Till last year, most software industry analysts had been raising questions about the long-term survival of mid-sized Indian IT services companies. Their performance had been highly erratic from quarter to quarter and they were struggling to maintain growth even as much larger companies were growing rapidly.

These companies suffered heavily in the slump that followed the collapse of the internet bubble. Demand for services slowed down significantly and stock prices crashed. By the time the cycle turned and demand picked up, the mid-size companies found themselves beleaguered by the larger companies, unscathed by the shake-out, better equipped to win customers.

However, over the last one year these companies have become potentially hot acquisition targets for global IT majors like IBM, EDS, CSC, Cap Gemini, etc. Some large deals have already been announced and many more are expected to follow as the IT and BPO services industry goes through a phase of consolidation.

The rapid growth of Indian IT service majors like TCS, Infosys, Wipro and Satyam over the last several years is changing the dynamics of the global IT services industry. These companies have matured and gained significant size, enabling them to bid for larger overseas projects, once the exclusive domain of global majors.

As a result, the global majors are being forced to fight back; they are taking the battle to Indian shores by scaling up their Indian operations. Shifting a large part of their software development and support operations to India would help in driving down costs and compete better with the Indian majors.

IBM and Accenture adopted the strategy of organic growth in India and have built up large-scale operations in the country. IBM was the first to attempt large scale expansion in India and went on to acquire Daksh to expand BPO capabilities.

Among global majors, IBM has the largest presence in India with more than 35,000 employees. Accenture has expanded fast in the last couple of years and now employs nearly 20,000 people in India.

EDS and Cap Gemini have been slow to expand their presence in India and are now trying to make for lost time. As there is severe competition for talent between these companies, the slow starters have been forced to look at acquisitions.

Growth in outsourcing
Growth in the outsourcing sector remains strong and the anti-outsourcing noises have become less shrill. It is estimated that during the first quarter of 2006, more than 80 major outsourcing deals worth a total of nearly $22 billion were signed. This is over 35 per cent higher than close to $16 billion worth of deals signed during the same period of last year.

Industry estimates indicate that contracts worth nearly $100 billion would be signed during the next two years. These are long-term deals spread over between three and five years, which means that the losing bidders would have to wait for a long period for the next opportunity.

Most of these contracts are currently with global majors like IBM, EDS, Accenture and CSC. When the time comes, large Indian companies are expected to bid aggressively for the contracts, putting their pricing and margins under pressure... making it all the more urgent for global majors to expand their operations in low-cost centres like India.

A win-win proposition
Except for a few companies that are niche players, second rung Indian IT companies are struggling to grow and their performance over the last few years has been patchy. Their margins are under threat because of rising employee costs and the constant attrition, with global and large Indian companies being able to pay higher salaries for experienced employees.

Hence it makes sense for these companies to merge their operations with large global companies rather than risk being driven to the wall. Also a large parent with a global presence would open doors to more business opportunities for the acquired company, helping them to achieve faster growth.

The stock market rally is also making such deals more interesting for Indian promoters. Though the stock prices of some of these companies have lagged considerably because of sub-par performance, they now command much better valuations than they did a few years back. Having nurtured these companies thus far, at least some of the promoters may now be looking for an exit route.

EDS bid for Mphasis
Early this month, EDS offered $380 million for a 52-per cent stake in Mphasis BFL. The offer is conditional upon EDS being able to acquire a minimum 52-per cent stake. Mphasis'' management has backed the deal and recommended the offer to shareholders.

Mphasis BFL focuses mainly on the banking, financial services and insurance (BFSI) vertical with a significant portion of its revenues coming from the US. The company has many blue chip clients like Citibank, JP Morgan and Morgan Stanley.

Mphasis also has a BPO outfit, Msource, and has a combined employee strength of over 8,000. If the acquisition goes through, EDS would have a total of 11,000 employees in India.

