Of all the names in the value screen mentioned above, Cap Gemini stands out to me. The market remains concerned by the risk of a profit squeeze in IT Services, due to stagnating prices and rising input costs. However, we think this is a normal ‘friction-point’ in the cycle, the result of vendors building capacity in anticipation of demand improving. And we think CAP is set for a multi-year earnings recovery.
Notwithstanding stagnant prices in Q1, revenues were ahead of budget and consensus, confirming that volumes are improving. We expect pricing power will follow. Accenture Q3 results last week support this thesis: on pricing they saw ‘stabilisation…and even some potential uplift in some parts’. For Cap specifically, in the last 25 years, margins have typically turned 4-6 quarters later than revenues. This time around, revenues bottomed in Q309 so we expect this is as bad as pricing gets. We have margins up 40bp in H1 and 140bp in H2, leaving FY11 up 80bps to 7.6%. We're modelling 6% underlying sales growth pa to 2013 (from 2010 trough). Add 230bp margin expansion over this period and you get a 23% EPS CAGR to 2013.
Take the net cash pile into account (they have cE500m post pension provisions) and the stock remains one of the cheapest in European IT services. Their E2.35bn of revenues in Q1 annualizes to E9.4bn vs. E8.7bn in 2010 (8% growth) and implies EV/Sales of 0.48x vs. the historic range of 0.3x to 1.3x. Margins troughed at 6.75% in 2010 but management target 10% margins today; previous peak was 9.1% in 2008…assuming an average of peak/trough of 7.9%, seems fair to pay 0.75x Sales. That implies 30% upside from here.
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