|Shares Out. (in M):||270||P/E||15x||11x|
|Market Cap (in M):||7,000||P/FCF||0.0x||0.0x|
|Net Debt (in M):||3,000||EBIT||0||0|
CGI is an IT service company with market cap around $7B. It is one of the best run in the group (both operationally and financially) and has decent business momentum in US and Canada (its core markets). Yet the stock has given back most of the gains from the initial excitement about earning accretion from a recently announced acquisition. Investors are nervous about the challenge of integrating a problematic European IT service company, but it no longer makes sense to bet against the mgmt team’s track record of creating massive value through acquisitions, especially since they recently upped cost synergy guidance. Stock now trades at 9x ’14 EPS and under 8x $3 EPS power. Another way to look at valuation is the core CGI (ex Logica) should earn close to $2 in CY ’14, putting the stock at 11x ’14, while the Logica business at just under $6B run-rate revenue (higher than core CGI) is ascribed little value. Logica stand-alone was making just under 6% op margin before the $200m announced cost synergy (about 300bps margin boost). The balance sheet does have some debt from the acquisition, but I expect the company will aggressively de-lever just as in prior acquisitions. I think the stock has $3+ EPS power in 2015 ($2 from core, and $1+ from Logica on 9-10% op margin). I see about $3 downside risk (10x core CGI EPS) and upside to $36+ over 12-18 months (12x $3 EPS).
Company Description: CGI is one of the largest IT service companies in the world. The company originated in Canada, with its legacy business providing IT service to Bell Canada (still among its most lucrative business). The stock busted after the dot com boom, but the company has grown at a high CAGR under the leadership of Mike Roach since 2002. This track record results from a combination of modest organic growth (4-6%), aggressive/transformative/well-timed acquisitions (AMS, Stanley, now Logica), and astute capital allocation – when mgmt could not find attractive deals, they aggressively bought back shares, including reducing share count by 40% in a span of 6 years from ’05 to ’11. I have met CEO Mike Roach several times over the last few years, and he struck me as one of the rare CEOs that gets it both operationally (evidenced by the margins and cashflow) and financially (capital allocation records). IT service is an execution business. It is all about avoiding bad contracts, which initially boost topline/profits, but will come back to haunt the company in latter years of the contract. We have seen the bad acts at HPQ/EDS, and virtually every European IT service company. The good players (Accenture, CGI) just avoid these unforced errors.
Logica Deal: Prior to the acquisition, CGI’s business is roughly 50% US, 45% Canada, and 5% Europe. After a weak year and longer integration process of its last acquisition of Stanley, CGI’s core business is strengthening especially in the US. In the most recent quarter, overall revenue grew 3%, US revenue grew 13% while op margin shot up to 11.6% from 8.8%. Bucking the negative backdrop, CGI is seeing a boom in the US Federal business with book/bill of 140% for the year and 160% in the quarter, as they are finally seeing the fruits of the Stanley acquisition in 2010. The company still accounts for less than 2% of the market in US, so further room for growth is substantial. Unlike many peers, CGI has some proprietary software which increases the stickiness of the revenue/cashflow. Canada has been flattish, but US business should power the core business to grow 6%+ in ’13 and ’14.
Then CGI announced the acquisition of Logica in June. The deal was at a 60% premium (though Logica stock was languishing at multi-year lows at the time). The deal ($2.8B, $3.3B EV) was financed by $1B in shares and the rest from issuing debt. Logica was the 3rd largest IT service company in Europe (behind Cap Gemini and Atos) with just under 4B pounds ($6B) in revenue and 300M pounds of EBITDA. The company itself was built through a series of acquisitions (Logica in Netherlands, CMG in UK, Unilog in France, WM-data AB in Nordic), and the revenue base was fairly diversified across major countries in Europe. The company was never fully integrated, and it was operating at 6% op margin, roughly half of the level of CGI and other leading IT service companies in North America like Accenture.
This acquisition fits CGI’s mold: it is ambitious/transformative in the sense that Logica’s business is bigger than the core CGI ($6B vs. $4B) and it dramatically changes the footprint/geographic mix of the new CGI. We happened to be involved with both stocks when the deal was announced, and my opinion is that CGI got an average company (with some good assets/countries) at trough valuation near bottom of the cycle. The integration process will prove more complicated since it spans a lot of different countries in Europe (where labor law is much tougher to work around than North America). However, the potential reward is also quite obvious – Logica is operating at sub 6% op margin, vs. CGI at 14%. Each 1% margin opportunity on a smaller Logica (assuming 10% unprofitable revenue churned) represents $50m EBIT or 10c EPS. Ways to improve margins include letting go highly paid business consultants (Logica had ambitions to break in to strategic consulting with little revenue/profits to show for), exiting unprofitable contracts, and back-end system integration. I have little doubt in CGI’s mgmt’s ability to execute these initiatives, although it may take a while. Already, CGI has upped the cost synergy guidance one quarter after closing (300m over 3 years, back-end loaded) and guided for 25-30% EPS accretion. Balance sheet has about $3B net debt, or about 2x ’13 EBITDA. Mgmt will likely aggressively delever using the cashflow.
The deal was initially well received by the market, as CGI rose from $22 to $27 on accretion optimism. The last quarter poured some cold water on the enthusiasm, as it included just a part of Logica’s seasonally weak summer quarter (vacation in Europe), which led to a bit of shortfall in Logica’s revenue relative to expectation (NA analysts were likely unprepared for the seasonality of European IT service companies). The stock has since pulled back to $22 level, which creates a very compelling entry point. Again, the company has strong operating momentum in US (now 25% of group revenue), and should exhibit strong EPS growth from deal synergy and deleverage.