Explainer: Infosys' Lodestone deal small but in right direction

Sitting on a cash pile of around Rs 20,000 crore, the size of Infosys’s deal to acquire Zurich-based Lodestone Holding for $350 million (over Rs 1,900 crore) is too small to make any significant impact on its earnings but will enhance the Indian software exporter’s presence in Europe.

Zurich-based Lodestone advises international companies on strategy and process optimisation, and provides business information solutions enabled by SAP. Infosys expects to complete the acquisition by the end of October. The company will pay only two thirds of the amount right now and one third of the amount will be paid after three years.

The acquisition is valued at an enterprise value/sales of 1.6-times and will be earnings per share (EPS) accretive in 18 months, Motilal Oswal said in a note today. “While the immediate financial impact is likely to be limited, we believe the deal is structurally positive for Infosys,” said Rikesh Parikh, VP-Markets Strategy and Equities,Motilal Oswal Securities.

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Prabhudas Lilladher is bullish on the stock and has a buy rating with a target price of Rs 2,850 in its September 10, 2012, research report as it believes the acquisition would enhance consulting and system integration practise of Infosys.

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Infosys has been struggling to expand its business because of slowing revenues from its main outsourcing markets of the United States and Europe and has not sealed a deal in Europe excluding a $28 million acquisition of three back-office service centers in 2007. In 2008, it did attempt to acquire European consulting company Axon, which was finally acquired by HCL Technologies. It has time and again reiterated that it is looking at acquisition targets in the European market to penetrate deep into the geography and add to its consulting capabilities, but has been unsuccessful in finding the right target.

“Infosys has been looking for acquisition from a long time to strengthen its presence in Consulting and Package Implementation domain. After loosing-out on Axon acquisition, Infosys organically grew its C&SI revenue to $525m (5% CQGR over last 20 quarters). We see this acquisition as much needed inorganic booster for the company,“Prabhudas Lilladher said today.

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However, the problem with this strategy is that Infosys is tweaking its model at a time when clients in the United States and Europe are cutting back on expenditure, dealing with fewer vendors, and taking longer to make decisions. Given that governments are likely to take some more time to resolve the crisis in the region, Infosys may just have to take price cuts to expand its clientele.

Lodestone will add 850 employees to Infosys’ 150,000, including 750 consultants experienced in advising clients on the use business management software from SAP AG. It will also increase Infosys’ clients to more than 900 from its current 700. But the acquisition is not likely to make any significant difference to the Infosys’ income statement as the revenues of Lodestone are less than 5% of Infosys’ projected financial year 2013 revenues.

However, shares of the IT company were only trading a percent higher after the announcement as the market is largely disappointed as this is a relatively small acquisition compared to expectations. CLSA continued with its underperformance rating on the stock as the acquisition was expected and it remains the only route to deliver topline growth.

The acquisition of Lodestone is driven by need to balance portfolio, SD Shibulal said at a press conference today, adding that the buy is strategic in nature and will help boost the company’s presence in Europe.

Says Ankita Somani, IT analyst at Angel Broking: “From the revenue side, the gains are not substantial but what works for Infy with this acquisition is that the company is strengthening its presence in Europe, where its other peers have significant presence.”

Post the acquisition, the combined consulting practice focusing on SAP programs will deliver revenues of more than $1 billion. However Ankur Rudra of Ambit Capital says the Zurich acquisition will only add about 10 percent to Infosy’s consulting segment.“It is a step in the right direction, one might say a bit too small for its size. They may need quite a few more of these,” he told _CNBC-TV18 t_oday.

While the deal is in the right direction, it remains to be seen if Infosys will deploy its free cash for more overseas acquisitions in a downturn market to move up the value chain and retain its premium position.

Will Infosys seize the moment?