Clinical Professor of Finance
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This case study is representative of those found in Mergers, Acquisitions, and Other Restructuring Activities, 5th edition, 2010 by Donald M. DePamphilis. For more information or to buy this book online, click here.
Changing Customer Requirements Force an Industry Shift
Reflecting the increasing cost and complexity of computing, many corporations have outsourced their information technology (IT) operations in an effort to streamline various business activities. These activities include procurement, customer tracking, record handling, and product design. Advances in technology enable IT vendors to more easily provide computing services delivered over the Internet from remote data centers (i.e., through the so-called “cloud computing”). Software such as word processing, spreadsheet, and customer management systems could be moved from desktop personal computers to become a Web-based service, accessible from anywhere.
In anticipation of a shift from hardware and software spending to technical services by their corporate customers, IBM announced an aggressive move away from its traditional hardware business and into services in the mid-1990s. Having sold its largely commodity personal computer business to Chinese manufacturer Lenovo in mid-2005, IBM became widely recognized as a largely hardware neutral systems integration, technical services, and outsourcing company whose services could be enlisted by corporations to assemble internal computer networks using the most effective hardware and software rather than only those proprietary to IBM. As part of its branding process, IBM became viewed as largely “hardware neutral” by its customers in that it offered the best possible solutions through its alliances with other IT vendors for its customers rather than favoring a particular IBM product or service offering.
As IT services have tended to be less cyclical than hardware and software sales, the move into services by IBM enabled the firm to tap a steady stream of revenue at a time when customers were keeping computers and peripheral equipment longer to save money. The 2008-09 recession exacerbated this trend as corporations spent a smaller percentage of their IT budgets on hardware and software. Software and hardware expenditures as a percent of total corporate IT budgets fell from 36 percent in 2004 to 28 percent in 2009 according to the Gartner Group, a market research firm. The remainder of corporate IT budgets were spent on operations and services provided by outside consultants.
Playing Catch Up
These developments were not lost on other IT companies. Hewlett-Packard (HP) bought tech services company EDS in 2008 for $13.9 billion. On September 21, 2009, Dell announced its intention to purchase another IT services company, Perot Systems, for $3.9 billion, a whopping 68 percent premium. One week later, Xerox announced a cash and stock bid for Affiliated Computer Systems (ACS) totaling $6.4 billion, a 34 percent premium to ACS’s closing price on September 25, 2009.
Each firm was moving to position itself as a total solution provider for its customers, achieving differentiation from its competitors by offering a broader range of both hardware and business services. While each firm focused on a somewhat different set of markets, they all shared an increasing focus on the government and healthcare segments. Consequently, these markets were likely to become increasingly competitive. However, by containing to retain a large proprietary hardware business, each firm faced challenges in convincing customers that they could provide objectively enterprise-wide solutions that reflected the best option for its customers.
The Xerox Strategy
Historically known as “the Document Imaging Company,” Xerox intends to move into providing technology services such as into the outsourcing business with a major focus on healthcare and government. Services contracts tend to provide a more recurring revenue stream than hardware sales. Xerox increasingly believes its customers wanted a stronger connection with vendors who could provide both back office (e.g., application and claims processing) and front office (e.g., customer service) information technology product and services.
Previous Xerox efforts to move beyond selling printers, copiers, and supplies and into services achieved limited success due largely to poor management execution. In an effort to expand into services, Xerox bought Amici for $174 million in 2006 to enter the business of helping lawyers organize digital documents created during the legal discovery process. In 2007, the firm acquired Advectis, which helps banks and consumers electronically manage mortgage documents for $32 million. While some progress in shifting away from the firm’s dependence on printers and copier sales was evident, the pace was far too slow. Xerox was looking for a way to accelerate the transition from a largely product driven company to one whose revenues were more dependent on the delivery of business services.
