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CTSH–big bet in core engineering services

CTSH announced the acquisition of Belcan for a consideration of US$1.29 bn, through a mix of cash and stock. Belcan is a North American ERD services provider, with significant presence in asset-heavy industries such as aerospace, defense and industrial products. Acquisition consideration implies a transaction multiple of 1.6X EV/sales. The acquisition follows moves by large Indian IT peers, adopting the inorganic route to acquire ERD services companies. While the acquisition addresses a white space in CTSH’s service offerings, ability to address different purchase centers for ERD and IT services would determine the extent of synergy realization. CTSH expects annual revenue synergies of over US$100 mn within three years.

Contours of the acquisition

CTSH has entered a definitive agreement to acquire Belcan for US$1.29bn, with a US$1.19 bn cash payout and US$97 mn in stock (1.47 mn shares). Belcan has a revenue run-rate of US$800 mn and grew at 8% over the past two years (lower organically). The acquisition’s strategic rationale is to (1) increase exposure to the ERD services market and play on the shift toward outsourcing of spends, (2) access to top clients in the aerospace, defense and industrial products industries and (3) scale ERD delivery leveraging CTSH’s global delivery model. Post-acquisition, Belcan would operate as a unit of Cognizant, with its current CEO Lance Kwasniewski continuing to lead the acquired entity. Cognizant expects annual revenue synergies of US$100 mn within the next three years.

The acquisition would be EPS dilutive in CY2024 due to the impact of (1) amortization of acquired intangibles and (2) integration and related expenses. CTSH expects 40 bps impact on EBITM in CY2024. We believe Belcan’s EBITDA margin might be in the high single-digit/low double-digit range, given its onsite-centric delivery model. The acquisition would be broadly neutral on CY2025 EPS and accretive CY2026 onward, driven by revenue and cost synergies.

Choice of verticals interesting; competition intensifying in ERD services

CTSH has relatively modest presences in ERD services and the acquisition addresses this white space. We concur that ERD services is a fast-growing market, with a shift by enterprises to outsource spends, but growth in the addressable market has few nuances–(1) spends are cyclical and aligned with the innovation cycle in an industry, (2) embedded and software engineering services would grow faster than mechanical (core) engineering services and (3) shift in delivery from onsite and nearshore models toward offshore centers.

We believe sourcing patterns in verticals such as aerospace and automotive are mature in comparison to relatively underpenetrated verticals such as industrial products. Furthermore, services oriented toward embedded and software engineering services, though in mature verticals such as automotive, would grow at a faster rate, given the technology transition underway in the industry. For instance, KPIT and TELX have been among primary beneficiaries, given higher exposure to auto ERD services. Large Indian IT peers such as Infosys and HCLT have also made strategic moves to tap into elevated ERD spends by OEMs in the vertical. Nonetheless, we believe competition is intensifying with the entry of larger peers, but would closely watch the ability to extract synergies from cross-sell, given disparate purchase centers for IT and ERD services and differences in the nature of work.

While Belcan’s offerings are diversified, weightage is higher toward traditional engineering processes, lowering the relative attractiveness from a growth standpoint.

Onsite-centric core engineering services provider to asset-heavy industries

Belcan was founded in 1958 and was acquired by AE Industrial Partners in July 2015. The company had revenues of US$700 mn and 7K employees in CY2016. It has a significant presence in onshore and nearshore, with 85% of delivery professionals based out of North America. The company has 6.5K engineers and tech consultants, and average revenue productivity of over US$120K. It has higher client concentration than Indian ERD peers, with its top-15 clients contributing 70% of Belcan’s revenues (Exhibit 2). Some of its marquee clients include Raytheon, Pratt & Whitney, Rolls-Royce, Boeing, Airbus, Lockheed Martin and GM. Belcan has reported a CAGR of 8% over the past two years and is likely to grow in CY2024E.

CTSH expects revenue synergies from–(1) cross-sell of IT services to Belcan’s clients, leveraging CTSH’s digital engineering, data, supply-chain and manufacturing operations capabilities, (2) scaling global ERD delivery to address demand from existing clients in sectors such as commercial aerospace and industrial manufacturing and (3) cross-sell Belcan’s engineering services to CTSH’s automotive and industrial clients. Engineering services require certain level of knowledge of clients’ products and success of cross-sell would depend on companies’ ability to address the varied requirements of CIO and CTO organizations.

Other highlights

4 Outlook. CTSH expects 2QCY24 revenues in the upper-half of earlier guided band of US$4.75-4.82 bn. CY2024 revenue guide remains unchanged and would be revised based on expected closure timelines of the acquisition. The company currently expects closure in 3QCY24.

4 Share repurchases. CTSH has increased its share repurchase plan for CY2024 to maintain outstanding shares at its current guidance of 497 mn for CY2024.

4 Client profile. Belcan works with each of top-10 R&D spenders in aerospace and defense verticals. There is minimal overlap of clients between both entities

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