The fall and rise of IT by Matt Miller, The Daily Deal Updated 01:04 PM EST, Apr-8-2003 The definition of a consultant, the well-worn joke goes, is some guy between jobs. The thinking should follow, then, that the best definition of a consultancy would be some company between owners. That description helps characterize the state of play in the once-hopping field of information technology consulting, a large part of the universe these days known as IT services. After more than two years of punishing cutbacks by corporations in their spending on technology, hundreds of small and medium-sized IT services companies are finding it tough to stay independent. Many are looking for new owners. Industry consolidation already is under way. The strong are acquiring the weak. Large are acquiring small. The generalists are adding companies with specialized expertise. Just about everyone expects the pace of deal flow to quicken in the months ahead. "It's like two steel companies coming together in the old days. The same conversations are going on in IT services," says Martin Wolf, who runs Martin Wolf Securities LLC, a San Francisco-based investment bank boutique that specializes in IT services. "The last 24 months have seen consolidation. That will accelerate quite dramatically." However, it most definitely remains a buyers' market. Many of those with the means to acquire are in no hurry to conclude deals as long as the economy and the effects of war remain uncertain. Nor are those looking to expand in any mood to offer generous premiums. "There's a tremendous overhang of deals that need to be done in this sector," says Jon Cutler, the founder, CEO and chairman of Quarterdeck Investment Partners LLC, a defense-focused investment bank which specializes in government-related IT services. A whole bunch of companies find themselves between owners. "Most potential sellers don't want to sell into this market," says Melanie McFaddin, a Houston-based IT services M&A consultant, whose clientele are mostly smaller-sized companies looking to be acquired. "They've come off the worst 12 months ever. They've survived. They have drawn a line in the sand." McFaddin says sellers expect a 25% bump in current valuations before they sign over their companies. A few well-defined niches have actually seen valuations jump in the past year. Most notable are government services, which were out of favor during the tech boom but which now are viewed as a much more robust revenue source. "They're near double-digit [Ebitda] multiples," says Joann Teal, a Quarterdeck vice president. But that's the exception. More traditional IT companies can expect to be valued only at about half trailing 12 month revenues or about 3 times Ebitda. At the peak, even some smaller companies were sold at 6 or 8 times trailing revenue and 20 to 30 times Ebitda. Even a recovery in technology spending may not keep many of the smaller players afloat. A growing number of corporate clientele are moving toward large IT companies that can provide a wide range of services, leaving smaller competitors out of the bidding. "There's a share shift going to bigger companies," says Joseph Vafi, an analyst with Jefferies & Co. "Plenty of niche companies won't be around," says Mike Trigg, an analyst with Morningstar Inc. "Before, corporations might go to 40 or 50 vendors. They've consolidated to eight to 10. It's more efficient." However, it also remains a huge universe. Even with the dramatic downturn in spending, IT services in North America in 2002 constituted a business that easily eclipsed $200 billion. It's also not an easy one to define. The marketplace can be sliced and diced in several ways. Vafi, for one, divides it between traditional consultants, offshore development, applications outsourcing and specialized IT, primarily government. McFaddin groups IT services into staffing, consulting, business process outsourcing and solutions, such as building a computer-based orders management system and then turning it back over to the company, rather than merely providing staff. Then she layers on specialist work in government or heath care. Even the jargon has changed. "What was professional services in the early '80s and technical services in the early '90s are now IT services," Cutler says. As some potential acquirers jockey for position, they're trying to determine what aspects of IT services will emerge particularly robust. Outsourcing is one, many have determined, as corporations have decided to jettison more of the technology work they have traditionally done in-house. Consequently, outsourcing companies now attract a much higher multiple than do traditional systems integrators, says André Nadeau, the executive vice president and chief strategy officer of CGI Group Inc., Canada's largest IT services company and a well-known consolidator within the industry. There is also a question of who will be buying. Some IT service companies have signaled their intent, from behemoths IBM Corp.'s Global Services and Hewlett-Packard Co. to aggressive second-tier players like CGI. McFaddin, for one, believes some private equity funds also are searching for acquisition candidates that can be "platform companies" in rollup efforts. Chicago-based GTCR Golder Rauner LLC, for example, is one PE concern that has already dabbled in IT services. While business may be down pretty much across the board, the industry still creates significant cash flow. Some of these well-heeled M&A players remain on the prowl for acquisitions. Others say they're biding their time. "We generate a lot of cash, which we can use for either M&A or buying back our shares," says Larry Vale, who heads investor relations at Boston-based IT consultancy and services company Keane Inc., which acquired its way to a solid second-tier status in the 1990s. "Right now, share repurchase is low risk," he says, while the company waits for what it believes to be even more attractive valuations. A few megamergers marked last year's deal flow. In July, IBM Global Services muscled its way into even greater IT dominance with its $3.5 billion cash purchase of PricewaterhouseCooper's consulting business. It was the biggest IT services