Got some change? I have to buy a service company!

Xerox announced last September 27^th that it will buy ACS (Affiliated Computer Services) for $6.4 billion dollars. ACS is according to Forrester Research one of the leading global IT infrastructure providers. This leading pack of providers, according to Forrester Research, includes among a few others the aforementioned ACS, IBM, EDS and Perot Systems.

Mergers and consolidation of companies are normal in times of crisis, when companies are looking for ways to scale their operations and simultaneously reduce the relative weight of their fixed costs. This merges tend to occur among companies of similar (or identical) products that allow sharing large parts of the infrastructure, including in many cases the sales force. In the IT field, the acquisitions of Digital Equipment and Compaq in relatively recent times were clear examples of this fact.

What is interesting is the recent trend of hardware manufacturers acquiring service companies. In reverse chronological order: Xerox is buying ACS, Dell Perot Systems, HP bought EDS, and IBM engulfed PWC Consulting. It is well known that the hardware industry is suffering from severe commoditization pressures and their margins are dwindling perilously. The commoditization is basically due to being entrenched between two very powerful forces: (1) a seemingly unstoppable move toward Intel-based architectures, that thanks to multiple-core machines are rising from the PC to mid-range servers and to compete fiercely with mainframes, and (2) the trend to middleware-empowered software designs that allow the coexistence of multiple vendors in a single integrated information system. To add additional pressure, companies have a tendency to maintain their hardware operational for a longer period, increasing the useful life of their investments.

	Dell	Xerox	IBM	HP	Perot	ACS	EDS
Revene	57.37	16.03	103	118	2.7	6.5	13.5
Net Income	1.98	0.45	12.65	8.3	0.117	0.35	1.2
NI/Rev.	3.45%	2.81%	12.28%	7.03%	4.33%	5.38%	8.89%

The previous table shows the revenues and net income form various companies for their last full fiscal year. Granted that companies can manipulate these numbers by increasing or decreasing R&D and some other reasonably discretionary fixed expenses, but they give an idea of this basic fact: profits over sales are a systematically better for outsourcing companies than for hardware companies, and when you combine hardware, outsourcing, and consulting, as it is the case for IBM, the difference is overwhelming.

 

Which brings us to the pairs DELL-Perot and Xerox-ACS. The two acquiring companies are those with the lower net margin of the pack. If they succeed on integrating their “couples” by effectively reducing the aggregated fixed structures, their margins will substantially increase. Additionally, they will both get an additional “asset”: a sales force that is used to walk the market and convince CIOs to sign long-term partnership contracts, skill that hardware manufacturing companies have not been very needy of.

 

Additionally, in the case of Xerox, it represents a step forward in its battle with HP for the printing business. Printing might be on its way down due to ecological pressures to reduce paper, but it is still a lucrative business dominated by HP and Xerox in their respective segments of departmental and data-center printing. HP gained entrance to the very large data centers via EDS, allowing it to compete in printing with Xerox face to face; it is only natural that Xerox retaliates by acquiring one of the most active competitors of EDS: ACS.

The next few quarters will tell us how successful these strategic moves will have been.