Please read our disclosure at the end of this entry. All figures in CAD unless noted otherwise.
This is our third in a series of entries on CGI Group, Inc. (GIB). We remain short CGI stock.
In this entry, we examine CGI's organic revenue growth and reported book-to-bill. We also examine CGI's cash flows in recent periods.
What is organic revenue growth? Why is it important?
Large acquisitions can make it difficult to measure how fast a business is growing. When one company acquires another, the revenues in the acquirer's public financials can go up even if the businesses underlying both the acquirer and the target are deteriorating on a stand-alone basis.
"Organic" revenue growth is a measure used by investors that adjusts for acquisitions to calculate the revenue growth of a company's underlying businesses.
Organic revenue growth is a key input for any standard financial model. All else equal, a company that is able to grow organically deserves a much higher cash flow multiple than a company that is only growing through acquisitions.
Can we measure CGI's organic revenue growth?
CGI has made two major acquisitions in the past five years: Stanley, Inc. in 2010, and Logica PLC in 2012.
Sell-side analysts disagree on CGI's organic growth trends in this period. For example, Deutsche Bank's research analysts state that CGI's organic growth has been negative, where Raymond James' analysts state that it has been positive in all but one quarter since CGI acquired Stanley.
We do not know why some analysts are confused about CGI's organic revenue trends: CGI's public filings unambiguously show that organic revenue growth of CGI's businesses has been negative since the Stanley acquisition:
Fiscal 2013 - 2014: CGI has reported only one quarter of financials in fiscal 2014. Page 15 of CGI's Q1 2014 MD&A shows that CGI's revenues declined organically -1.9% year-over-year if we exclude the effect of currency fluctuations.
Fiscal 2012 - 2013: The Logica acquisition took place in fiscal Q4 of 2012. CGI does not provide data to calculate organic revenue growth in each quarter of fiscal 2013. However, CGI discloses data to calculate annualized revenue growth in fiscal 2013.
Note 24(a) of CGI's fiscal 2012 financials states that revenues for CGI would have been $10,232 million had CGI acquired Logica at the beginning of fiscal 2012. This figure suggests a -1.4% organic revenue decline to reported consolidated revenues in fiscal 2013. The Canadian dollar weakened relative to the Euro over fiscal 2013, meaning that constant currency organic revenue decline over the period would have been even steeper.
Fiscal 2011 - 2012: Schedule C of a Business Acquisition Report filed by CGI on November 5, 2012, shows that CGI and Logica combined generated pro forma revenues of $10,412 million in the fiscal year ended September 30, 2011. This implies organic revenue decline of -1.7% in fiscal 2012. Exchange rates between the Canadian dollar and the Euro supported CGI's reported revenue growth in fiscal 2012 as they did in 2013.
Fiscal 2010 - TTM ended 6/30/2012: CGI acquired Stanley in August of 2010, and CGI's last quarterly report before the Logica acquisition was for the period ended 6/30/2012.
CGI's fiscal 2010 financials state that CGI would have had revenues of $4,556 million had the Company acquired Stanley at the beginning of the fiscal year. We compare this $4,556 million figure to CGI's reported revenues for the trailing twelve months ended 6/30/2012 and find that annualized revenues declined organically -8.5% over the corresponding period.
Currency moves in this 21-month period were volatile but likely had a minimal overall impact on organic growth, as did CGI's switch from reporting under Canadian GAAP to reporting under IFRS in 2011.
The calculations above show that the organic revenue growth of CGI's businesses has been consistently negative for the past several years. We do not know of any basis for claims by sell-side analysts that CGI's organic revenue growth has been positive.
What is the book-to-bill? Why does it matter to CGI?
Each quarter, CGI reports a "bookings" figure. Bookings represent future revenues of new contract wins, extensions, and renewals signed by CGI during the period. As CGI generates bookings, they are added to CGI's backlog of revenues. CGI's backlog is reduced as contracts are completed and the backlog is converted into revenues.
