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IT Could Be Next Private-Equity Target

There are no deals yet, but private equity's entry into the IT services sector looks imminent.

A buyer never materialized Wednesday after rumors circulated that

Computer Sciences

(CSC)

might receive a takeover offer, but investors' favorable reaction to the news spotlights the reasons why information technology services companies may become buyout targets.

Computer Sciences shares jumped nearly 2.5% Wednesday to $57.52 and continued rising after the markets closed, on speculation that a buyer was lurking. Last year, the company tried to sell itself, but it gave up after talks with private-equity giant

Blackstone Group faltered.

The most likely acquirers for companies such as Computer Sciences would be other private-equity firms and copycat hedge funds eying the possibility of steady cash flow streams from multiyear IT services contracts.

Computer Sciences and its similarly sized rivals --

EDS

(EDS)

,

Affiliated Computer Services

(ACS)

and

Accenture

(ACN) - Get Accenture Plc Class A Report

-- would certainly be easy enough to swallow, given the growing appetite of these investment pools.

In March, Cerberus Capital Management teamed up with Darwin Deason, ACS board chairman, to

make a bid for the 58,000-employee computer services company.

"Big traditional IT players whose growth has slowed but that have long-term contacts would draw attention of private-equity buyers," said Jefferies & Co. analyst Joe Vafi.

There's plenty of room for buyout firms to improve operations and cash generation. IT services projects and outsourcing deals are notorious for eroding profits after running over budget and taking longer than expected.

"I think there are private-equity players out there looking at the field and saying, 'If you guys can't make it work, we're going to figure it out for you,'" said Paul Roehrig, an analyst with Forrester Research.

Simply improving billing could squeeze more cash from operations. Days sales outstanding, a measure of how quickly sales turn into cash, stand at 63 days for EDS, 84 days at ACS and 91 for Computer Sciences, according to data from PricewaterhouseCoopers. Accenture and

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Perot Systems

(PER) - Get Sandridge Permian Trust Report

, by contrast, have shown how much lower this can be. Their DSO stands at just 37 days and 30 days, respectively.

Cerberus, which has

just snagged 80% of

DaimlerChrysler

(DCX)

, sweetened its original offer for ACS to a premium of about 24% over the 90-day average closing price.

"You can probably make the assumption that they will not be a publicly traded company much longer," said Moshe Katri, an analyst with Cowen & Co., which doesn't do banking with the companies mentioned.

What's more, some of the mid-tier companies have already been spoken for, leaving few alternative candidates besides the major players. In April, Michigan-based

Covansys

(CVNS)

accepted a buyout offer from Computer Sciences.

On Tuesday, shareholders of Boston-based

Keane

(KEA)

agreed to be

taken over by privately held Caritor for $854 million.

Jefferies' Vafi says buyout firms would look at the companies with the lowest proportion of spending on servers and network equipment relative to sales. By this measure, Perot Systems grabs the spotlight, with expenditures running about 3% of sales vs. roughly 6% for Computer Sciences.

Vafi and his firm do not do business with ACS, CSC, Perot or ACN. Jeffries has a noninvestment-banking and securities relationship with EDS.

The interest in ACS and Computer Sciences suggests that the dealmaking machine may already be running.

Judging by the Cerberus bid for ACS, a buyout offer would give investors a hefty return on shares that have underperformed the broader market for the past few years.

This would give shareholders all the more reason to sell, especially as IT spending looks poised to hit a plateau, or even take a dip.