Ganesh: We’ve all seen in India the phenomenal growth of the IT Sector initially in the 90’s then it kind of tapered off, then we found a new vein of growth in terms of e-commerce, digital etc. And today of course, every company is either posing or is really a digital firm.
So, were do we think we are going? What is the real opportunity in the sector?
Douglas: I love your use of the word posing in that question. Because indeed it has been fascinating to us to see so many of the companies we work with have re-branded themselves as digital, when indeed their still doing the exactly what they’ve done in the past.
But coming back to your question, kind of where we see it today? Essentially in the initial growth phases of the business you largely saw the benefit of labor arbitrage and resource availability driving the growth. India had incredible talent and they were able to provide that talent to global enterprises at a very reasonable price.
So those two factors alone, allow for 20 to 30 % annual growth with really very little impediments to stop that growth. I think what you’ve begun to see is that pure labor arbitrage – cost differential is no longer enough to sustain long-term growth in the industry. Firms really are beginning to have to focus on providing specific technological advances, technological specialties; again to combine with an amazing set of resources that are available here in India. There is no other place where the quantity of qualified, really spectacular technical resources are available. But cost differential is just not enough to drive the market anymore.
Ganesh: So what does that mean for mid-tier companies? If I were the CEO of a 200 to 400 million-dollar company, what should I worry about and where would I look at M&A or acquiring companies to really make me more successful in the long run?
Douglas: Let me start of by saying, the premise to your question would petrify me. Being a mid-tier 3 to 500 million-dollar undifferentiated IT services company today, I think would be incredibly difficult. I think that the larger firms have gotten much better at really capturing full-market share from their clients. And there are dozens of really exciting smaller firms that are specialized in some of the new technologies. So, that middle market is an extraordinarily difficult place to be right now and I think those are the firms that are really going to need to change their model extensively in order to continue to perform. And I think that’s why I have seen a fair amount of M&A in this space and a fair amount of consolidation.
Looking at two large deals in the last few years with iGate getting taken out of the market and recently other firms of that size have decided to sell out because that is a very tough competitive market. If you are still in that space, I really believe the only way to maintain consistent growth and competitive advantage is to really pick some very specific areas where you’re going to be able to differentiate yourself from either some of the smaller who have specific technologies or specific technological advantages or the giant global SI’s, who really can provide full-service to your clients. That mid-market is probably the most challenging.
Ganesh: So Douglas what I hear you say is that, if you’re a medium sized company, there is no point in doing M&A just for bulking up. But it’s probably good to do it either for a location advantage (if you want to enter a new territory) or definitely for a capability advantage if you are looking at a company which has a demonstrated capability in a specific space. So is that the way you should think about it?
Douglas: Let me respond two ways. If you are looking to continue to grow and be relevant in the market, absolutely need to focus on some specialization. Either around some very specific industry verticals, because if you can become for instance very specialized around financial services so the clients actually come to you for solutions to their business problems, you can be a mid-size firm and be very successful.
Or if on the other hand, you have some very specific technological specialties around some of the new technologies; for instance, knowing how to leverage the cloud in a very business specific way can also be valuable. But I do want to give one other comment.
While I was somewhat negative on the generic mid-size space, we do know a few firms who are actually bulking up and becoming essentially cash cows. We kind of call them the widowed firms or the old maid firms. They have some very long-term clients and are able to maintain regular relationships with those clients. But they aren’t really growing, they aren’t moving into new technologies but by being incredibly tight with costs, they are able to generate decent cash flows and are actually going to generate decent cash returns over a period of time. They are kind of more in the harvesting or cash cow mode as opposed to leading technology.
Ganesh: Moving to the opportunity for the smaller firms. If I am running a 20 million-dollar company and I have some pretentions or some capabilities in digital, what is the path for the next five years to ensure that the company realizes value for the efforts put into the business?