CGI's bookings correspond to CGI's "book-to-bill" ratio, which is also reported each quarter. The book-to-bill is the ratio between CGI's bookings in a given quarter and the revenue recognized by CGI in that same quarter.
Sell-side analysts closely track CGI's book-to-bill because they believe it is a predictor of CGI's future growth prospects. Analysts believe that if a company consistently generates a book-to-bill above 100%, a company will grow revenues organically. Following CGI's earnings announcement last week, several sell-side analysts cited CGI's book-to-bill as a bullish signal for future growth.
CGI's management also explicitly targets a book to bill ratio above 100%. The MD&A states that management is "committed to maintaining a target [book-to-bill] ratio greater than 100% over a 12-month period."
Can investors trust CGI's book-to-bill?
CGI's reported book-to-bill ratio has been above 100% in every fiscal year since 2008.
We do not know what could plausibly account for the discrepancy between CGI's reported book-to-bill (which reached 124% in 2010) and the substantial organic revenue decline we have seen since the Stanley acquisition in 2010.
Currency movements do not explain this inconsistency. The Canadian dollar has devalued relative both to the Euro and the US dollar by approximately 7% and 4%, respectively, from 9/30/2010 through 12/31/2013. The delta between the expected growth implied by CGI's book-to-bill and the actual rates of organic decline is much larger than could be accounted for by these currency moves.
If we assume that CGI's book-to-bill is not overstated, it may be the case that recent bookings relate to extremely long-dated business that may be prone to cancellation.
Has CGI shifted the definitions of bookings and backlog?
CGI does not explicitly define "bookings," but the Company does define "backlog."
We noticed a small change in the definition of "backlog" in CGI's MD&A in the third fiscal quarter of 2012. The change is as follows:
- Quarter ended March 31, 2012: "Backlog - represents management's best estimate of revenue to be realized in the future based on the terms of respective client agreements active at a point in time."
- Quarter ended June 30, 2012: "Backlog - represents management's best estimate of revenue to be realized in the future based on the terms of respective client agreements in effect at a point in time."
We do not know if, in CGI's usage, it is possible for a client agreement to be in effect but not active. For example, we do not know whether a contract that is booked three years in advance, but is not being worked on today, is in effect but not active. If so, current bookings numbers would be elevated relative to prior bookings numbers.
Will cash flows improve in future quarters?
In the fiscal Q1 2014 financials, CGI reported negative free cash flow to equity holders (CFO - capex - contract costs - purchase of intangibles). Cash flow was affected by an increase in working capital accounts of more than $200 million in Q1 2014, which was due in part to an increase in accounts receivable. The increase in accounts receivable may partly reverse in future periods.
In the Q1 2014 conference call, CGI's management drew investors' attention to CGI's operating cash flow, excluding integration payments, for the trailing twelve months ended 12/31/2013. This figure amounts to $819 million and is shown on slide 12 of the earnings deck.
We would make two points:
- Short-term accrued compensation has risen over $200 million in the trailing twelve months. Had accrued compensation due within twelve months remained flat over this period, operating cash flow plus integration payments would have been less than $620 million. (We assume that CGI will eventually pay employees their bonuses).
- CGI regularly spends cash on purchasing PP&E, contract costs, and intangible assets. Over the trailing twelve months, total expenditures on these three items was over $260 million.
Operating cash flow before integration payments, less the cash benefit from growth of accrued compensation, less the disbursements on PP&E, contracts costs, and intangibles, would have been less than $360 million in the trailing twelve months.
Are bullish sell-side analysts admitting that the bears are right?
We were confused by a research note published by TD analysts Scott Penner and Doug Taylor this morning that was written to refute "bearish arguments" related to CGI's accounting. CGI bears such as Deutsche Bank have argued that CGI's accruals will generate earnings but no corresponding cash flows.
In today's note, the TD analysts argue that the bears are wrong, yet they also write the following sentence: "We believe that accrual accounting has given rise to about $285mm of remaining working capital that will roll into income with no impact on cash."
We are confused because the TD analysts appear to be confirming the most important element of the bear story - that CGI's accruals are creating a significant discrepancy between earnings and cash flow.
