IT Services: Ripe for Buyouts

Once-battered tech-services outfits are finding love from private investors enchanted with long-term contracts and steady cash flow

There was a time when IT services companies such as Computer Sciences (CSC), Affiliated Computer Services (ACS), and Electronic Data Systems (EDS) were all the rage on Wall Street. Computer Sciences ranked 36th on BusinessWeek's list of 100 top information technology companies as recently as 2004. But share prices throughout the sector have tumbled in recent years, as revenue and profit growth slowed amid a decline in corporate tech spending.

Yet as public shareholders' enthusiasm has waned, IT services companies have found an entirely new group of fans. Private equity investors—who shunned the sector during its high-growth phase in the '90s—love IT now that corporations are investing in new tech gear and the industry's turmoil has abated. IT services outfits now rank high on the list of potential leveraged buyouts maintained by investment banks, private equity firms, and research groups.

Credit strategists at Goldman Sachs Group (GS) issued a report in March that analyzed nearly 1,000 buyout prospects. IT services companies accounted for five of the top 20 names, tying with real estate as the sector with the most opportunities for lucrative buyouts.

Computer Sciences, Affiliated Computer, and EDS all ranked in the top 20, with potential internal rates of return of 48% of more. Figures like that easily garner notice from private equity investors, who typically want an internal rate of return (IRR) of at least 20%. The IRR is a way of estimating future cash flows after spin-offs and other forms of income-generating restructuring are taken into account.

On the Block

A high rank on such lists is no guarantee that a buyout will occur. "Other factors, such as family or union control, can discourage investors from buying companies that have a high rank on our leveraged buyout screen," says Tim Backshall, chief strategist at Credit Derivatives Research, a firm based in New York.

Yet many IT services companies are in play. Computer Sciences, which ranked No. 15 on the Goldman Sachs screen, hired Goldman bankers in 2006 to explore a possible sale (see, 4/4/06, "Computer Sciences Goes on the Block"). It's not uncommon for bankers at big firms like Goldman to do business with companies that analysts in other parts of the firm cover. Computer Sciences opted to buy back up to $2 billion of its stock instead of continuing to explore a buyout, although that doesn't mean unsolicited offers can't be made.

Cerberus Capital Management offered in March, 2006, to buy Affiliated Computer Services for $8.2 billion, including debt (see, 3/21/07, "A Private Affair"). A special committee of Affiliated's board is studying the offer, which is backed by Affiliated's founder and chairman, Darwin Deason. Before the offer was made, Affiliated ranked 19 on the Goldman screen and had a projected IRR of about 49%.

Seeking Steady Cash Flow

Private investors tend to value a company in different ways from public investors. That's why, in a leveraged buyout, it's possible for companies that fare poorly in the stock market to have a lot of potential value (see, 4/3/07, "When Bad Stocks Make Good Buyouts").

Public investors value companies based on the growth of earnings and revenue, which are reported at quarterly intervals. Private investors don't need such evidence of quarterly growth. They can wait two to four years—or more—while they renovate their investment and then sell it or take it back to the public markets.

Private investors also seek signs of steady, substantial cash flow that can support debt, which they use to boost the value of an investment. There are plenty of companies that produce strong cash flow, despite weak earnings or revenue growth.

For the past few years, Plano (Tex.)-based EDS, which manages corporate IT systems, has had a rough ride in the stock market (see, 2/8/07, "EDS Puts Its House in Order"). The shares closed on Apr. 19 at $29.21, less than half their market peak in 2000.

Yet despite several quarters of slowing income and revenue, EDS maintains big contracts that produce a steady stream of cash, making it suitable for an LBO. That cash can support debt, a key component in many go-private investments.

More Global Competitors

Why has the IT services sector had such trouble in the stock market? Globalization has been a double-edged sword for many services companies, boosting both risk and opportunity, but battering many of their stock prices.

That, in turn, allows private equity players to acquire them at an attractive price. "Services are among the industrials most amendable to outsourcing," says Phillip Phan, a professor of management at Lally School of Management & Technology at the Rensselaer Polytechnic Institute. Services outfits such as EDS have a much bigger global market now, but that market is full of more competitors. To emerge as a net winner, private equity firms "replace labor with technology, downsizing to maximum efficiency," Phan says.

Private equity firms also wield an important advantage over public owners: They can afford to hire the best management talent. And it's easier to jettison jobs and other costs as a private company, which tend to receive far less public scrutiny.

Services companies say their appeal reflects their growth prospects, too. "We certainly think there are significant growth opportunities in the IT services space, especially in areas such as enterprise security, outsourcing,…software solutions…and servers," Unisys spokesman Jim Kerr says. He estimates the growth range at 8% to 10% for outsourcing and 20% for other markets, including security, open-source, and Microsoft (MSFT)-based software solutions and virtual servers.

Growth prospects also help a buyout firm with its ultimate goal: fixing companies for a return trip to market, where investors are far more likely to appreciate a company's growth prospects than they did before the buyout.

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