Will CSC invest nearly $1.2bn in M&A in the space of a few months?

Or will Capita progress with a bidding war?

CSC has sent a letter to the Xchanging board outlining its interest in making a cash offer of 170p per share for Xchanging stock. This would constitute a premium of 6.3% over Capita’s October 14 offer of 160p per share. CSC’s offer is dependent on Xchanging not deciding to pay a dividend to shareholders. It has until December 9 to announce if it intends to make a firm offer for Xchanging.

CSC is late in joining what had looked to become a one-horse race. Apollo, who had also expressed its interest in making a 170p per share bid, bowed out on November 4th.

So why is CSC interested in Xchanging?
(We are talking about the “new CSC”, its global commercial business, once the CSRA U.S. federal business is spun off)

Xchanging’s H115:

• Net revenues were £199.4m (~$305m), down 2.8% y/y; it expects CY15 revenues will be similar to CY14, or ~£406m
• Adjusted operating profit was £20.4m, a margin of 10.2% (up 4 pts y/y); CY15 adjusted operating profit is likely to be slightly below that of CY14 (£55.8m, a 13.7% margin).

CSC's offer, which values Xchanging at £421m (~$640m), is thus a bit over 1x revenue and an estimated 7.5 -8x adjusted operating margin.

If acquired, Xchanging would represent ~7.5% of CSC's FY15 $8.1bn revenue. And it is, in spite of its troubles in recent years, a more profitable business than CSC (who had a 10% adjusted margin in FY15).

Xchanging generates approximately:

• 45% of its revenue from technology-enabled BPS in the insurance sector. This is by far the most profitable business currently, with an adjusted operating margin of 29.2% in H115
• 23% from “Technology”, primarily insurance sector software, also some Application Services, and unit in Malaysia. H115 adjusted margin was just 7.8%
• 25% from technology-enabled BPS in the financial services sector
• 6.5% from procurement BPS.

Insurance is a key sector for CSC (accounting for ~22% of its FY15 revenues):

• CSC will be particularly interested in Xchanging's presence in the London market, where Xchanging has a leading market share for its own and now also AgencyPort software products (CSC, which has its own SICS suite, was one of the companies interviewed by the CMA during its investigation into the Agencyport Europe acquisition). Xchanging would provide CSC with the opportunity to support Lloyd’s in its ‘Market Modernisation program’, also the potential for aaS offerings
• More broadly across the insurance sector, Xchanging has invested a total of over $200m since 2011 in software, both in platform development of the Xuber suite and in acquisitions: in 2014 alone, Xchanging invested £75.6m in acquiring Total Objects, whose binder software is now integrated into the Xuber suite, and Agencyport Europe, plus a further £11.7m on development of Xuber. Xchanging has found converting interest in the U.S.in Xuber to sales more challenging than anticipated - and CSC has a longstanding presence in the U.S. insurance sector with its proprietary software. Xchanging’s first attempt to enter the U.S. market, through the Cambridge acquisition, was disastrous, and the U.S. today accounts for just 8% of its global revenues (not all of which from Xuber). Once Xuber gains traction, this business will become much more profitable - for anyone who can succeed in taking Xuber to marker, the timing is opportune
• Xchanging’s highly profitable insurance BPS business will expand CSC’s own non-life BPS coverage
• And Xchanging’s £100m per annum financial services BPS business would bring in a BPS capability in the capital markets sector, a new target market for CSC (see below).

In contrast, Xchanging’s unprofitable procurement business is unlikely to be of interest to CSC, who might choose to sell it off.

This would be CSC’s second targeted sector-led acquisition in BFSI: in September it completed its acquisition of Fixnetix (also London-headquartered), a much smaller provider (120 employees) of front-office managed trading solutions. Fixnetix provides an entry point for CSC into the capital markets sector. (See our blog here)

CSC has also been acquiring in other areas:

• In September, it closed its acquisition of Fruition Partners, a global integration partner for ServiceNow
• And in October, it announced its intended acquisition for ~$300m of UXC, and is coming to the end of a five-week exclusive due diligence process (see our commentary here.) The rationale for UXC is not about sector IP, but about scale in Australia, with UXC's Microsoft Dynamics and ServiceNow units and its burgeoning cybersecurity capabilities being particularly attractive.

If both UXC and Xchanging are transacted, CSC will have made a total investment of $1,170m (or more, if there is a bidding war for Xchanging) on four acquisitions in a very short timescale. Earlier this month, it indicated its capital allocation intentions for the next three years, including ~15% on acquisitions. The company is clearly in a hurry to boost its portfolio in BFSI sector IP and BPS, hotter areas of IT services, and to increase its market share in the U.K. and Australia.

And what about Capita?

At the time of Capita's offer, NelsonHall published a blog (Capita’s Offer to Xchanging: How it Makes Sense, see here).

There are very strong complementarities between Capita's business and Xchanging – but Capita has never before been in a situation where it has had to enter a bidding war to make an acquisition and this would go against the company's previous approach to M&A. But then again, Capita has never made an acquisition of this size. Capita started its discussions with Xchanging over three months ago, and had clearly been interested in the company for some time (we had indeed expected an offer might be forthcoming). So will it now make a counter offer? We think yes.

CSC's offer is below Xchanging's current share price (171p at the time of writing), and  this is unlikely to be the end of the story. And a third bidder could very well enter the fray.

Post Script

We were prescient. A few days after writing this, eBix stated its interest in a possible 175p per share offer. eBix (2014 revenues $214.3m) operates insurance data exchanges, which connect multiple entities within the insurance markets:

• The company is acquisitive: in 2014 alone it made five acquisitions, the largest of which were Vertex Inc, for $27.25m plus an earnout of $2m, and Oakstone Publishing, for $23.7m ($31.37m less a closing net WC adjustment of $7.65m).
• Again, it is Xchanging’s insurance software that is the main – and in this case the sole – attraction. eBix has a stated goal "to be the largest insurance software services player in the world".

However, we don't imagine eBix will be the final victor in this instance.