Please read our disclosure at the end of this entry. All figures in CAD unless noted otherwise.
This is our fourth in a series of entries on CGI Group, Inc. (NYSE:GIB). We remain short CGI stock. We refer readers to our first, second, and third articles on CGI, in which we discuss "cookie jar" accounting and CGI's acquisition of Logica PLC.
In this note, we analyze the company's fiscal Q2 cash flows, we estimate the magnitude of CGI's customer backlog cancellations during the quarter, and we discuss Serge Godin's ownership stake in CGI.
Can a company juice short-term cash flows by managing accounts receivable?
A company's level of working capital is a key driver of free cash flow. A company that increases its level of working capital produces less free cash flow, all else equal. In the long run, working capital levels are driven by a company's growth and its negotiating leverage with customers and suppliers.
But in the short term, management teams have tactics at their disposal to reduce working capital and temporarily increase a company's cash flows. Importantly, managing working capital to juice near-term cash flow can involve tradeoffs that lead to reduced cash flow, profits, or growth in the future.
One component of working capital that can be managed is accounts receivable. Accounts receivable is a balance sheet account that represents revenue that has been recognized and billed but for which no cash has been received. The level of receivables outstanding depends on a company's ability to collect from its customers. Lowering the accounts receivable balance indicates faster customer collections and leads to a one-time improvement in cash flow.
There are several ways a company might temporarily manage its accounts receivable to produce more cash in a given period:
- Pressuring customers to pay outstanding bills
- Refusing to provide additional services until outstanding bills are paid
- Offering discounted future services to customers who pay bills quickly
- Factoring receivables
Each of these tactics increases near-term cash flow but involves a tradeoff - whether in customer service, future growth, margins, etc.
Why do companies factor receivables?
Factoring receivables involves selling receivables to a third party for their face value less a fee. When a company factors receivables, management is choosing to receive less money from a third party today instead of more money from customers in the future.
In some industries, factoring receivables is common only in companies in financial distress that are in need of short-term cash flow. For this reason, receivables factoring can sometimes be an earnings quality "red flag."
Even when factoring receivables is not an earnings quality red flag, the cash generated by factoring is not representative of the sustainable earnings power of a business. When a company factors receivables, it is simply shifting cash flow forward at a lower margin that would have been received at a higher margin at a later date.
Did CGI juice fiscal Q2 cash flows by factoring receivables?
In a prior note, we explained how "cookie jar" accounting manipulation will lead a company to grow working capital over time. Growing working capital leads companies to report earnings that are unsupported by underlying cash flows.
In the last 12 months, CGI's growing working capital cut the company's cash flows by over $543 million. But in fiscal Q2, working capital impacted CGI's cash flows by less than $1 million, resulting in $351 million in operating cash flows.
86% of the sequential improvement in CGI's fiscal Q2 operating cash flow can be attributed to improved working capital performance.
Note 10 to CGI's fiscal Q2 financials supplies investors with a breakdown of how each working capital account impacted CGI's cash flows. There, we see that shrinking accounts receivable positively impacted CGI's quarterly operating cash flow by $250 million.
Without this reduction in accounts receivable, CGI's fiscal Q2 operating cash flow would have been 71% lower.
CGI's fiscal Q2 MD&A attributes the decrease in accounts receivable primarily to "the result of the completion and collection of billing milestones on certain large U.S. contracts and the catch up of the Q1 2014 system conversion impact of the France and Finland billings… The collection of tax credits also contributed to the improvement."
Noticeably absent from this description is any mention of factoring receivables.
Yet if investors look in the last paragraph of the very last page of CGI's fiscal Q2 financials, under a section on financial instruments, they will find that CGI factored nearly $75 million of receivables. It is unclear why this factoring was not disclosed in the cash flow section of the MD&A.
"During the six months ended March 31, 2014, the Company sold some of its accounts receivable with a carrying amount of $74,892,000 through a factoring agreement with two financial institutions. The accounts receivable sold have been derecognized since the Company has met the derecognition criteria, even though the Company has retained some late payment risk."
On the conference call, in response to one analyst's questions, CGI management stated that the company factors receivables regularly as a normal part of business operations.
In our research, we have been unable to find another single mention of receivables factoring in CGI's entire history of regulatory filings.
