CGI Group: Strong Growth and a Rocky Road

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Jan 09, 2015
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What kind of company takes on the giants of information technology, IT, and not only survives, but thrives?

CGI Group (GIB, Financial) on the NYSE and (GIB-A.TO) on the Toronto Stock Exchange) is that company. It’s grown rapidly, and rapidly enough to become one of the giants itself, now ranking fifth among the worldwide players who fight for the territory occupied by computers and all the wires and infrastructure that brings them together.

Because of its strong and consistent earnings growth, it has earned a place on the Buffett Munger list, a GuruFocus screener that finds undervalued or fairly valued companies with predictable earnings growth. Here’s the company’s history in a nutshell (share price in green, EBITDA in blue):

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Note how the share price and EBITDA lines have soared in the past few years. But lurking below the surface are several bumps that investors need to consider before jumping on for the ride.

History

1976: Serge Godin and André Imbeau found CGI in Godin’s basement, in Quebec City, Canada (CGI stands for, in English, Consultants to Government & Industry).

1986: CGI becomes a public company, and uses the proceeds from this first share offering to buy outsourcing company BST.

1992: Listed on the Toronto Stock Exchange (GIB.A).

1994: First IT consulting firm in North America to earn ISO 9001 certification.

1998: Merger with Bell Sygma almost doubles the size of the company.

2001: Aquires IMRGlobal, which adds operations in India.

2004: Lists on the New York Stock Exchange (GIB, Financial); buys American Management System, which doubles the size of operations in the U.S.; AMS becomes a subsidiary named CGI Federal Inc.

2010: Acquires Stanley Inc., including subsidiary companies Oberon and Techrizon.

2012: Acquisition of Logica (a British IT company), which increases staff size from 31,000 to 68,000.

2013: In the U.S., the Affordable Care Act (also known as ACA and Obamacare) website goes live on October 1, but millions of users can’t access it; fingers point at CGI Federal. Deutsche Bank downgrades CGI alleging aggressive accounting practices.

2014: The federal government replaces CGI Federal with competitor Accenture on the ACA project; the company also runs into problems with state implementations of the ACA.

History based on the company website, its annual reports and Wall Street Cheat Sheet.

Takeaways: An entrepreneurial and relatively young company that has grown quickly, mainly because of its acquisitions (not all of them shown here). Also a company that has attracted controversy, whether deserved or not, with operational delivery problems and questions about its accounting practices.

CGI’s business model

CGI is an IT (Information Technology) company, the fifth largest in the industry. It provides three types of what it calls "end-to-end" services (as contrasted with niche or specialty services):

  • Outsourcing, or Management of IT and Business Functions: client companies/organizations replace some or all of their inhouse staff and resources with services provided by a company like CGI.
  • Systems Integration: CGI customizes third-party resources (such as software) and integrates it into the client’s IT system, to achieve a client’s strategic objectives.
  • Consulting: experts from CGI work with clients on projects such as business transformation, IT strategic planning, business process reengineering, and systems architecture.

This illustration, from the company’s fiscal 2014 Management Discussion & Analysis (MDA) shows the revenues attributable to these segments:

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Here’s how the revenue breaks out by geography:

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Within the IT industry, CGI focuses on five vertical markets, which collectively represent 90% of revenues:

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Client concentration risk: The company does not provide details in its 40-F for 2014, but does report it generate a significant amount of its revenue from the U.S. Federal government and its agencies. It also notes that loss of contracts in this area could have a material affect on its financial condition.

CGI, based in Montreal, Canada, has listings on both the New York Stock Exchange (GIB, Financial) and the Toronto Stock Exchange (GIB-A.TO). In this article, you will see references to SEC form 40-F, which is used by companies based outside the U.S. but trading on an American stock exchange; it is the equivalent of the SEC’s 10-K for domestically-based companies.

Competition

CGI says it operates in a highly competitive and rapidly evolving global industry, and its competition is "...a variety of global players, from niche companies providing specialized services to other end-to-end service providers..."

It also notes in its 40-F for fiscal 2014 that it is "...one of the few remaining IT services firms that operates independently of any hardware or software vendor. Our independence allows CGI to deliver the best-suited technology available to our clients." This allows CGI to claim it can offer objective advice to potential clients on big-ticket projects.

Yahoo! Finance lists CGI’s big, end-to-end competitors (in the Internet Software & Services industry) as International Business Machines (IBM, Financial), Hewlett-Packard (HPQ, Financial), and Accenture (ACN, Financial). Other sources, including GuruFocus, show Infosys Technologies Ltd (INFY) as a major competitor. Infosys also has a higher market cap than CGI.

Takeaways: One of the giants of the IT field, CGI focuses on three specific areas: outsourcing, systems integration and consulting. In addition, it focuses on five vertical markets, and that no doubt helps it compete with huge competitors such as IBM and HP.

