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CSC/ HPE ES Merger: A Logical Next Step for Both Companies to Accelerate Their Transformation? The Jury's Out

Yesterday evening provided what was possibly the biggest surprise in the IT services industry for some time: the news that Hewlett Packard Enterprise (HPE) is spinning off its Enterprise Services business via a Reverse Morris Trust (RMT) to HPE shareholders, for the business to be able to merge with CSC in a tax-efficient manner.

Firstly, here are a few of the details of the transaction, which is targeted to be completed by March 31, 2017 (the end of CSC’s FY17). The expectations include:

  • The transaction will have ~$8.5bn after-tax value for HPE shareholders (details below), who will own ~50% of the new company’s shares
  • The merger will produce first-year synergies of ~$1bn, with a run rate of $1.5bn by the end of Year 1
  • The newco will have Year 1 revenues of ~$26bn (of which ~$18bn ex HPE ES)
  • CSC’s Mike Lawrie will become chairman, president and CEO of the new company and Paul Saleh its CFO
  • HPE CEO Meg Whitman will join the new company’s board of directors
  • HPE ES’ Mike Nefkens will report to Lawrie and “become a key part of the new company’s executive team”.

The last few years have been dramatic for both CSC and HPE ES (not to overlook Xchanging, now also part of the mix), featuring break-ups, divestments, problematic mega deals that nearly broke the back of each, and also from CSC some ambitious partnership announcements. Hence, the newco, whose name will be announced at a later date, will be like a jigsaw puzzle created from parts of several other jigsaw puzzles, all of which have lost large chunks of their original layouts.

Let’s start with the largest company in the newco: HPE ES

HPE ES is primarily based on EDS, acquired by HP for $13.9bn in 2008. Just as a reminder of its former size, HP Services and EDS had combined revenue in 2007 of over $38bn. There has been a lot of water under the bridge since then, including the loss of its top three clients (which between them accounted for ~65% of its operating income). In 2012, HP removed $8bn of goodwill from its balance sheet relating to the EDS acquisition, and the restructuring costs have run into billions. Then in September 2012, Whitman unveiled a multi-year restructuring program for the Services division. In its FY15, HP ES generated revenues of $19.8bn and a divisional operating margin of 5.3%.

This transaction is happening at a time when HPE ES is performing well against what it has been asked to do, essentially to stabilize and get to a market-competitive cost structure. In its Q2 FY16, it delivered a second consecutive quarter of y/y topline growth in CC, the Applications & Business Services business for the third consecutive quarter, the ITO business (60% of revenues) for the first time in four years. And operating margin (excluding corporate costs) was up 314 bps y/y to 6.7%, its eighth consecutive quarter of y/y margin expansion.

So, given that the division appeared to have been meeting its remit, why the spin off – was it a complete surprise? In some respects no; it certainly would not have been a few years ago. But in the last year or so there appears to have been a more effective integration of the various divisions within HPE. The very name HPE Enterprise Services does, however, provide a clue that HPE never really got to grips with the services capabilities that it acquired with EDS. Spelt out in full, the moniker “HPE Enterprise Services” becomes “Hewlett Packard Enterprise Enterprise Services”. When the “Hewlett Packard Enterprise” brand was announced, I enquired what would be the precise name of the former Services division, pointing out the oddity of adding “Enterprise Services” to “Hewlett Packard Enterprise”. The fact that HPE never bothered to get clean its branding for its $19.8bn ES division is indicative of something about priorities.

HPE’s Whitman calls this a “spin-merger”; I’d call it a spin-off by HPE and a reverse takeover by CSC.

And now CSC

If we go back to its FY09, CSC reported global revenues of $16.74bn and was declaring its ambition to become the second largest IT services provider globally. Again, there has been a lot of water under the bridge since then, including massive write downs and substantial charges relating to the U.K. NHS contract, accounting irregularities and restatements, and in 2014 a $190m penalty from the SEC and an requirement to restate results for FYs 2010 to 2012. In 2011 there was “Plan 2014” and in 2012, with the arrival of Mike Lawrie as CEO, a new turnaround program. There followed a spate of divestments, some profitable but small, others much larger businesses, for example its U.S. Credit Services unit for $1bn in December 2012, also its Applied Technology Division (FY13 revenues of $760m) for $175m.

And then in 2013, CSC resumed acquisition activity. Those that will be very relevant to the newco include ServiceMesh; Fixtnetix; UXC, nearly doubling its presence in Australia, and most recently, Xchanging. There is a clear deepening industry focus.

CSC also announced its results yesterday: its Q4 FY16 revenues were down 5.5%, down 2.4% in CC to $1.81bn, this including $30-40m from UXC. GIS (42% of revenues) was down 7% (down 3.7% in CC). Operating margin, excluding one-off costs, was 7.6%, down 270 bps y/y.

On a separate note, CSC will not be picking up a stake in Mphasis: last month, HPE announced it was selling its stake in Mphasis to Blackstone in a deal pricing HPE’s stake at ~$825m (in FY15, HPE recognized ~$650m of revenue and $110m of operating profit from Mphasis). HPE did state it plans to renew the current MSA with Mphasis for another five years in connection with this transaction.

CSC and HPE ES have a lot in common; they both used to be global heavyweights in the IT infrastructure management services market of the old, pre-cloud world; started major turnaround programs in H2 2012; have stepped back from the brink (as has, indeed Xchanging), and went through a break-up last year (completed within a month of each other).