Private equity firm Barings is the single-largest shareholder in Mphasis with a 36-per cent shareholding. Barings tried to sell its stake last year and suitors included Cap Gemini and Singapore government controlled investment firm Temasek apart from some of the large Indian companies. However, the sale was called off after months of negotiations, reportedly on valuation differences.

The EDS offer values Mphasis at $731 million or more than 22 times current earnings. The offer from EDS is at a significantly higher valuation than the offers received last year as the Mphasis stock had seen a significant rally earlier this year on rumours of a potential deal. Hence it is likely that investors, including Barings, would accept the offer.

The acquisition would give EDS a significant presence in India, which would help drive down costs and improve margins. Mphasis also brings significant domain expertise in the BFSI space.

Flextronics exit
The latest deal in the sector is the sale of Flextronics Software Systems (FSS), earlier Hughes Software, by Singapore-based Flextronics to private equity firm Kohlberg Kravis Roberts & Co (KKR). Flextronics is selling an 85-per cent stake in its software division, which includes FSS, to KKR for $900 million and would retain a 15-per cent stake.

FSS develops communication software for mobile phone networks and customers include Intel and Motorola. The company is also building its development capabilities for IP telephony software. The other mid-size Indian company in telecom software is Sasken.

KKR is one of the oldest global investment firms and has completed more than 125 large deals over the last three decades. The total value of these deals is estimated at over $160 billion, the $31.4-billion leveraged buyout of RJR Nabisco in 1988 being the largest.

Flextronics acquired 70 per cent of Hughes Software from a Rupert Murdoch-controlled News Corp group company in 2004. This was followed by an open offer and Flextronics raised its stake to over 93 per cent. Hughes Software was renamed as Flextronics Software Systems.

Flextronics decided to sell out within two years of acquiring FSS and trying to de-list it from the domestic exchanges. It is expected that the company would anyway be de-listed before the sale to KKR is concluded.

Though there are many theories about what prompted Flextronics to sell-out, the most plausible one is growing discomfort among key clients on the company''s attempts to expand its software and content capabilities.

Flextronics is the largest contract electronic manufacturer globally with clients like Dell, HP and Microsoft. These companies would have seen Flextronics as a future competitor if it builds the capability to develop products and the software to go with those products.

There were also reports that some of the US-based institutional investors were forcing Flextronics to divest the software business to improve cash flows and margins in its core business of contract manufacturing. Whatever be the reason, we may see another deal involving FSS sooner than later as KKR would look to exit at an opportune moment.

Other deals
Last year, ERP giant Oracle acquired a majority stake in i-Flex Solutions to add core banking software to its portfolio. Most of the banking industry still rely on custom-developed systems, but are expected to shift to core banking suites like Flexcube from i-Flex.

Flexcube is one of the most popular core banking suites globally with a large customer base across the globe. But its customers are mostly smaller banks who find it very costly to develop and maintain legacy systems.

Analysts estimate the opportunity in this sector at around $70 billion over the next few years. Oracle is trying to corner a big chunk of it by combining the product development skills of i-Flex with its database platform. The association with Oracle would help i-Flex to target larger clients as well.

Earlier this year the US-based RR Donnelley & Sons acquired Office Tiger, an accounting service BPO with most of its employees in India. Accounting services is a fast growing BPO segment, which could see more such deals in the future.

Other potential targets
There has been many media reports and market speculation about overseas companies planning to acquire Polaris Software, one of the larger mid-size IT companies. The potential acquirers include IBM and EDS, if these reports are to be believed. Though it has denied these reports, the company remains a prime target for a possible acquisition.

Most other mid-size IT companies like Hexaware, Zensar, Visualsoft, Datamatics, Scandent etc are also potential targets. Most of these companies do not have strong promoters and the promoters'' stakes are also low in some cases. Private equity investors and other institutional investors hold significant stakes in some of these companies and they may be willing to sell out at the right price.

Unlisted BPO companies like EXL Services and WNS Global are also attractive to global players who wish to enhance their BPO service offerings. These companies need to raise funds for expansion and are reportedly considering IPO''s. Instead, they may sell out to any of the global majors as well.