NelsonHall CMS Insight: September 2009

This news comes just a week after the announcement of Dell's acquisition of Perot Systems, also headquartered in Plano, Texas. In both cases, a U.S.-centric IT services provider with a strong presence in the healthcare market (Perot with healthcare providers, ACS primarily but not solely in Medicaid) is being acquired by a technology company, though there are significant differences in the look and feel of the two transactions.

The announcement was made on Yom Kippur, the Jewish holiday: Ursula Burns stated that this was not the original intention but there was a pressing need to announce the deal before it began to leak.

An acquisition of ACS has been on the cards for some time, and in many respects ownership by Xerox will greatly assist its ongoing evolution, for example:

Xerox's brand reputation and global account management capabilities will be a major advantage in helping ACS' efforts to internationalize (c. 93% of ACS' revenues are generated from U.S. based clients and it has struggled in the past to establish a significant direct presence in Europe)

The application of Xerox document technology to automate more of ACS' BPO activities should lead, among other things to significant efficiency improvements and further insights from being able to analyze unstructured information, helping ACS to be able to offer clients a lower cost and higher value-add service

In recent years, Xerox has also made a number of niche vertical-specific software acquisitions, which have the potential to enhance ACS' proposition in areas such as mortgage processing and litigation document processing.

For Xerox, the acquisition will bring in an additional $6.5m higher margin services revenue (ACS' operating margin in its FY ended June 30, 2009 was 10.5%, compared with the 7.4% operating margin achieved by Xerox Group in the same period). In total, all services will now represent 45% of the combined group's $22bn revenues, of which BPO will account for 27%.

This is an audacious move by Xerox. The stated intention is that "ACS, a Xerox Company" will be the BPO arm of Xerox. Certainly, document management is a core component within nearly all forms of BPO (another being contact center services) and the rationale for Xerox to make an aggressive play into the BPO market makes absolute sense and it has chosen wisely: much of ACS' BPO business is transaction-heavy.

It is not widely known that Xerox has been building its own document management BPO business for several years, in the form of its BPS (Business Process Services) unit within Xerox Global Services. NelsonHall ranks Xerox as the largest document management BPO vendor globally: Xerox BPS now generates revenues of nearly $900m, and has been particularly successful in the U.K., with recent successes in the government and NHS sectors. Xerox has chosen wisely with ACS: much of ACS' BPO business is transaction-heavy and geographically the two companies complement each other well.

Nevertheless, Ursula Burn's description of the proposed acquisition as a game-changer for the group is appropriate: whereas the BPS business sometimes looked like a marginal activity, the addition of ACS will fundamentally change the business mix of Xerox Group. Whether Xerox is able to fully grasp the extent to which BPO is different from managed print services or from fleet management services remains to be seen. In recent years Xerox Global Services did not even merit a mention in the Xerox annual report, let alone its BPO unit. However, the scale of the acquisition indicates that Xerox has made a strategic decision to undertake a new direction.

With this acquisition, as well as entering the premier league of BPO players, Xerox also becomes a closer competitor to HP, who has been aggressively developing its software portfolio around information management, though as yet with HP, BPO has not been a core element within its information management messaging. Also, where EDS is now folded into HP's TSG division, ACS will have a direct report to the Xerox CEO. This is potentially an important difference, for example with investment decisions.

It is not yet clear how Xerox BPS will integrate with ACS: this is particularly relevant in the U.K. where ACS does not yet have a meaningful BPO presence. Though Xerox has the stronger brand and local market presence, a reverse merger of Xerox BPS into ACS is likely.

Another area of synergy is ACS' $1.4Bn ITO business (22% of its global revenues): opportunities exist for Xerox to cross-sell its Managed Print Services into ACS' ITO client base.

Parts of ACS' business that will be completely new for Xerox include its transportation solutions activity - including road user charging - and the Buck Consultants practice within its HCM business (14% of its global revenues). Overall, Xerox's decision to ring-fence ACS is a very wise move in the short term. Longer term, the combined entity could position for the type of long term partnerships in the local government sector covering a broad range of ITO/BPO services that is gaining attention, not just in the U.K., but also in other countries.

An immediate challenge for Xerox will be managing the partnerships that it has been building for its BPO arm. IBM, for example, is unlikely to be keen to continue with a joint go-to-market partnership moving forward.

Xerox has only recently been trying to extricate itself from the IT infrastructure management contract extension it awarded former partner EDS just before its acquisition by HP, for example signing a U.S. datacenter management deal with HCL Technologies.

Once the transaction is approved, Xerox will more than double in size, in terms of headcount ACS is substantially the larger organization, having 74,000 employees compared with c. 54,000 across the whole of the Xerox Group. This simple fact poses several challenges in itself.

Xerox's offer is slightly higher than the $6.2bn offer made in March 2007 by Cerberus Capital Management in partnership with ACS founder and chairman Darwin Deason. Several directors rejected the proposal, hoping for a higher offer. This never materialized, and in November 2007 Cerberus rescinded its offer, citing poor credit markets.

Based on ACS' FY 2009 (period ended June 30, 2009), the Xerox offer is 1x revenue (plus the $2b debt), and 9x EBIT. Based on FY 2010 EPS estimate of $4.08, the offer represents a multiple of 13x-14x P/E. Overall this appears to be a reasonable valuation.

In addition to Dell/Perot and Xerox/ACS there are several other smaller IT services acquisitions taking place at the moment. This resurgence in M&A activity indicates easier access to credit and a belief that the worst of the economic downturn is behind us.

NelsonHall published a comprehensive 94 page Key Vendor Assessment on ACS earlier this month: if you are interested in purchasing this, contact rob.hughes@nelson-hall.com