CGI's Short-Term Revenue Growth Is Slowing, but Our Long-Term View Is Unchanged

Equity Analyst

Malik Ahmed Khan

CGI is a leading global IT-services firm, catering a bit more to governmental agencies than its peers, providing managed IT, consulting, and intellectual property solutions. We believe that CGI benefits from strong switching costs and intangible assets, which lead us to assign the firm a narrow economic moat rating. Despite the macroeconomic headwinds, CGI has posted steady revenue due to long-term contracts with many of its clients. We think such stability will continue with the help of CGI’s switching costs and intangible assets, which both work to create stickiness among existing customers. 

CGI has long operated differently from many of its peers, focusing more on a proximity-based operating model that places CGI offices near its clients. While the firm's offshore leverage is lower than many of its peers, it still provides global delivery centers. The proximity model is important for the firm's government vertical as governments often require data to remain within their sovereign borders to better ensure data security. We think there are trade-offs to CGI’s government focus. On one hand, it creates even greater stickiness as we believe the government vertical has marginally stronger switching costs than enterprises. But we think that CGI’s growth potential is more limited than its peers due to the greater resources enterprises tend to have to invest in themselves.

On top of switching costs, CGI possesses intangible assets in the form of expertise it has and continues to acquire. We expect CGI to benefit from vendor consolidation through its "build and buy" strategy as it continues to acquire smaller IT firms, with their own niche expertise, to gain access to localized markets across the globe.

Business Strategy & Outlook

We believe CGI warrants a narrow moat rating due to significant switching costs and intangible assets associated with its business model. CGI is a leading IT-services provider, offering a broad portfolio of consulting, systems integration, application maintenance, and business process services. In our view, these subindustries are generally primed for switching costs and intangible assets throughout the IT-services industry. With its hefty revenue backlog and sticky multiyear contracts, we believe CGI has a robust platform for future growth.

CGI derives just over half of its revenue from its managed IT and business process service segment. Managed IT and BPS contracts are typically long-term (longer than five years). Work pertaining to this segment usually includes application development, maintenance, tech infrastructure management, and business process services. These contracts are long-term in nature, and there are substantial switching costs associated with not renewing/extending a contract. Throughout a multiyear contract, we believe that CGI will fine-tune and customize the client's system as well as deploy IP solutions to streamline processes and increase efficiencies. During this period, we think CGI will be able to increase its knowledge of the firm's exact needs and how they can be serviced. All these marginal improvements and knowledge buildup can make it more difficult for the client to switch firms as the contract nears its end date. For example, in 2016, the Scottish Borders Council signed a 13-year $125 million contract with CGI to manage its IT infrastructure. The contract was initially slated to expire in 2029. In October 2020, however, the council extended the contract until 2040. Although this example does not resemble every contract, it does point to the strong switching costs advantage CGI gets from these long-term contracts, where the client is more than willing to continue to work with the company it has worked with for several years instead of finding another company to do the same job.

The remainder of CGI's revenue comes from its systems integration and consulting, or SI&C, segment. These are large-scale digital transformation projects involving mission-critical systems for large enterprises. The mission-critical aspect of these contracts is particularly relevant to the switching cost advantage CGI has through them. With more companies embarking on digital transformation journeys, a trend strengthened by the pandemic, we can expect them to often choose the same IT consultant for a new project as these projects tend to require a lot of trust in the consultant from the company's side. With CGI's 95% on-time and on-budget record, along with a high customer satisfaction score, we see significant switching cost advantages for CGI in this segment as well.

We think the SI&C segment also serves as a funnel for the firm's clients to hire CGI for longer-term managed IT contracts. SI&C contracts are typically shorter, so companies tend to engage with CGI in this segment first. This behavior makes intuitive sense as a firm may hesitate to give a multiyear contract to an IT-services firm it has not encountered before. However, after hiring the firm for a short-term contract, the client may be more inclined to continue with the same firm for a longer contract.

Historically, we believe clients across verticals have been hesitant to delegate a large chunk of their IT-services work to a single firm. We often see this fear of overdependence leading to firms diversifying their IT-services work across various firms. However, with data breaches all more common (exacerbated by copious amounts of data leaving official premises due to pandemic-related working from home), we think firms are reviewing this strategy. Instead, we’re seeing favorable trends where firms are consolidating their IT-services work to reduce potential breaches by limiting possible points of entry for malicious actors. This trend bodes well for more prominent players such as CGI, which would benefit at the expense of smaller, more niche players in the IT-services industry. This phenomenon entrenches companies like CGI further in the clients' IT infrastructure, increasing switching costs further. We believe the roughly 4% increase in global market share of the top 25 firms in the industry over the last five years is an indication of this trend.