"We do, as a matter of course, have some factoring or receivable programs in place, so there was just one particular one that was of a little bit of a larger size that we had specifically called out and here disclosed. It is something that - this one is an annual activity. We were expecting to have the cash in before the end of March. It will - we will be receiving it in this next couple of weeks here, and I don't really see it as being a major issue. I don't see it as an issue at all here. It's just something that we are looking at trying to optimize the cash going forward."
We do not have the full details regarding all components of the $250 million decrease in accounts receivable in fiscal Q2, so we are unable to comment beyond the $75 million in receivables factoring.
We will leave it to the reader to determine whether factoring $75 million of receivables, and disclosing this factoring on the last page of the last paragraph of the financials, is consistent with the actions a company would take to manage working capital to juice short-term cash flows.
Can investors calculate customer backlog cancellations?
CGI's fiscal Q2 earnings announcement showed a 105% book-to-bill for the quarter. Sell-side analysts cited the bookings as a bullish signal of future growth, as analysts believe that CGI will grow revenues so long as the company consistently reports a book-to-bill above 100%.
CGI does not provide investors with a full reconciliation of the quarterly change in the company's backlog. The company only discloses backlog, bookings, revenue, and book-to-bill. A full reconciliation would also include currency effects and backlog cancellations, as follows:
By estimating the effect of currency movements, investors can back into an estimate of backlog cancellations and build a full quarter-on-quarter reconciliation.
Did customers cancel bookings that were in backlog during fiscal Q2?
The Canadian dollar depreciated substantially relative to each of the Euro, US dollar, and British pound in fiscal Q2. This depreciation was a steady continuation of the depreciation that took place in the trailing 12 months ended 3/31/2013.
When the Canadian dollar depreciates relative to other currencies, CGI's reported backlog is adjusted upwards to account for the portion of the backlog that is attributable to international operations.
The same is true for revenues in a given period. In fiscal Q2, CGI reported organic constant currency revenues down -2% year over year, while headline revenues were up 7% year over year. Thus, CGI reported a 9.3% year over year currency benefit to revenues.
The depreciation in the Canadian dollar during fiscal Q2 was less than the year-over-year depreciation reflected in the 9.3% adjustment to constant currency revenue growth. We estimate that the fiscal Q1 to Q2 currency impact to backlog was approximately 3%. Other investors may have different estimates, but there is no question that CGI's backlog received a bump from currency.
With this 3% estimated currency impact, we calculate backlog cancellations of approximately $500 million CAD, as shown in the calculations below.
Will ongoing backlog cancellations limit future revenues?
Just as CGI is able to book new business every quarter, customers cancel or renegotiate contracts every quarter.
Therefore, we propose "net bookings" and "net book-to-bill" as indicators of future revenue growth. These figures adjust for backlog cancellations by subtracting them from bookings to produce "net bookings."
With the estimated $500 million CAD in backlog cancellations, we calculate a fiscal Q2 net book-to-bill of 87%.
This is substantially less than the 100% figure allegedly required for organic revenue growth. (Even a 2% currency impact on the backlog would imply a sub-100% net book-to-bill.)
We leave it to the reader to determine whether a company with an 87% net book-to-bill can, over time, expect to grow revenues.
Do CGI's cash flows justify the current valuation?
CGI's recent fiscal Q2 earnings report showed -2.3% constant-currency revenue decline. This outcome continues a multi-year period of organically declining constant currency revenues at CGI.
As of May 2, 2014, CGI traded at 28x trailing 12 months free cash flow, a significant premium to comparable companies on this metric. Many of those comparable companies have grown revenues organically.
Without having factored $75 million in receivables, CGI would be trading at 32x trailing 12 months free cash flow, which would imply an even greater premium to comparable companies on this metric.
Integration and restructuring charges at CGI have persisted since 2010; but even if we add back integration and restructuring charges, CGI trades at a 19x trailing 12 months free cash flow multiple, which would still put CGI at a premium to comparable companies on this metric.
We leave it to the reader to determine whether a 28x free cash flow multiple is appropriate for an IT and business process outsourcing company with a multi-year track record of negative organic revenue growth.
How much stock is CGI's Executive Chairman selling?
Serge Godin has some stock he would like to sell you.
Godin is the Executive Chairman and Founder of CGI Group, as well as its former CEO. Former CGI employees report that today he remains as active in the operations of the company as ever.
