Capita states it believes the acquisition would:

• Position Capita as a leading provider of technology-enabled BPS
• Provide a stronger platform for Xchanging to accelerate sales growth and to develop its offerings
• Enable Capita to secure £35m+ in cost synergy benefits
• Be immediately earnings accretive.

Capita has been in discussions with Xchanging since early August regarding a possible offer, upping its initial 140p offer to its final 160p proposal on September 24 - which Xchanging’s board confirmed it would be willing to recommend on September 29 should Capita make a firm offer. Capita was granted due diligence access and had until 5pm on November 2 to make an announcenent.

There is another suitor, Apollo, with whom Xchanging has been having discussions about a potential 170p offer. Will this announcement push Apollo into making a counter offer? Xchanging's share price has surged since the news of the potential talks (over 165p at the time of writing, though still below its one-year peak).

Xchanging has been contending with a range of issues, and its global portfolio lacks coherence, partly a reflection of its heritage in a few large and diverse “Enterprise partnerships”. Xchanging is currently between CEOs, Ken Lever having announced his intention in July to step down at the end of the year, and new CEO Craig Wilson not yet started.

If Capita were to complete, this would be its largest ever acquisition, dwarfing its second largest, the £157m acquisition of avocis this February (though there have been a number of £50m+ acquisitions since 2011, helping Capita expand into new markets or extend its IT capabilities).  So why is Capita so interested?  

In recent years, Xchanging has repositioned and invested to emphasize its capabilities in “technology-enabled BPS”- exactly what Capita is emphasizing with its own various BPO offerings.  Also, the private sector is increasingly important to Capita (over 60% of its current pipeline is in commercial sectors) and Xchanging would increase its presence in the Lloyds market, where Capita already has a presence for specialist services.

Looking in more detail at Xchanging assets that would be attractive – or at least very relevant - to Capita:

1. Xuber software suite for the non-life commercial market: the biggest investment to date (a whopping $200m+ in total investments since 2011), both in platform development and in acquisitions: in 2014, Xchanging invested £75.6m in acquiring Total Objects, whose binder software is now integrated into the Xuber suite, and Agencyport Europe,extending its software into the health insurance sector, with software for international private medical insurance and exposure modeling (acquisition was delayed), plus a further £11.7m on development of Xuber. Xchanging has found converting interest in Xuber to sales more challenging than anticipated, particularly in the U.S. Will Capita’s greater commercial clout help? It would inherit sales teams from Xuber, Total Objects and Agencyport Europe that need integrating into a single unit to cross-sell, where relevant, the portfolio. Would Capita place the Xuber business in its newest operating division “Capita Digital and Software Solutions”, or would it place it in an insurance sector division?
2. The Xchanging Claims Services BPS unit : Capita is already active with a range of specialist services in the London insurance market: this capability would neatly expand its portfolio
3. Xchanging’s business in Germany, where it provides investment account administration BPS for Fondespot Bank, will also be of interest to Capita, who is building a presence in the DACH region, via an acquisition spree in the CMS BPS market, also via an insurance BPS contract with Zurich. The complex administration services in Germany that Xchanging would bring in to Capita would fit well in its Asset Services division
4. Procurement: Xchanging has been through a significant change of direction with its procurement services in recent years, to technology-led offerings, boosted by the acquisitions of MM4 (which was U.S centric) and Spikes Cavell Analytics Ltd (SCAL, which was U.K public sector centric). These offerings may find traction in the Capita client base
5. Expanded offshore IT services capabilities: in India, Xchanging has centers in Chennai and Pune, Bangalore, and tier 3 cities such as Shimoga (Karnataka).  It also has a center in Kuala Lumpur, Malaysia, most providing IT infrastructure services to YTL Communications, and a smaller ADM unit in Singapore (where Capita also has a small presence, targeting the reinsurance sector). There is also some offshore BPO activity in India and Malaysia. Capita may rationalize some of these sites, but would certainly be interested in the expanded offshore application services and BPO delivery capabilities
6. IT services: Xchanging has some networking capabilities, with a client base in the education and health sectors, as well as Lloyds – this would fit well into the Capita IT Enterprise Services division, which has grown through a series of acquisitions in recent years

And less attractive to Capita?

• The Australian operations, where Xchanging’s New South Wales Workers’ Compensation contract was not renewed, and where its procurement business has not really gained traction.
• The U.S. business: Capita’s international efforts are currently focused on Northern Europe. It would be a major change of strategy for Capita to start targeting the U.S., and its management will be highly aware of other service providers who have tried and failed to penetrate the U.S.

But overall, Xchanging’s portfolio is particularly well suited to Capita's business and where it is looking to develop over the next few years. And the cost synergies from the head office rationalization are also a particularly good match.  

We thus believe is highly unlikely that, even if there is a higher counter offer from Apollo, the Xchanging board will change it recommendation to shareholders: Capita presents a better option longer term. Howver, a counter offer from another IT services vendor might be more attractive.

NelsonHall has just published a comprehensive Key Vendor Assessment on Capita. We have also historically included Xchanging in the KVA program.

However, IBM is in the midst of a major adjustment of its portfolio. In line with this, the company is reporting $25bn in revenues (and 16% revenue growth) in 2014 (out of a total of $92.8bn) from its "strategic imperatives". IBM's acquisition of Softlayer, where it continues to invest strongly, appears to be delivering $3.5bn annual "as-a-service" run rate and IBM reports that its "Cloud" business had 2014 revenues of $7bn and 60% revenue growth (this includes hardware, software and services),

The revenue growth reported from IBM's other "strategic initiatives" were:

• Analytics +7% (2014 revenue approx $17Bn)
• Security +19%
• Mobile >200%.

