The bar's gone up

Monday, June 21st, 2004

Competitive business models in the Indian software industry have been continuously in an evolutionary state. The Singapore-headquartered Flextronics International's recent acquisition of a 55 per cent equity stake in Hughes Software System has added yet another dimension to this constantly evolving chain. This deal is probably the first of its kind in the Indian IT services arena, in which a global electronic manufacturing services major has snapped an Indian software services firm, specialising in the telecom domain. That this deal was "hotly contested" is obvious as the names of prominent IT/software majors such as Tata Consultancy Services, Wipro and two private equity funds have figured as serious contenders (though these companies have all remained studiously tight-lipped on this issue) over the past few months.

As one takes stock of this stunning all-cash deal involving an outlay of $226 million (about Rs 1,017 crore) by Flextronics, two elements clearly stand out. The first element is an obvious one. In the IT services arena, the centre of gravity has shifted from computer hardware or electronics manufacturing to software and related services. And as this deal goes to show, for Flextronics which has been providing strategic operational services (ranging from component manufacturing, assembly, design services and logistics) to companies in computer, networking, telecommunication, consumer and medical industries, the absence of "software services" had been a significant gap in its portfolio of offerings. No wonder, to fill this strategic gap in its portfolio and acquire a controlling interest of 55 per cent (with an option of acquiring an additional 20 per cent through the open offer route, involving an outlay of $82 million), it has been willing to pay such a stiff price for Hughes. It may be too early to gauge whether Flextronics has overpaid for the acquisition. Hughes has logged revenues of $80 million (or Rs 360.4 crore) and post-tax earnings of $17 million (or Rs 76.9 crore) for the year ended March 31, 2004.

The second element springs from the ability of Flextronics to position itself as the first electronics manufacturing service provider to offer a "total outsourcing solutions", at least in the telecom domain. Straightaway, this acquisition will help Flextronics cross-sell its range of products and services to the telecom original equipment manufacturer (OEM) customer base of Hughes and vice versa, to some extent. As of March 31, 2004, Hughes had contractual relationships with five of the nine Tier - I telecom OEMs (which have revenues of $10 billion and above). Similarly, in the January-March quarter, out of Flextronics' revenues of $3.77 billion, Sony-Ericsson and Siemens accounted for 11 per cent and 10 per cent of revenues, respectively. These figures exhibit the power of cross-selling opportunities that can open up for the combined Flextronics-Hughes entity.

Apart from software services being a differentiator, it will also help improve the operating margins of the consolidated entity as, typically, software has enjoyed distinctly better pricing power as against electronic mass-manufacturing services. The combination of these two factors is expected to put Flextronics on a better footing compared to its other global competitors such as Celestica, Sanmina-SCI Corporation and Solectron.

However, there is at least a significant downside to this deal. So far, Hughes Network Systems, the parent of Hughes Software, has also been one of its largest customers. HNS accounted for 20 per cent of revenues of Hughes Software for the year 2003-04. The sell-out by the Rupert-Murdoch controlled Hughes Network Systems raises a question mark over the certainty of this revenue flow. While the top management of Hughes Software has got an assurance that Hughes Network Systems will continue its software relationship with the company, it nevertheless exposes Hughes Software to an important risk variable.

Last updated : June 21, 2004