where the focus would be more on multi-vendor support and facilities management. To sum it up, the focus would be totally on the domestic market.

While the decision to sell off its software exports business to HCL Tech definitely seems logical in view of the recent trends in the industry, some analysts Express Computer spoke to were of the view that with this deal HCL Insys has lost one of its growth drivers. Says Chopra, “The software business was complementary and was expected to be the more profitable part, allowing HCL Insys to offer a complete solution. While we agree that hardware is the core competency for HCL Insys, the software part allowed the company to offer the much-needed bouquet of solutions. The impact is certainly negative for HCL Insys as a growth engine is lost.”

Adds Vijay Bhambwani, CEO, Bsplindia.com, “In spite of the common logic that consolidation of strengths is the way forward, one is compelled to say that the current inorganic strategy of the company points to the company’s lack of confidence in a difficult business space. One is also compelled to ask the management questions such as: Why float so many companies when they overlap and cannibalise each other’s business spaces and then merge/amalgamate divisions inter-group? Why not expand some companies’ capital by rights, rather than float mega issues of new companies?”

Future outlook
While gains have started to appear through the inorganic growth initiatives, the future growth of the company will depend on how successfully it can integrate the acquisitions with the core business. Till that happens, in the interim, the company may continue to underperform industry growth rates. But if HCL Tech manages to successfully pull off its inorganic growth strategy, there will surely be many Indian companies who would be looking at reinventing themselves using the same route.