With annual sales of about $6.5 billion, ACS handles paper-based tasks such as billing and claims processing for governments and private companies. With about one-fourth of ACS’ revenue derived from the healthcare and government sectors through long-term contracts, the acquisition gives Xerox a greater penetration into markets which should benefit from the 2009 government stimulus spending and healthcare legislation. More than two-thirds of ACS’ revenue comes from the operation of client back office operations, with the rest coming from providing technology consulting services. ACS would also triple Xerox’s service revenues to $10 billion, with almost 80 percent due to recurring revenue based on services and equipment leases.
Xerox is betting that it can apply its globally recognized brand and worldwide sales presence to expand ACS into Britain, Germany, Spain, and other geographic areas. Currently, about 92 percent of ACS’s revenue comes from the U.S. ACS technologies could also benefit from Xerox’s research in imaging and text recognition.
Xerox expects to save $300 million to $400 million in the first three years after the deal closes in early 2010. Most of the cost savings will come from ACS providing services to Xerox operations that would allow for some internal staff reduction.
Investor Reaction Mixed
The cash and stock offer for ACS was valued at $63.11 a share. ACS shares rose by 14 percent to $53.86 while Xerox shares dropped 14 percent to $7.68. Xerox also will assume $2 billion of ACS debt and issue $300 million in convertible preferred Xerox stock to ACS’s founder Darwin Deason to acquire his super-voting shares (i.e., those having multiple voting rights) which give him about 42 percent of total voting rights in ACS.
A perceived lack of synergies between the two firms, Xerox’s rising debt levels, and the firm’s struggling printer business fueled concerns about the long-term viability of the merger. Xerox has about $1 billion in cash and expects to borrow another $3 billion. Standard & Poor’s put Xerox’s credit on the “watch list,” with a credit downgrade to triple-B-minus, one notch above junk, likely.
Integration is Xerox’s major challenge as the firm has not done a lot of large deals. The two firms revenue mixes are very different as are their customer bases, with government customers often requiring substantially greater effort to close sales than Xerox’s traditional commercial customers. Xerox intends to operate ACS as a standalone business which will postpone the integration of its operations consisting of 54,000 employees with ACS’ 74,000. If Xerox intends to realize significant incremental revenues by selling ACS services to current Xerox customers, some degree of integration of the sales and marketing organizations would seem to be necessary.
With little experience in managing a services company, the acquisition will put Xerox in head-to-head competition with a variety of U.S. and foreign competitors. These include HP, Accenture, and Computer Sciences Corporation, as well as Indian service providers such as Satyam Computer Services, Infosys Consulting, and Wipro Technologies.
Operating ACS as a separate business could significantly reduce the ability of Xerox to realize the anticipated revenue gains due to cross selling. While Xerox notes that only 20 percent of the customers of the two firms overlap, it is hardly a foregone conclusion that customers will buy ACS services simply because the ACS sales representatives gain access to current Xerox customers. Presumably, additional incentives are needed such as some packaging of Xerox hardware with ACS IT services. However, this may require significant price discounting at a time when printer and copier profit margins already are under substantial pressure.
Dell, HP, and Xerox are primarily hardware firms desirous of moving increasingly into services. The presumption seems to be that the distinction between selling product and services is becoming blurred, particularly as “cloud computing” makes it increasingly attractive to deliver services from remote locations. Nonetheless, given their long histories, customers are likely to continue, at least in the near term, to view these firms more as product than service companies. The sale of services will require significant spending to rebrand these companies so that they will be increasingly viewed as service vendors.
The continued dependence of all three firms on the sale of hardware may retard their ability to sell packages of hardware and IT services to customers. With hardware prices under continued pressure, customers may be more inclined to continue to buy hardware and IT services from separate vendors to pit one vendor against another. Moreover, with all three firms targeting the healthcare and government markets, pressure on profit margins could increase for all three firms. The success of IBM’s services strategy could suggest that pure IT service companies are likely to perform better in the long-run than those that continue to have a significant presence in both the production and sale of hardware as well as IT services.