deal since the tech bubble burst. (Sky-high valuations skewed share swaps during the boom. In early 2000, for example, two Web services companies merged to form MarchFirst. The deal was valued at $6.5 billion.) Computer Sciences Corp. paid $950 million in cash, shares and assumption of debt for DynCorp., a deal announced in December but completed only in March. KPMG Consulting Inc. — subsequently rechristened BearingPoint Inc. — paid almost $300 million for some European operations of bankrupt Arthur Andersen, then plunked down another $685 million for KPMG Consulting AG, its sister company in Germany. In Europe as well, Paris-based Atos Origin in June paid €657 million ($707 million) for KPMG Consulting in Britain and Holland. London-based Logica plc paid £717 million ($1.12 billion) for competitor CMG plc, a deal announced in November. "Large companies feel the need to get larger," Wolf says. This year, deals have tended to center on midmarket transactions, which range from $50 million to $300 million. For example, Perot Systems Corp. announced in March its intention to buy for up to $107 million Soza & Co., a services company that specializes in government work. In January, CGI bought Canadian rival Cognicase for C$322 million ($220 million). Just about anyone following the industry believes there's room for a whole lot more dealmaking. The terrain is a natural for consolidation. The field remains highly fragmented. IBM Global Services may be the largest player, but its $36.4 billion revenue in 2002 still represents less than 10% of total IT services spending worldwide. Business is tougher for the smaller shops to attract and keep. Clients demand more in terms of consultant muscle and resources. "There's a minimum size needed to compete," Wolf says. "And that bar has got raised." So, even if IT spending recovers, happy days won't necessarily be here again for many consulting companies. Multi-year contracts mark many IT services. Corporations don't want to sign up with shops that may not survive the next business downturn. "The smaller and medium players are going to be marginalized," Nadeau says. "They'll realize they have to make a deal." For some, it's already too late. Take the mostly late and little lamented Web services, which burst on the scene in the late 1990s with weird-sounding names like Scient Corp. and Sapient Corp., Proxicom Inc. and Xpedior Inc. These companies designed the Web sites and online functions that became de rigueur for companies big and small. They hired thousands of eager, young consultants and pulled in as much business as they could handle. More than a dozen went public. Valuations went ballistic, as investors subsumed concerns of profitability and focused on revenue gains. "Several of these companies were jokes with cash," sniffs Mac Slingerlend, president and CEO of Ciber Inc., another second-tier IT services company, with a history of acquisitions. By 2001, the demand for Web services had pretty much vanished. Most of the Web-focused consultancies died as quickly as they flourished. During the second half of 2002, SBI and Co., a private, midmarket IT services company based in Salt Lake City, purchased the remnants of three e-services companies. It bought Scient assets out of bankruptcy for $4.9 million, bought the stock of Lante Corp. for $42 million and Razorfish assets for a mere $8.2 million. At its height, Razorfish, which had acquired a number of consultancies itself, boasted a market cap of $2.5 billion. Scient's market cap was about $5 billion. "We never thought we'd have the opportunity to bring in these sorts of brands and people," says Ty Mattingly, SBI co-founder and its executive vice president. Mattingly says these companies maintained top-level personnel and an impressive clientele list, despite a revenue freefall. "We have some of the best teams that existed in Internet services," he says. All that was needed was to remove the uncertainty of whether the companies would remain in business. "We just had to get the noise out of the equation" SBI's revenue totaled $87 million in 2002. The company expects this year's revenue to hit $150 million. That kind of trajectory, Mattingly says, gives SBI the chance for an IPO or an acquisition by "one of the big boys." It wasn't just Web services that fell on hard times. With little barrier to entry, thousands of systems integrators, staffing shops and computer consultants sprung up in the 1980s and early 1990s, many no more than a couple guys, telephones and a nameplate. A booming economy, advances in technology and concerns about Y2K all combined to create unprecedented demand for IT services and consulting in the late 1990s. As technology spending accelerated, IT service companies found they had more business than they could handle. Mergers and acquisitions became one way to quickly meet demand as well as acquire a customer base. Multiples understandably skyrocketed. By the end of the decade, companies were being acquired for as much as 32 times Ebitda and 10 times trailing revenue, McFaddin says. Demand for IT services fell as fast as it grew. Keane booked $375 million in Y2K revenue in 1998, $250 million in 1999 and $5 million in 2000. The end of Y2K concerns coincided with the bursting of the tech and Internet bubbles. Spending evaporated in the second half of 2000, stayed dry during the entire 2001 and only began recovering during the second half of 2002. "There was significant paralysis," Slingerlend says. Corporations "didn't do anything [in IT services] that was optional." The shakeout among IT services companies continues to this day. The latest example is Electronic Data Systems Corp., second in size only to IBM. In March, the board fired Dick Brown, its CEO and chairman, after the company reported business in a tail-spin. Rumors are flooding the market about possible minority investments or even an acquisition of the Plano, Texas, company, whose shares have dropped more than 70% in the past year. Time to call in the consultants. http://www.thedeal.com//NASApp/cs/ContentServer? pagename=TheDeal/TDDArticle/StandardArticle&c= TDDArticle&cid=1048854299675&Box1=102013190 6746&Box2=1019496876560