Growth

Here’s a chart illustrating how CGI has grown its revenue over the past 10 years, from just under $2 billion to about $9.5 billion; note the boost coming from the acquisition of Logica in 2012:

03May20171216221493831782.png

How has that growth translated into gains on the bottom line? Quite well, it appears, with net income rising from $150 million to $780 million, albeit somewhat irregularly:

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Between the company’s founding, in 1976, and mid-2013, the company spent about $6 billion acquiring some 70 companies.

CGI has what it calls a Build and Buy strategy, which is to continue organic growth (build) and to keep buying companies that provide a strategic fit (buy). Within that strategy, it has four pillars:

  • Organic growth through smaller contract wins, renewals and extensions.
  • Pursuing new large, long-term outsourcing contracts, leveraging its end-to-end services, global delivery model and critical mass.
  • Buying smaller firms or niche players, firms that strengthen its vertical market knowledge or increase the richness of its service offerings.
  • Pursuing transformational acquisitions that expand its geographic presence and critical mass. The company considers itself to be a consolidator in the IT services industry. 

Takeaways: Continuing a strategy that has worked well so far, CGI Group plans to keep building and buying for continued growth (giving itself additional competitive heft against much bigger competitors.

Management

Founder and Executive Chairman of the Board: Serge Godin, age 64, served as president & CEO from founding until 2006; began his career as an IT professional.

Founder, Vice-Chairman of the Board and Corporate Secretary: André Imbeau, age 64, served as Executive Vice-President & Chief Financial Officer until 2006.

President and Chief Executive Officer: Michael E. Roach, age 61, CEO since 2006. Prior to joining CGI, he was president & CEO of Bell Sygma, and led an initiative which saw the two companies merge in 1998.

Since the senior executives are near the conventional retirement age, we checked on succession, and found the following in the 40-F for fiscal 2014 report, "As part of our succession planning in key positions, we established the Leadership Institute, our own corporate university, to develop leadership, technical and managerial skills inspired by CGI’s rootsand traditions."

Board of Directors: A board of 14, with nine independent directors; the five related positions include Godin, Imbeau, and Roach. Members of the board have expertise or experience in retail, human resources, accounting, investing, IT, insurance, government, mining, aerospace, and technology management (based on information from the company website).

ISS Governance QuickScore: CGI Group receives a failing score of 10; the scale extends from 1 (low governance risk) to 10 (high governance risk). The board receives red flags for: Board Practices, Board Policies, One Share One Vote, Meeting & Voting Related Issues, Use of Equity, Equity Risk Mitigation, Non-Executive Pay, Communications & Disclosure, and Termination.

Takeaways: All three of the senior executives are above the age of 60; at the same time, the company has a thorough succession plan in place. The board of directors has a significant number of independent directors and a broad range of experience and expertise; however, the ISS Governance QuickScore (whatever its merits or lack of them) is worrying (we’ll have more on this in the Ownership section, which follows).

Ownership

Gurus: Because CGI is based in Canada, we do not have access to guru holdings, but we can take a look at the guru trades in the past year. What catches our attention here is that this has been a trading stock for several gurus. Jim Simons (Trades, Portfolio), for example, during the course of 2014 sold out entirely during the first quarter, bought back in during the second quarter and reduced his holdings in the third quarter. Similarly, Joel Greenblatt (Trades, Portfolio) has bought and sold GIB stock over the past two years.

Institutions: GuruFocus lists institutional investment at 85%, and shows that while this category of ownership has more than doubled in the past five years, it has been bumpy growth:

03May20171216241493831784.png

Short sellers: Mixed news in this case: GuruFocus puts short interests at 6.86%, which is relatively low given the controversies and the ISS QuickScore. However, those interests have spiked this year:

03May20171216251493831785.png

Insiders: According to CGI’s 40-F for fiscal 2014, it had 1,748,149 performance share units (PSUs) outstanding as of September 30, 2014. That’s less than 1% of the 311,690,000 shares outstanding on that date.

Takeaways: Although there are many reasons to argue against ownership of CGI shares, institutional investors have a strong showing and the shorts have not shown much interest.

CGI by the Numbers

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Takeaways: Capitalization over $10 billion, shares outstanding has grown slightly, no dividend, price is moving toward but not yet near the 52-week high, P/E levels are reasonable, and the ROE is high.

Financial strength

GuruFocus rates CGI’s financial strength as 7/10 and its profitability & growth at 8/10:

03May20171216251493831785.jpg

Looking in the financial strength section, we note a couple of debt-related red icons; not compared with its peers, but in the context of its historical record. We can confirm that change with a quick glance at its long-term debt record:

03May20171216261493831786.png

Debt rose from an almost-negligible $109 million in 2011 to more than $3 billion in late 2012. That timing of that sudden loading corresponds with CGI’s acquisition of Logica in 2012. As we’ve noted, that purchase significantly boosted the company’s revenues and earnings. Here’s how EBITDA (green line) and net income (blue line) jumped after the acquisition:

03May20171216261493831786.png

Turning to the 10-Year Financials at GuruFocus we see the current portion of long-term debt was $73 million for the quarter ended September 30, 2014. We also see free cash flow for the same period was $832 million.