Douglas: Some of the most successful firms in that space are ones that have specialized almost completely. One of our clients, Model Matrix only focused around salesforce and AWS. So it was a cloud-based focused business with salesforce being their primary focus. And they essentially said “no” to most other business. Now they didn’t grow at 30 or 40 percent a year, but their specialization allowed them to be known in the market for what they did and they were able to command a premium pricing, which led to a very successful exit.
So that’s one direction. The other direction would be to really create a portfolio of services around new technology.
Ganesh: So how does Chesapeake work?
Douglas: Again, coming back to some of my earlier comments, what we really look for is companies that have kind of laid out a fairly specific strategic plan and have been willing to execute on it, even when its little bit painful. Even when sometimes they go through some bumps in the road but then overcome them.
The one thing I will say is that we are finding that more successes come with companies that are willing to take on some outside capital. The reason being that it gives them a lot more flexibility in making strategic decisions rather than making decisions based in cash flows. Across the board, we’ve seen greater value being created with companies that have been willing to bring in a capital partner and use that capital to leverage their strategic advantage.
Ganesh: So if you’re to give one word of advice to a young entrepreneur who is looking at building enormous value over the next three years and has kind of built a successful company, what I hear you say is – choose to focus, make sure that you have a capital partner, and at some point of time you encourage them to buy more companies smaller than themselves or sell out entirely?
Douglas: Both! The answer is that if there is a good strategic fit and there really is an opportunity to enhance the strategic direction that you’ve chosen, M&A is actually generally quite successful in building overall enterprise value.
Coming back to the earlier comment though, I wouldn’t do M&A just to bulk up for revenue. In my view that will only decrease the enterprise value. We represent a number of larger SIs in their acquisition program and those that are really disciplined are the ones that have been the most successful.
Ganesh: That’s very interesting. Do you think that as next few years, we will see a lot more transactions in the space? Young companies will start merging with larger companies and larger companies will actively seek more acquisitions?
Douglas: The way Chesapeake looks at it; this is the third phase in the SI maturity market. It is going to be very rare that you are going to see the replication of companies’ like Infosys and Cognizant that started at 25 million and are at 5 billion revenues somewhat organically with M&A along the way. That is not what’s going to happen in today’s market.
That kind of organic growth is just not where this market is. This will result in significantly more consolidation and recognition that you really are often better creating strategic value together than just kind of continue on an organic path.
Ganesh: What I hear you say is that you are still positive about the opportunity for both the small and the medium companies in software and IT services?
Douglas: Some of the mid-size companies that have created incredible enterprise value in the last three or four years. We’re seeing those firms commanding market topping prices. It is a little bit surprising to me right now seeing the value that is created if you are a focused operation. Again, on the other hand, for the undifferentiated or generic companies, it is very difficult to even find a buyer today.
However, we don’t know how long this market is going to maintain. This is looking like a little bit of cyclical high but this could last for quite some time because there is a demand for these new technology skills and there is still huge demand for real skills around digital transformation.
Ganesh: Thank you very much Douglas. It was a pleasure talking to you.
So what we’ve heard Douglas say is very interesting. On one hand he is saying that software services as a sector is changing and there is no pulling back the good old days where you could be a 25 million-dollar company and organically aspire to be a billion or two billion. So you have to take some positive actions.
I think his view is that if you’re a mid-tier company you could either decide to be just a cash flow generating company or you could be very significant to you customers in the digital market place. And for that, there is a value in looking at acquisitions.
His advice to larger companies is to look for the right dance partners who can actually take them into the world of digital.
For the smaller companies, I see a lot of positivism in what Douglas has said. Smaller companies should either choose one segment to dominate or a small basket of services where they can create value for customers. They should look at strategic acquisition and not for bulking revenues. And beyond a point, to really release some of that value with their capital partners, they should may be consider selling or raising more funding etc. So I think it’s an interesting journey we are talking about. Clearly, Douglas has shown with his wisdom that there is huge optimism in the sector, but I think all of us, people running small companies, medium companies will have to take the right steps. Look at capital raising, look at opportunities to buy and even sell as we grow and become successful companies in the industry.