Lawrie and Whitman declare the merger as a “logical next step” for both companies… one that will “build on their progress to date and significantly accelerate their transformation” (Whitman).

So looking ahead, what might we expect?

The clear beneficiaries are the shareholders (share prices have surged in both CSC and HPE since the announcement). Lawrie has proven experience of taking out costs: HPE ES was already making progress in its own cost take out program. There is little question that the $1bn cost synergies will be achieved, with additional opportunities from real estate rationalization.

Lawrie spelled out five positive attributes of the combined entity. Looking at the first two:

  • Firstly, he referred to increased scale. With $26bn of annual revenue, the new company will be one of the largest IT services business in the world, or what Lawrie referred to as “the upper echelon of global IT services players”. But having scale is no longer the critical success factor it was in the era of mega outsourcing deals. Size isn't everything: organizations are looking for a different set of attributes today: at a TCS client event yesterday for example, two financial services clients gave glowing comments, completely unprompted, on qualities such as partnership, co-creation, agility, and providing guidance and support in a digital transformation. In the old world, EDS and CSC were the global heavyweights, fighting each other. Today the competition is smaller, faster, offshore-oriented, getting closer to the client’s business, and investing heavily in automation and AI
  • Secondly he referred to “complementary industry leadership”, with CSC and HPE Enterprise Services, both having “strong vertical expertise”. While CSC has been beefing up its insurance and financial services IP recently, HPE ES does not bring to the table any strong industry-specific assets or presence outside some IP in the air travel sector and its Medicaid business (which, although profitable, is looking increasingly non-core). But the comment does indicate something about his thinking. Will the establishment of the newco provide a vehicle for a major reshuffle of go-to-market structures?

Lawrie claims the newco will be a “world-class agile and versatile global technology services firm... (able) to lead the digital transformations for our clients”.

  • But around 43% of its business will still be infrastructure services, a lot of which in legacy deals and in services which continue to face pressures on margins. Also, the stances taken of technology independence (CSC), and by HPE ES of the value of being part of “one HPE” have been diametrically opposite. There will need to be a major adjustment from both companies when joining the newco
  • What Lawrie call “next gen offerings” (cloud, cyber, apps, next-gen workplace, big data & analytics) will represent just 12% of revenues of the newco. There need to be other capabilities in this “next gen offerings” stable if CSC is really to position on its ability to “lead the digital transformations for our clients”
  • On a more positive note, for HPE ES, its applications and BPS businesses may find in the newco a more congenial atmosphere to thrive. These businesses, where it can be easy to articulate to clients the delivery of business value, will be as critical to any future organic growth as its "next gen offerings" stable. Neither CSC nor HPE ES has been very good (outside BPS) at developing relationships inside client organizations outside the CIO office: this will need to change.

There is the question of the U.S. federal business that HPE ES will bring in, a market that CSC has only just exited. Will it play a part in the newco? Overall U.S. public sector would account for around 11% of the newco, way below CSC’s non-compete threshold. When asked about this in the earnings call, Lawrie declared “post-close, all options and I underscore the word ‘all options’ would be on the table”. A further divestment may well be on the cards.

And for CSC, what will happen to the CSC/AT&T partnership, also to the relationship with HCL Technologies?

And what about the HQ of the newco? Virginia reflects the old CSC's presence in the federal sector and will have little relevance to the newco. Or will there be a shift, perhaps to the HP heartland of California, closer to Silicon Valley?

Employees from both companies (and many have worked for both) will be facing yet more large scale layoffs. Beyond managing the rightsizing, management will need to work as hard on employee morale, on training and reskilling of existing staff, and on nurturing a different corporate culture, as much as on efforts to be an employer of choice to attract bright new talent.

Last year, we had a spate of break-up announcements. And now we have three product companies (Xerox, Dell, HPE) that, having acquired outsourcing businesses to build a services business, have decided to let them go, having failed to integrate and leverage the different types of capabilities and client relationships these businesses brought in. Many of the HPE ES employees who transfer to the newco are likely to be pleased to work in a pure services environment once again.

*************

More details of the transaction and the $8.5bn value to HPE shareholders:

  • HPE shareholders will get an equity stake of ~50% for ~$4.5bn (for tax exemption, a RMT requires that the former subsidiary being spun off buys the target company, so HPE shareholders have to own a majority of the merged company at the time of the spin-off)
  • HPE will get a cash dividend of $1.5bn from CSC
  • $1.9bn of HPE debt will either be retired or assumed by CSC, and ~$0.6n of net pension liabilities will transfer to CSC

Comments to this post:

  • Wonderful article Rachael. Accurate facts and insight. A winning services company must have service in its backbone. These mergers combine two different DNA's, axe-style cost cutting, and employee instability over months to years - no way to win deals against seasoned competitors aware of your weakness. The brand is seen as unstable. Deal wins are limited in your (few) strongholds. Deal losses degrade the sales/retention pipeline quickly and the P&L gradually, with a long tail. It's a tough spot, because optimizing size/costs, the reason to do the merger, is essential for cost savings that underlie the same deal competitiveness. At least, being a pure play again starts CSC/HP ES on the right foot.

    May 28, 2016, by Alex Halikias

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