CTSH - CGI Performs Well But Client Delays Await

2023-06-29 17:28:38 ET

Summary

• CGI Inc. provides an array of IT consulting, managed services, and IP services to clients worldwide.
• The company has produced revenue growth and rising operating income.
• However, consulting firms are seeing increasing signs of client project delays or cancellations as macroeconomic conditions continue to slow.
• I remain Neutral [Hold] on CGI Inc. for the near term.

A Quick Take On CGI

CGI Inc. ( GIB ) reported its FQ2 2023 financial results on April 26, 2023, beating both revenue and EPS estimates.

The company provides IT technology and business consulting services worldwide.

I previously wrote about CGI with a Hold rating.

While my previous Neutral [Hold] outlook was probably too conservative in retrospect, my concern about client spending reductions for the consulting industry has increased, as I’ve seen other major consulting firms cite client delays and discretionary project cancellations as current realities.

As such, I’m still Neutral [Hold] on CGI Inc. for the near term.

CGI Overview

CGI Inc. is an IT and business process services company providing services to clients in various industries worldwide.

It provides IT management and business outsourcing, systems integration and consulting, software solutions, application development and maintenance, testing, portfolio management, digitization services, business consulting and a range of business process services.

The firm’s clients are in various industries such as government, banking and capital market, health, utility, communication and media, oil and gas, retail, consumer and services, space, manufacturing, insurance, life sciences, retail and consumer service, and transportation and logistics.

The firm is headed by Chief Executive Officer George Schindler, who came to the firm in a senior role in CGI’s acquisition of American Management Systems. He led various teams throughout the company before being appointed CEO.

CGI’s Market & Competition

According to a 2021 market research report by 360 Market Updates, the global market for digital transformation strategy consulting was an estimated $58.2 billion in 2019 and is forecast to reach $143 billion by 2025.

This represents a forecast CAGR of 16.2% from 2020 to 2025.

The main drivers for this expected growth in IT consulting are a large transition from on-premises, legacy systems to cloud-based environments with complex architectures.

There is also expected growth in the number of industries adopting digital transformation strategies, such as manufacturing, finance, and retail, as well as a growing demand for improved customer experience.

IT consulting firms can also leverage their expertise to help companies develop and maintain new or better business models which are better suited to the digital world. Many organizations are turning to IT consulting firms to help them align their digital transformation strategies with their business objectives. This can help companies better leverage technology to improve customer engagement, boost collaboration, and reduce costs.

Also, the COVID-19 pandemic likely pulled forward significant demand to modernize enterprise systems, resulting in increased growth prospects for digital transformation consultancies.

The growth of IT consulting is expected to continue due to the evolving digital landscape, increased demand for improved customer experience, the need to develop and maintain new or better business models, and the accelerated demand for modernization due to the pandemic.

Major competitive or other industry participants include:

• Globant

• Thoughtworks

• EPAM

• Slalom

• Accenture

• Deloitte Digital

• McKinsey

• BCG

• Ideo

• Cognizant Technology Solutions

• Capgemini

• Company in-house development efforts.

CGI’s Recent Financial Trends

• Total revenue by quarter has continued an upward growth trend; Operating income by quarter has recently turned upward as well.

• Gross profit margin by quarter has been as follows:

• Earnings per share (Diluted) have risen materially in recent quarters:

(All data in the above charts is GAAP.)

In the past 12 months, GIB’s stock price has risen 31.25% vs. that of the SPDR® S&P Software & Services ETF’s ( IGV ) growth of 13.16%, as the chart indicates below.

For the balance sheet , the firm ended the quarter with $951.2 million in cash, equivalents and short-term investments and $2.35 billion in total debt, of which $561.2 million was categorized as the current portion due within 12 months.

Over the trailing twelve months, free cash flow was an impressive $1.34 million, during which capital expenditures were $124.5 million. The company paid $42.3 million in stock-based compensation in the last four quarters, the highest trailing twelve-month result in the past eleven quarters.

Valuation And Other Metrics For CGI

Below is a table of relevant capitalization and valuation figures for the company.

(Source - Seeking Alpha.)

Below is an estimated DCF (Discounted Cash Flow) analysis of the firm’s projected growth and earnings.

Assuming generous DCF parameters, the firm’s shares would be valued at approximately $88.67 versus the current price of $103.74, indicating they are potentially currently overvalued, with the given earnings, growth, and discount rate assumptions of the DCF.

As a reference, a relevant partial public comparable would be Cognizant Technology Solutions Corporation (CTSH); shown below is a comparison of their primary valuation metrics.

(Source - Seeking Alpha.)

Commentary On CGI

In its last earnings call ( Source - Seeking Alpha ), covering FQ2 2023’s results, management highlighted the growing demand for global service delivery, which is resulting in an increased employee base outside the U.S., from 22% of the total headcount to 23% year-over-year.

The firm is seeing growth in demand for its IP services, which now represent 21% of total revenue.

Its overall book-to-bill ratio was 103% in FQ2 compared to 101% year-over-year, while its IPO book-to-bill ratio was a very strong 18%.

Global backlog for CGI was a company record $25.2 billion and represents 1.8 times total revenue.

Management did not disclose any company, customer or employee retention rate metrics.

Total revenue for FQ2 rose 5.1% YoY on an as-reported basis, while gross profit margin grew slightly by 0.1%. Operating income increased by 5.9% year-over-year.

Looking ahead, management expects to continue its "buy and build" growth strategy but says that "M&A consolidation activities have recently slowed across the IT services market, keeping fragmentation of the market at a high level."

Its acquisition pipeline "remains robust, with a steady influx of new opportunities identified through our expanded sourcing strategy."

The company's financial position is moderate, with plenty of liquidity but also significant debt; free cash flow has been quite strong, typical of large, public consulting companies.

From management’s most recent earnings call, I prepared a chart showing the frequency of key terms mentioned (or not) in the call, as shown below.

I’m most interested in the frequency of potentially negative terms, so management or analyst questions cited "Uncertain" four times, "Macro" five times and "Drop" once.

The negative terms refer to a bit slower demand from North American clients who are exercising greater caution in their IT investments. This is similar to what I’ve seen from other IT services companies, so is not peculiar to CGI.

Analysts questioned company leadership about the soft results in its Managed Services segment, which management said was due to normal "lumpy" bookings on these types of contracts.

Regarding valuation, CGI appears to be highly-priced by the market, both on a generous discounted cash flow basis and by comparison.

In the past twelve months, the firm's EV/EBITDA valuation multiple has risen by over 22%, as the chart from Seeking Alpha shows below.

The primary business risk to the company’s outlook is a softening macroeconomic environment, which is leading customers to delay or cancel discretionary spending on projects.

While my previous Neutral [Hold] outlook for CGI Inc. was too conservative in retrospect, my concern about client spending reductions for the consulting industry remains, as I’ve seen other major consulting firms speak to those current realities.

As such, I’m still Neutral [Hold] on CGI for the near term.

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