For Cap Gemini, the Wrong Mate at the Wrong Time?

Its merger with Ernst & Young's consultancy is sinking profits

It was billed as one of the great transatlantic mergers of the new millennium. In May of last year, Paris technology-services company Cap Gemini (CAPMF ) laid down $11 billion for the consulting arm of Ernst & Young, propelling itself overnight into the ranks of the top five global consulting firms. Analysts hailed the deal as a perfect match of European high-tech expertise and an American marquee name.

As it turned out, the honeymoon was brief. Profits at Cap Gemini Ernst & Young are set to fall by more than half this year, to $154 million on sales of $8.1 billion, as the firm's clients slash tech spending in the face of a global economic slowdown. What's more, the Ernst & Young acquisition increased Cap Gemini's exposure to the U.S. market, where the tech downturn has been sharper than in Europe. "The timing was impeccably wrong," says Richard Holway of British information-technology research group Ovum Holway. To compensate for lost business, Cap Gemini has slashed 9% of its 60,000-strong workforce. Still, its shares have shed two-thirds of their value since the merger.

Now it's up to a newly appointed CEO to tailor Cap Gemini's ambitions to fit the industry's new realities. On Jan. 1, former Chief Operating Officer Paul Hermelin, a 49-year-old Frenchman, takes the helm. He replaces Geoff Unwin, a 59-year-old Briton who is taking a long-planned retirement after 11 years at the company. Hermelin's appointment was announced at a Dec. 12 press conference, at which the company also disclosed it was taking a full-year $180 million restructuring charge to cover a new round of 2,500 layoffs and other cost-saving measures. "We've tried to be too many things. It's time to streamline," says Hermelin.

An eight-year Cap Gemini veteran, Hermelin is seen as a good choice to lead the company through a restructuring. "He has a strong focus on operations and costs," says Ariel Bauer of Merrill Lynch Global Securities. Cost- cutting is essential now that demand for Cap Gemini's core business--helping clients install big, complex IT systems--is plummeting. More clients are trying to control costs with outsourcing deals, in which they hire outsiders to run their IT systems, from inventory control to customer-relations management. Although outsourcing is a relatively low-margin business, rivals such as IBM, EDS, and Accenture have posted healthy results this year by concentrating on such deals. But Cap Gemini has been a laggard: Even on its home turf in Europe, it did less than $1 billion in outsourcing work last year, compared with almost $4 billion by industry leader IBM.

Hermelin says he's pushing to boost outsourcing and expects it to account for 30% of all business in three years, up from 16% in 2000. In a bid to lure cost-conscious clients, Cap Gemini is setting up an affiliate that will rent out engineers at daily rates. That's a risky move, since long-term consulting relationships yield the fattest profits.

Indeed, with scant demand for the management-consulting services that were Ernst & Young's strong suit, operating margins have shrunk from more than 10% to only 5%. The layoffs will help. But Cap Gemini still has to prove that the marriage made sense in the first place. Hermelin contends that when the economy rebounds, big corporate clients will again seek advice from a full-service global group. Others, however, argue that the merger was a mistake. "There's just no need for prima donnas in consultancies developing fabulous new projects," says Holway.

So where does that leave the ex-employees of Ernst & Young? Management acknowledges they account for a disproportionate share of the layoffs, although it won't give precise figures. Others have left voluntarily. "They are dismantling the core consulting business that Ernst & Young built up," says one. "I just didn't see a place for myself there." Just another reminder that a merger made in a boardroom isn't necessarily a marriage made in heaven.

By Carol Matlack in Paris

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