October 18, 2010

Thoughts on the IT Sector

by Martin Wolf, Chairman, MergerTech Advisors

Two things.  Would you be happy with a service company valuation of 7-10x TTM revenue vs. TTM EBITDA? Well, if you were a somewhat traditional services company, and headquartered in China, the market would reward you accordingly. You would also be growing exponentially faster, more than 50% faster, than the large U.S. IT conglomerates (low single digits) and large Indian IT outsourcers (high single digits). As long as the growth can be sustained, the valuation will hold. In the case of the big three Indian outsourcers, they maintained 5-8x revenue multiples for years when their growth averaged 30% and still trade around 5x TTM revenue. The equivalent U.S. and European companies trade at less than 1x, sans outliers.

It’s with this in mind that I travel to Shanghai and Beijing this week to speak at an IT outsourcing conference with the leading Chinese service and outsourcing firms, and then hold private meetings with senior company leadership. Think India 1990 redux. The consequences of this anticipated growth has meaningful consequences for many companies we track in the space and a roadmap on how to respond and profit. It is not a new play, just new players.

Secondly, the IPO market continues to be moribund, but the M&A marketplace in the quarter was on fire, with many headline deals. In the services space, PWC acquiring Diamond Management is a marquis deal. At 14.5x TTM EBITDA, it provides lots of cost take outs as it collapses its infrastructure into to their own and is a high water benchmark in the services space. Dimension Data, a huge Cisco VAR with other pieces and parts, sold to NTT, the Japanese telecommunications giant, at 10x TTM EBITDA.  This is a huge price for this asset and many, many marketing synergies will need to be found to justify the price. To round it off in technology, the IBM purchase of Netezza at 7x revenues, and the HP rebid, rebid, rebid purchase of 3Par at 11x TTM revenue suggests extreme growth in the cloud for slower growing conglomerates with mature sales forces and customer relationships. Don’t forget HP’s acquisition of Arcsight announced immediately after 3Par for just over 7x TTM revenue. Only time will tell if they can make these work. My personal favorite was IBM’s acquisition of Tivoli, years back, and the 7x revenue purchase price was made up year one with a 10x growth in revenue. Pretty cheap in retrospect. However, this is the exception, not the rule.

The takeaway? Growth has a premium, technology is the enabler, and in the service and supply chain space, it comes in quantity outside U.S. borders. It also suggests, there continues to be too much capacity, and top line laggers create work, not wealth.