What now for e-business services?

Nearly all the companies in this sector have suffered large sequential revenue declines and are losing money. Many of their stocks are trading at prices below cash-per-share, a sure no-confidence vote from investors. But while everyone thinks consolidation is inevitable, where will the buyers come from?

In April, there were two acquisition announcements that I believe might herald the start of a trend: E-business strategy consulting company Mainspring agreed to be acquired by IBM, becoming part of Big Blue's Global Services' consulting arm, while Compaq Computer bought Proxicom.

First IBM.

When the largest IT services company in the world--with $33 billion in revenues--buys a $48-million e-business consultant, the obvious question is, why? Mainspring is an e-business strategy consulting pure play. Though it offers no implementation capabilities, Mainspring competed in a sector where IBM has long wanted to bolster its presence.

What's more, Mainspring brings additional strategic consulting and expertise to IBM's consulting arm. And though a $48 million revenue run rate doesn't even qualify as a rounding error for IBM Global Services, Mainspring is actually a sizable acquisition when you consider head count; Big Blue's consulting arm has only 450 to 500 people in North America, so Mainspring's 170 billable consultants raise its feet on the Street by more than 30 percent.

Turning to Compaq, why the interest in Proxicom?

Proxicom has only $160 million in revenues, or about 2 percent of Compaq's $7 billion in services revenue. Compaq cited Proxicom's vertical expertise, along with its focus on larger clients, its strong technology skills, and its emerging skills in areas such as wireless.

Valuing the deals
Second question: What was the valuation, and were these good deals?

Mainspring will be acquired for $4 per share--25 percent premium to the prior day's closing price of $3.20--or about $83 million total. On a market cap basis, the valuation is about 1.7x latest quarter annualized revenues--not bad, right? From an enterprise value perspective, which is much more appropriate because it accounts for debt and cash, IBM got Mainspring for a song.

Using an enterprise value perspective (EV) to account for Mainspring's $70.9 million in cash (4Q 00) and no debt, the deal puts Mainspring's EV at $12 million (possibly slightly more if we assume that Mainspring burned more cash since 4Q 00). That's about 0.25x EV/ latest quarter annualized revenues, vs. our current e-business comp group average of 0.6x and the traditional IT services comp group average of 0.8x. Proxicom fared much better in its valuation, with an EV/ latest quarter annualized revenues of 1.7x.

That being said, what are the key takeaways?

We have been flirting with consolidation for a while. For example, SeraNova was acquired by Silverline Technologies, and AppNet was acquired by Commerce One. The latest two deals and the continuing difficult demand environment may begin the consolidation process in earnest.

Separating wheat and chaff
Look for three general categories to emerge. The "leaders," such as Sapient, DiamondCluster International, and Inforte, are the companies which will survive and eventually thrive. The "marginals," are companies with enough cash, desirable capabilities or a roster of clients that merge or get acquired (though some might survive on their own). Then there's what I call the "fodder," the companies which are likely to wind up consolidated via bankruptcy such as US Interactive, Xpedior, and MarchFirst.

The IBM deal is a statement that Mainspring had little confidence about its ability to survive as a separate company. The company sold out for little above cash value, while Proxicom was obviously able to state a more compelling case to Compaq.

From an investor perspective, mergers and acquisitions would be a difficult and risky way for investors to make much of a return. Investors will have to time their buys well. For example, while IBM's offer represented a 25 percent premium to Mainspring's closing price that day, Mainspring's July IPO was priced at $12.

Even Proxicom, which received a much higher valuation, was only at a 33 percent premium to its close and 90 percent below its 52-week high. The only targets that I believe would attract a premium are the leaders previously mentioned.

The big, well-performing players such as IBM and Electronic Data Systems are likely fishing for deals, but they have the luxury of paying pennies on the dollar. They are looking for specific fits around geography and capabilities. From what I have heard, services providers are expressing interest in consulting capabilities, packaged enterprise application implementation capabilities, and key technology skills such as Java. Vertical industry expertise and client relationships are also valuable.

Finally, who's selling and who's next? Probably everyone except the leaders I mentioned--though I don't rule anything out. But to avoid the appearance of spreading rumors, I will abstain from singling out specific companies at this point.

My last thought on this topic: Consolidation, either through M&A or bankruptcy, would have a long-term cleansing effect and narrow the field to a more sustainable size. But buckle your seat belts because that will certainly make for a volatile environment in the near term.