Deal forces change in biz model
Guest Column: Peter Bendor-Samuel, CEO and Founder Everest Group

This is the largest acquisition that HCL has made which would make it one of if not the largest acquisition any of the Indian IT firms has made. Buying a significant part of IBM’s software business positions HCL as a significant software house with a wide portfolio of offerings and a big customer base of over 10,000 firms. Though it is a business related to HCL’s product engineering portfolio, it is still a significantly different business model with different sales motions, investment cycles and customer relationship management.

As such this is a huge bet by HCL on a new business line. It should not be seen as an extension of their product engineering business, which although related has a different business model and should be run independently from their new software business. The company’s product engineering business may well be a client of their software business and utilise the same capability but it is fundamentally a different kind of business. Clearly the investments and success they have enjoyed in their product engineering business has laid the foundation for this acquisition by building the relationship with IBM and allowing them to build expertise and learning which will be vital as they move into the software business.

Different

Clearly HCL is pursuing a different strategy to those that the other Indian major IT firms are pursuing. The company has chosen to leverage its balance sheet and acquire legacy business which it can then further invest in to extend the life and harvest profits from the mature phase of the life cycle. It has pursued this strategy in product engineering where it has acquired the right to provide product support for legacy products and now is extending this strategy by acquiring a legacy software portfolio and related business. This strategy allows HCL to utilise its labour arbitrage advantages to increase profits from these legacy assets, it also establishes a large client base in which it could potently introduce new products at a later date.

HCL is making the claim that it also allows the tech firm to cross sell services to these new clients, though I view this claim with a significant amount of scepticism as the buying centres and sales motion are quite different. However, even if this last claim proves to be a stretch HCL’s entry as a legitimate software house with a large portfolio of software products and a large customer base is a very different strategy than any other Indian service firm.

Customers

Arguably, TCS is trying to become a software house but it is taking a grow-your-own approach and has yet to emerge with a large suite of successful products and a significant customer base for its software business. What remains to be seen is, if HCL has the appetite or the wherewithal to make the ongoing IP investments necessary to maintain this portfolio and add new offerings to the mix. Software investments are large and require investors which are patient and committed.

Typically these investors are different from those who invest in service firms who have low investment intensity. To succeed they will need to adjust their governance and do a lot of educating of their key investors. I do not expect the other Indian firms to follow HCL down the path of buying legacy software assets. To date, the other Indian firms have focused on building assets which are positioned in the new digital area. With the exception of TCS they also have shown little interest in committing to the ongoing investment required sustaining and expanding software business and even TCS is making a modest ongoing investment in its software business.

For these firms to go down this path they would have to completely change investor expectations and we have seen from Infosys that this is a hard thing to do. However, that is not to say that this will not evoke a completive response (competitive action). As all Indian tech firms struggle with the realities of pivoting into the new digital markets they will all have to come to grips with the higher investment intensity of owning and growing IP based business.

Hence this HCL-IBM transaction is indicative of the growing trend of inorganic activity which is changing the landscape of the Indian IT Service providers and forcing a business model changes. This will likely cause many of the firms to recommit to their acquisition strategies. But once again I do not think many if any will be looking for legacy assets similar to those that HCL has picked up.

Growth

HCL appears to have paid a price which is consistent with the legacy nature of the assets they are acquiring. The company may have received a modest discount due to the fact that HCL was the natural owner of some of these assets due to the previous product development and support relationship that existed which would have been difficult and expensive to unwind. With regard to the free cash flow that will be generated typically these legacy software products throw off significant cash flows provided that the support cost are kept under control and in this case it appears that portfolio is in fact generating significant cash flow at attractive margins.

Given the advantages HCL has through access to low cost labour it would be reasonable to expect that the tech firm will be able to enjoy strong cash contributions from these assets for some time. However, once the initial growth impact of the acquisition is worked through the slow growing and potently shrinking market for these assets will create a drag on over all HCL growth unless they are able to introduce new products or product extensions. Investing in these new products and product extensions is likely to prove expensive and these new expenditures should they be made will pull down earnings.

Perspective

From the IBM perspective this is a continuation of its ongoing efforts to divest the slower growing legacy parts of business and focus on the faster digital and AI parts of its business. HCL was a natural partner for IBM and by selling the assets to HCL, IBM overcome some entanglements which it would have faced when they entered the long term agreements with HCL to provide product engineering support and level 2 and 3 help for a number of the products which were sold. By selling these assets IBM can devote more time and resources to their big bets and by divesting the slower growing legacy assets their overall portfolio of business will grow faster.

I expect that this divestiture will be welcomed by the investment community as well as their customer base. The IBM customers will now likely get increased investment in these legacy assets as will see   more focused Big Blue. Given the declining nature of the IBM legacy business it has little choice other than attempt to remake its self into an AI and cloud company. To keep the legacy assets would doom it to a long slide into irrelevance and loss of market leadership. The real question is not is this the right thing for IBM to do? But has it acted fast enough in doing it.

(As told to Mini Tejaswi)