The GuruFocus system shows one Severe Warning Sign, and that references a decline in the operating margin. As the following shows, this is a short-term issue, and reflects what appear to be normal fluctations:

03May20171216271493831787.png

Takeaways: We do get some red flags for the CGI Group’s financial strength, but further checking suggests these are relatively minor issues. Debt has grown exponentially, but at the same time, so has the capacity to service it. And the operating margin issue would be only be a concern if the decline continued for several more quarters.

Valuation

We turn to the Buffett Munger screener when we want undervalued or fair valued stocks with consistently strong earnings. Looking across the listings in the screener we see, among other data, how many gold stars the stock receives and its PEPG or PEG ratio.

The gold stars, normally 4, 4.5, or 5 in this screener (out of five) give us a guide to the predictability of the company’s earnings (normally in EBITDA –Â Earnings Before Interest, Taxes, Depreciation, and Amortization). Consistency in earnings should lead, all else being equal, to consistently higher share prices. Or to put it a another way, consistency in a company’s past makes us more confident about predicting future earnings and share prices.

CGI comes through the screener, in part, because it has a 4-Star predictability rating. Backtesting by GuruFocus has found 4-Star stocks average gains of 9.8% per year, and have only an 8% likelihood of being in a loss position if held for 10 years.

The second half of the Buffett Munger snapshot shows us a relative valuation, based on the PEPG or PEG ratio. That’s the familiar P/E ratio divided by the average 5-year EBITDA growth rate (also shown in the screener).

CGI clocks in with a PEG ratio of 0.83 at the close of trading on January 8, 2015. Its P/E ratio is 16.40 and its average EBITDA growth rate over the past five years is 19.70; dividing the former by the latter we get the PEG ratio (0.83).

In this system, a stock with a valuation of less than 1.0 (such as CGI) is considered undervalued, a stock with a valuation of 1.0 to 2.0 is considered fair valued, and a stock with a valuation of more than 2.0 is considered overvalued. Some investors aim to buy stocks trading for a valuation of less than 1.0 and to then sell them when their valuation gets over 2.0.

Here’s how CGI’s chart of EBITDA over the past five years looks:

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Two other issues may factor into valuations, either directly or indirectly: dividends, which CGI does not pay, and share buybacks. Until 2011/12, when it took on a load of long-term debt and bought Logica, the company had actively repurchased its shares and reduced its shares outstanding and float. Since then its shares outstanding have risen slightly, presumably reflecting share issuances to management and staff.

Takeaways: With its current P/E and strong and consistent EBITDA growth, CGI is ranked as an undervalued stock, and a candidate for investors who follow Warren Buffet and Charlie Munger (Trades, Portfolio).

Opportunities and risks

In its 40-F for 2014, the company reports it had 800 face-to-face interviews with clients to assist in its strategic planning. Those interviews uncovered or underlined three key trends:

  • A digital transformation driven by mobile and digital technologies
  • Increasing regulatory compliance issues in many industries
  • Growing cybersecurity threats.

The company has identified several other potent trends, including the growth of the Internet of Everything (which requires increased infrastructure), and pressure for productivity and performance improvement.

Risks

The economy: When governments and the private sector have less coming in, they spend less. That means less work for the IT industry and, ultimately, lower prices for vendors in the space.

Finding and keeping employees and managers: while unemployment numbers may be high in some jurisdictions, the number of qualified IT professionals may be limited, pushing up costs and requiring more reliance on subcontractors.

Protecting its own and respecting the intellectual property (IP) of others: companies in this sector depend on proprietary knowledge, some of it patented. Loss of IP or being sued for infringing on the patents of others could be costly.

International issues: With exposure in some 40 countries, CGI faces currency exchange risks, hostile legislation or regulations, and exposure to unforeseen national controversies.

For more on opportunities and risks, see the 40-F for fiscal 2014.

Outlook

In a world that becomes more and more dependent on information technology, CGI is well positioned to move forward. As noted in the Growth section, it has a build-and-buy strategy that guides both organic growth and acquisition opportunities.

It does face some operational risks, as noted above, but most of them face most companies in its industry. We see no specific threats on the immediate horizon.

Conclusion

On these pages more than two years ago, Gordon Pape called CGI Group "A Buy for Aggressive Investors."Â That assessment, made soon after the Logica acquisition, continues to be valid today. With no dividend, this is not for income investors.

The company has demonstrated it knows how to both build and buy, to use the name of its growth strategy. It made it into the Buffett Munger screener by merit of its strong, consistent EBITDA growth.

At the same time, there appear to be several low-profile threats that cause concern. What are the long-term implications of its difficulties with IT for the Affordable Care Act, at both the federal and state levels? Should we be concerned about the now-aging accounting practice allegations from Deutsche Bank? And, need we concern ourselves about the high governance risk rating issued by the ISS Governance group?

All told, adventurous investors looking solely for capital appreciation might find CGI Group rewarding, assuming they’ve done their due diligence or at least placed tight stops.