Furthermore, the analysts do not indicate the source of this $285 million estimate, nor do they address whether accruals have created a discrepancy between earnings and cash flows in prior periods.
The TD analysts also commit a very significant error in their valuation model. They take the $285 million in "remaining working capital that will roll into income" and add this number to their target enterprise value to back into an implied EBITDA multiple that is adjusted for the working capital drag.
In fact, the valuation effect of the $285 million depends on the number of periods over which the analysts expect working capital to expand by $285 million.
If working capital is expected to increase by $285 million in a single year, then the figure should be multiplied by the analysts' target earnings multiple. The TD analysts suggest investors use a 14x multiple in fiscal 2015 EPS. On this multiple, the negative effect on CGI's valuation would be $3,990 million pre-tax or roughly $2.6 billion after tax, rather than $285 million.
We suggest that investors relying on TD's research revise their analysis accordingly.
In this note, we have discussed the following:
- Organic revenue growth is a key input to any standard valuation model. Organic revenue growth adjusts a company's reported revenue growth for acquisitions.
- Sell-side analysts disagree on CGI's organic revenue growth since the Stanley acquisition in 2010. Some analysts state that CGI has grown organically over this period.
- CGI's own filings unambiguously show that CGI's businesses experienced negative organic growth since the Stanley acquisition.
- CGI's book-to-bill is used by analysts as a predictor of future organic revenue growth. In theory, a book-to-bill above 100% should correspond to future revenue growth.
- CGI has reported a book-to-bill greater than 100% in every fiscal year since 2008 even though CGI's businesses have seen consistent organic decline since the Stanley acquisition. Currency movements cannot account for this discrepancy.
- CGI changed its definition of "backlog" in fiscal Q3 of 2012. We do not know the importance of the definition change.
- CGI generated negative free cash flow to equity holders in fiscal Q1 of 2014, which was reported last week.
- In the trailing 12 months ended 12/31/2013, CGI's short-term accrued compensation liability increased by over $200 million. Had short-term accrued compensation remained flat in 12 months ended 12/31/2013, operating cash flow before integration payments, less the disbursements on PP&E, contracts costs, and intangibles, would have been less than $360 million.
- A TD research note published this morning makes significant errors in financial analysis and appears to concede that there will be a significant discrepancy between CGI's earnings and cash flows going forward.
In subsequent notes, we will analyze CGI's margins.
This article is for informational purposes only and is not investment advice, and does not constitute an agreement, offer, a solicitation of an offer, or a recommendation to purchase or sell any particular security or pursue any investment or trading strategy. This article should not be construed as legal, tax, investment, financial or other advice. This analysis reflects our current opinions regarding CGI Group, Inc. Funds managed by us have an economic interest in the price movement of CGI Group, Inc.'s securities and specifically a decrease in the price of CGI Group Inc.'s shares. Our views and these economic interests are subject to change and we expressly disclaim any obligation to update the data, information or opinions contained in this analysis. We acknowledge that there may be confidential information in the possession of the companies discussed in this presentation that could lead such companies to disagree with our conclusions. Although we may do so, we do not expect to announce subsequent changes in our thinking or economic interests regarding CGI Group, Inc., but it is possible that there will be developments in the future that cause us to change our holdings in CGI Group, Inc.'s securities. We have based this analysis on public sources, including CGI Group, Inc.'s public filings, which can be obtained at sedar.com and sec.gov. While we believe the information presented in this article to be accurate, we make no representation or warranty to that effect, and we cannot guarantee that any projection or opinion expressed in this article will be realized.
Additional disclosure: Please see full disclaimer at the bottom of this article. This article is for informational purposes only and is not investment advice, and does not constitute an agreement, offer, a solicitation of an offer, or a recommendation to purchase or sell any particular security or pursue any investment or trading strategy. Funds managed by us have an economic interest in the price movement of CGI Group, Inc.’s securities and specifically a decrease in the price of CGI Group Inc.’s shares.