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Bold consulting move comes with increased risks

Wipro (WPRO) announced the acquisition of Capco, a London-based BFSI-focused business and technology consulting firm, for a sum of USD1.45b on 3rd March 2020.

Elevated valuation to require flawless execution

* We see Wipro’s aspiration to scale up its BFSI practice as a positive, especially given the potential spend by large banks on technology over the next few years. Moreover, Indian IT companies have historically lagged behind their global peers in terms of consulting capabilities – this is a gap that Capco could bridge for Wipro.

* However, we see significant risk from this acquisition on account of a) integration risk due to Wipro’s weak track record and b) execution risk on challenges related to realizing potential synergies. The execution risk is further aggravated by a weak growth performance from Capco over the last two years – even after adjusting for the drag due to COVID-19.

* Finally, our analysis suggests Wipro has paid c20x Capco’s 2020 EBITDA, a significant premium despite unexciting growth. This, in our view, should result in additional pressure on Wipro’s share price in the near term – as investors would wait for benefits from the acquisition to start accruing before rewarding Wipro.

* Assuming consulting margins and industry average amortization, the successful completion of this acquisition would result in a) our FY22 USD revenues rising 700bps and b) a negative impact of 6–7% on our FY22 EPS. We are not factoring in the impact in our estimates pending deal completion.

* We continue to see Wipro as the least preferred name in our large-cap coverage on account of its weak growth performance.

Capco to add to Wipro’s BFSI capabilities

* Capco (incorporated in 1998) is a London-based consulting firm operating in the BFSI market – with more than 5K consultants and 100+ clients across the globe.

* Capco has a strong market positioning as a consulting firm in the BFSI industry. It has worked across the Banking, Capital Markets, Wealth & Asset Management, and Insurance sectors in the past 20 years.

* Capco’s consulting capabilities would enable Wipro to provide end-to-end solutions, therefore offering a better go-to-market pitch.

* WPRO also expects to capitalize on Capco’s relationships with CXOs to go beyond CIOs to source deals.

Wipro to pay 2x 2020 EV/sales for the acquisition

* Wipro would acquire 100% of Capco for a purchase consideration of USD1.45b (using cash + debt). The transaction is expected to be completed by June’22

* Capco reported CY20 revenues of USD720m, implying 2.0x EV/sales.

* Wipro expects significant revenue synergies from the combined entity, although it has not quantified any specific goals.

* It expects the acquisition to be margin-dilutive in FY22 (200bps impact) and EPS to turn accretive by the third year post the acquisition.

* As of 3QFY21, WIPRO had USD5.2b net cash, giving it sufficient room to easily go through with the transaction.

Valuation and view

* We are not changing our current estimates given that the deal is yet to be completed. We see the transaction as EPS-dilutive (6–7%) for FY22E.

* Ongoing restructuring and investments would take a toll on margins in the near term, eating away at gains from operational efficiency. Even lower margins from acquiring Capco would further put pressure on the bottom line.

* We remain vigilant of the fact that Capco has not grown in revenues over CY18– 20 and thus remains a concern even on the topline. We continue to view Wipro as the least preferred name in our large-cap coverage due to its weak growth performance. Maintain Neutral.

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