Maintaining a high mix of software remains important to IBM but its strategy is now much more nuanced than the simplistic "software good" strategy the company sometimes appeared to adopt in earlier years, with the company rediscovering success in IT infrastructure management. Indeed IBM's acquisition of SoftLayer and its ongoing investment in Cloud infrastructure including in additional in-country SoftLayer data centers and cloud enablers such as security and its Bluemix cloud development platform is arguably having more impact on its signings than any of its investments outside Watson and analytics. In Q4, IBM's cloud infrastructure business moved way beyond the standard fare of IaaS contracts with start-ups to facilitating major infrastructure transformation contracts with values of a $1bn+ with the likes of Lufthansa and WPP.

Indeed, while the impact of SoftLayer was insufficient to lead to material growth in IBM's outsourcing revenues in Q4 2014, its impact is certain to be felt on outsourcing revenue growth  in 2015 as a result of these and additional major transformations to cloud infrastructure. Led by these deals, IBM's outsourcing signings transformed in Q4 2014, up 31% (in constant currency and adjusted for disposals). IBM now just needs its application management business, which is continuing to decline under competitive pressure, to undergo a similar transformation.

Looking at signings:

• Full year 2013 signings were up 20%, with BPO and ITO renewal rate at 92%, above the target range of 85% to 90% and 7 points higher than 2012. And new business signings was up 9% in BPO and up and up 23% in Document Outsourcing (DO)
• In Q4 2013, overall signings TCV was flat y/y with fewer renewal opportunities in the quarter, though renewal rate was a strong 92% and new business signings were up 5%. For BPO, TCV of signings in the quarter was up 20% y/y, with strong growth in healthcare payor, healthcare provider, F&A, and Europe (the latter presumably driven by recent M&A activity in Europe). However, TCV of DO and ITO signings were down. In its ITO business, Xerox is focusing on executing on some large deals and improving margin.

Revenue growth in Services (DO up 4%, ITO up 2%, BPO down 3% in Q4) has decelerated, as expected. BPO revenues had a 1.5% impact from the student loan contract run-off. And Xerox has not had the benefit of acquisitive growth, which has traditionally contributed 2%-3% of Services revenue growth (under the former ACS model).

But Xerox continues to be challenged in its attempts to improve Services operating margin, once again lower than planned. As late as November 2013 (half way through Q4), in its investor conference, Xerox was guiding on achieving full year 2013 segment margin of 9.8% to 10% for Services … in fact, it achieved 9.76%, just getting into the bottom end of this. And it missed guidance for Q4: segment margin was 9.6%, below the targeted 10%.

Management acknowledges “although (margin decline was) driven by known issues, this is an area where we need to make more structural progress”.  So what were the contributory factors for the 160 bps y/y decline? The following factors have been given as major factors contributing to the y/y decline in Q4:

• The student loan run-off, which had a 60 bps impact on segment margin – but this was not an unforeseen event!
• Unforeseen extra expenses on healthcare platform contracts (MMIS, also healthcare exchanges), where Xerox allocated additional resources to projects. Given the newness and complexity of building a Healthcare exchange, and the challenge of doing so within a tight time constraint, one cannot fault Xerox for taking action to avoid the type of debacle seen in the federal exchange project. Having to do so also on MMIS projects indicates longer standing execution issues
• Slower than expected ramp ups in wireless customer care, leading to volume pressures. It is not clear whether this is delayed or lost work.

This is the third quarter of sequential margin decline, and in a year when Xerox said it was increasing its focus on improving profitability of Services. Services segment margin has now declined every year since 2010. Xerox is now guiding on a margin improvement of 50 basis points in 2014, with this improvement becoming evident in H2 “as near-term margin pressure dissipates and the impact of our margin improvement actions accelerate” Q1 2014 margin is expected to be flat y/y, at around 9.3%.

In the November investor conference, Xerox outlined a five plank strategy for Xerox Services. Some of the initiatives to improve margin – for example further offshoring – are initiatives that the former ACS was talking about even before its acquisition by Xerox.

Xerox needs to demonstrate in 2014 that it is getting a firmer grip on improving profitability of Services, ideally with no more unexpected expenses.

Acquisition spend in 2013 was substantially below the plan of $300m to $500m for the year. The $60m Invoco acquisition closed in January. In 2014, Xerox expects to spend up to $500m in acquisitions (including Invoco). A focus of recent acquisitions has been expanding its customer management services BPO capabilities in Europe: will we see in 2014 acquisition activity that brings in IP in other areas of its portfolio?

Pindar has become the third CEO of a major U.K. outsourcing company to resign this year. The other two, Nick Buckles of G4S and Chris Hyman of Serco, both left behind companies that are being investigated for fraud by the British Government. No such allegations have been directed at Capita.

The company has done extremely well under the leadership of Pindar. In the past ten years alone:

• Its revenue has more than doubled (from £1,081m full year in 2003 to £1,891m in H1 2013 alone)
• The share price has increased by > +316% over the last 10 years, compared with the FTSE (>+52%).

Pindar leaves the company in good shape, with:

• £2.9bn of major new contract wins so far this year
• An anticipated organic topline growth of 8%
• An operating margin that is expected to stay steady at 12.5% to 13.5% for the foreseeable future.

Today's announcement coincides with the news that Capita has resolved the problem of its under-performing personal insurance BPO businesses. It is selling Lancaster Insurance Services, Sureterm Direct, BDML Connect and Delta Underwriting to Markerstudy Group for an undisclosed price. The four businesses (685 personnel based across three locations) are expected to generate ~£47m in revenue and make a combined operating loss of £15m in 2013. Capita is also closing its SIP administration business based in Salisbury.