* Improving spending, economy increase appeal of IT services
* Hardware, software firms looking for stability eye services
By S. John Tilak
BANGALORE, Oct 28 (Reuters) - The U.S. information technology services sector is likely to be a focus of merger and acquisition activity as its companies are among the most attractive in the technology space.
A rebound in tech spending has increased the appeal of IT services companies and put them in the crosshairs as deal momentum picks up in the industry.
The ongoing recovery in the economy and credit markets has made tech companies look for ways to come out on top, and they have shown a willingness to pay hefty premiums in a sector that has historically commanded high prices.
IT services firms have a recurring revenue stream, high margins, a strong growth outlook and impressive returns on investment, making tempting targets for buyers. They offer consulting, software services, business process outsourcing, systems integration and interactive marketing.
Cash-rich technology giants plan to strengthen their portfolios, and smaller firms want to stay in the game through acquisitions as their larger rivals become even more formidable.
Attractive acquisition candidates include Sapient, Computer Sciences, WNS, Amdocs, Cognizant Technology and ExlService, analysts said.
Consolidation is under way. In September, Xerox Corp said it would buy Affiliated Computer Services Inc in a deal valued at about $5.5 billion, and Dell Inc said it planned to buy Perot Systems Corp for about $3.9 billion.
"The pattern here is that you have commoditizing tech product companies looking for a strategy that's better than doing nothing," Sanford C. Bernstein analyst Rod Bourgeois said.
"They're looking at the IT services industry to juice up their struggling tech product business."
Possible acquirers could be tech giants such as IBM, Hewlett-Packard or Cisco, European players like BT or Deutsche Telekom and Asian companies like Hitachi, Fujitsu or NEC, analysts said.
"There's definitely going to be some strategic acquisitions -- there's no doubt about that," Goldman Sachs analyst Julio Quinteros said. "It's just, how much are you willing to pay? And would you rather wait for the market to come back a little bit?" The recurring revenue stream that IT services firms have gives them more visibility and stability.
"What's driving a lot of this is the evolution of hardware companies looking for more stability and recurring revenues that are typically associated with services models and by the same token software companies potentially looking for the same thing," Quinteros said.
Hardware and software companies want to diversify their portfolios by adding services, to help them survive and even prosper through tough times.
"What's alluring about services for tech product companies is first the precedent of IBM and HP coupling products with services to be able weather the downturn well," Bourgeois said.
In 2008, Hewlett-Packard acquired EDS for $13 billion in what is considered the biggest acquisition in the space ever. In 2002, IBM bought PwC Consulting from PricewaterhouseCoopers for about $3.5 billion.
"Vendors are trying, to some extent, to emulate the integrated model that IBM really pioneered when they got into the services business years ago," UBS analyst Jason Kupferberg said. "HP followed suit buying EDS. Now you're seeing a continuation of that theme."
TRANSFORMATIONAL IN NATURE
A barrier for acquisitions is valuations, analysts said.
For example, Cognizant, with a market capitalization of about $11.75 billion, is trading at 24 times forward earnings.
"I don't necessarily believe that valuations will completely prevent these deals from happening now," Kupferberg said. "A lot of these companies have a lot of cash on the balance sheets. So they can afford to do some deals."
While analysts are sure that deals will happen, not everyone is certain they will be blockbusters.
Large mergers in the space are not necessarily wise moves, said Abhi Gami, a senior equity analyst with Invesco Aim, an investor in IT services stocks such as Accenture, Cognizant, IBM and HP.
"They are almost by definition transformational, where the acquiring company will need to make significant changes to its operations in that space in order to integrate the newly acquired large services business," Gami said.
"I think a transformational deal by its nature creates a lot of risk."
IT services companies could be acquirers themselves, with companies like Accenture capable of pulling off big deals.
A range of companies, such as Hewitt Associates in human resources, Jack Henry & Associates in transaction processing, Amdocs in telecoms billing or Genpact in back office offshore services, could prove to be attractive targets for Accenture, Kupferberg said.
Hot areas in services include interactive marketing and risk management, Brigantine Advisors analyst Matthew McCormack said.
"Sapient would be a very good example of a smaller IT services company that has focused on some very specific areas that have very good longer-term growth outlook," McCormack said.
Sapient, which offers interactive marketing and risk management services, trades at 32 times forward earnings.
One group of services firms that are likely to be involved in M&A are the Indian outsourcers, which include Tata Consultancy, Infosys Technologies and Wipro.
While most analysts say they are more likely acquirers, Goldman's Quinteros sees it both ways.
"I can also make the case that they could be takeout candidates because they have not done an effective job in really moving up the food chain, bringing the value-add competency to the skill-set table," he said.