On Monday, May 5, 2014, CGI issued a press release stating that Godin will sell up to 2.1 million shares of CGI stock. At the May 2 closing price of CGI's shares, 2.1 million shares would represent over $80 million of CGI stock. A portion of the shares will be donated to a charity, though the company's press release did not specify the size of the donation.
CGI's press release states that "the maximum number of Class A subordinate voting shares to be disposed of represents 6.4% of his total number of securities in the company."
But investors may be interested to know that 2.1 million shares represents much more than 6.4% of Serge Godin's economic interest in CGI common stock. In May of 2008, Serge Godin entered into a transaction that hedged out his economic interest in 8.5 million shares of CGI that he continues to own and control today. In other words, Godin effectively shorted out 8.5 million shares of CGI while retaining the right to vote those shares. Thus, Godin's economic interest in CGI common stock is 8.5 million shares less than the equity ownership figures shown on CGI's proxy statements.
We calculate that a 2.1 million share sale is equivalent to roughly 9% of Godin's current economic interest in CGI common stock.
Separately, we do not know of any plans by CGI to discontinue its buyback program.
Why is CGI's Executive Chairman exercising his options early?
According to the same May 5 press release, 1.2 million of the shares that Godin intends to sell will be acquired from the exercise of stock options.
The release specifically states that Godin is exercising options that expire soon:
"Serge Godin, Founder and Executive Chairman of the Board, filed a notice of intention to dispose of, on or after May 13, 2014, up to 2,102,230 Class A subordinate voting shares of the Company, including up to 1,238,230 Class A subordinate voting shares acquired pursuant to the exercise of stock options. Mr. Godin intends to exercise stock options granted to him between 2004 and 2007 and that are nearing their expiry dates due to pre-determined quarterly and other blackout periods prescribed by the Company and that limit periods during which stock options can be exercised before their expiry and cancellation" [emphasis added].
We found this explanation strange because Appendix A of CGI's most recent proxy circular discloses that as of September 30, 2013, Godin held only 275,730 stock options that would expire in 2014.
Therefore, the expiration excuse offered by the company in the May 5 press release can account for only 22% of the options that Godin has set aside to sell.
Why is CGI's Executive Chairman exercising his options early?
Standard financial theory says that one should almost never exercise an option early. Theory does, however, provide a few exceptions to this rule.
One scenario in which it would make sense to exercise a call option early is when (A) you are unable to sell call options, including any you own, (B) you are unable to short stock, and (C) you have high conviction that the underlying security will trade down in the future.
This set of circumstances and beliefs could explain Godin's planned monetization of CGI options more than one year in advance of expiry.
In this note, we have discussed the following:
- Companies have the ability to manage accounts receivable to pull operating cash flows forward, and one method of managing accounts receivable is to sell receivables. If a company sells receivables, they receive less cash flow sooner versus more cash flow later.
- CGI sold $75 million of receivables in fiscal Q2. The corresponding disclosure was made in the last paragraph of the last page of the financials.
- On the earnings call, CGI management stated that they regularly sell receivables. However, we have been unable to find any other mention of the practice of selling receivables in CGI's entire history of regulatory filings.
- We show how one bullish sell-side analyst published an important factual error related to fiscal Q2 cash flows.
- CGI does not provide a reconciliation of bookings, revenues, and backlog that includes adjustments for currency effects and customer backlog cancellations.
- We estimate $500 million in backlog cancellations in fiscal Q2.
- With this cancellations estimate, we calculate a "net book-to-bill" of 87%, which is substantially lower than the reported 105% book-to-bill. Net book-to-bill adjusts bookings for customer backlog cancellations.
- In fiscal Q2, CGI continued its multi-year pattern of negative organic constant currency revenue growth.
- CGI trades at 28x LTM unlevered free cash flow, a significant premium to comparable companies, many of which continue to grow revenues organically. If CGI had not sold the $75 million of receivables, it would be trading at 32x LTM unlevered free cash flow.
- The Chairman of CGI, who remains involved in the day-to-day operations of the company, has filed to sell up to $80 million of stock, which is equivalent to approximately 9% of his economic stake in common shares.
- The Chairman has also filed to exercise 1.2 million options. CGI stated in a press release that he plans to exercise options that will expire soon; however, 78% of the options that he has set aside to exercise do not expire within the next year.
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.
Disclosure: I am short GIB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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.