Overview
The general business environment and M&A deal flow have seen improvement in the two previous quarters. However, IT services companies are yet to see a demand recovery to pre-COVID levels.
There has been a significant cut in discretionary spend budgets across industries, which has impacted on the new business pipelines. While there is no clear timeline for improvement in enterprise spending in the near term, there is a marked shift in the way businesses reach out to their customers in the new COVID environment, and such solutions are heavily technology dependent.
While the impact of COVID on the topline of IT companies is apparent, it has also had a significant impact on their operating aspects and well as inorganic activities.
Improved operating margins but lower utilization
Almost the entire the IT services workforce continues to work from home due to the pandemic. This has resulted in lower operating costs and, subsequently, margin improvement for IT companies.
The operating margins are being further bolstered by restrictions on travel due to the pandemic, which has resulted in significantly lower marketing costs in the past two quarters. This has artificially propped up margins for a number of IT services companies.
The lower operating costs offset lower revenue, reduction in pricing and headcount to a certain extent, but in the long term, this is worrying for the smaller IT services companies that are dependent on a few large customers for bulk of their revenue.
PE backed companies are focusing primarily on cash conservation and streamlining operations. Businesses are also taking a hard look at their respective utilization numbers – a metric that has been masked or ignored in previous years due to the high growth environment. We expect cautious hiring trends going into the middle of 2021.
Impact on mid-market IT M&A
Because 2020 has been a dampener in terms of growth for several mid-market IT services businesses, entrepreneurs have shelved exit plans in anticipation of a return-to-growth scenario next year, that will help them realize a higher valuation for their businesses. In short, profitable digital businesses are not getting sold at discount prices.
On the other hand, several IT buyers ($100-500m in revenue) are searching the market for value buys to bolster their top lines and profitability.
Successful acquirers, however, have not altered their M&A strategy significantly and are continuing to do deals to add to their digital capabilities, explore new markets and add marquee customers – such deals are still happening at fair, if not premium, valuations.
Truly digital companies are being valued at 2-3x revenue or 10-14x EBITDA depending on their size, nature of services, customer profile and profitability.