Contract renewals and extensions have made up 65% of CGI's new bookings for the past five years, with new business making up the remaining 35%. With an average book/bill of 108% over the past five years, we can see that CGI has been excellent in extending/renewing contracts and winning new business. We also view CGI's 100%-plus book/bill ratio as evidence of the switching costs that form the firm's economic moat. Further, since roughly half of these new bookings have been for managed IT and BPS, we know that they are long-term contracts that the business has been able to renew, extend, or win.

With data privacy and data security fundamental to many governments' and companies' digital transformation efforts and IT needs, we think the trust and knowledge CGI has accumulated with its clients is worthy of an economic moat stemming from these intangible assets. These intangible assets' impact is discernible in the government vertical, which constitutes roughly a third of CGI's revenue. Take, for example, CGI's current contract with the US government in which it manages and processes US visas in countries across the world. Much like its other work with governments, we believe this contract is predicated on a lot of trust in CGI's effective and secure delivery. To this effect, we think CGI's proximity-based operating model, with over 400 global offices, benefits the company as governments often require companies to operate near governmental offices. We think CGI's ability to maintain IT teams near government agencies further builds this trust, an intangible asset that keeps governments from switching to another consulting firm for their ITS needs.

These intangible assets are not limited to CGI's work with governments, however. With commercial clients, we think CGI's deep functional knowledge of the client's business, built through either managed IT or SI&C contracts, results in intangible assets. An effect of these intangible assets can be seen in CGI's 95% customer retention rate. Our understanding is that as CGI works with a client in a contract from either segment, it builds up valuable knowledge of the firm's precise IT needs. If the client wishes to renew or extend the existing contract, CGI would be the frontrunner. However, if the client now wishes to find an ITS firm for a separate project, the intangible assets that CGI has built up might help the firm land the new contract as well.

Due to the nature of CGI's contracts (many of which are long-term), revenue recognition is delayed as the company uses the percentage-of-completion method, which is measured by labor costs/hours to measure progress to completion. As a result, the company has a significant backlog. The long-term nature of the backlog strengthens our confidence in the firm's ability to generate excess returns on capital for the next 10 years.

Narrow

Economic Moat

CGI Group

CGI, Inc. engages in the provision of information technology and consulting services. It operates through the following segments: Western and Southern Europe, U.S. Commercial and State Government, Canada, U.S. Federal, Scandinavia and Central Europe, UK and Australia; Finland, Poland, and Baltics, Northwest and Central-East Europe, and Asia Pacific. The company was founded by Serge Godin and Andre Imbeau in June 1976 and is headquartered in Montreal, Canada.

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Stock Market Symbols GIB.A (TSX)GIB (NYSE) cgi.com/newsroom MONTRÉAL, July 21, 2021 /PRNewswire/ - CGI (TSX: GIB.A) (NYSE: GIB) will release results for its third quarter fiscal year 2021, ended June 30, 2021, on Wednesday, July 28, 2021 before the markets open. Management will host a conference call to discuss results and answer questions at 9:00 a.m.

CGI to release third quarter fiscal 2021 results on July 28

Program will provide improved user experience tools to fulfill the Library's mission Stock Market SymbolsGIB (NYSE)GIB.A (TSX) www.cgi.com/newsroom FAIRFAX, Va., July 15, 2021 /PRNewswire/ - CGI (NYSE: GIB) (TSX: GIB.A) has been awarded a seat on the Library of Congress' (Library) IT Services Indefinite Delivery/Indefinite Quantity (IDIQ) contract, worth $150 million over a five-year period.

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Stock Market Symbols GIB.A (TSX)GIB (NYSE) cgi.com/newsroom MONTRÉAL, July 13, 2021 /PRNewswire/ - CGI (TSX: GIB.A) (NYSE: GIB) signed a full managed IT services contract with the international life sciences firm Nexelis. Through the agreement, Nexelis will leverage CGI's global scale, best practices in IT modernization, and approach to accelerate business transformation.

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Stock Market Symbols GIB.A (TSX) GIB (NYSE)  cgi.com/newsroom MONTRÉAL, July 6, 2021 /PRNewswire/ - CGI (NYSE: GIB) (TSX: GIB.A) is pleased to announce that Frank Witter has joined its Board of Directors. A longtime executive with Volkswagen, Mr.

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Stock Market Symbols GIB.A (TSX)GIB (NYSE) cgi.com/newsroom Bookings up 40% and EPS up 13.6% year-over-year Q2-F2021 performance highlights Revenue of $3.08 billion; Adjusted EBIT of $486.3 million, and margin of 15.8%, up 40 basis points year-over-year; Net earnings of $341.2 million, up 8.4%, for a margin of 11.1%; Diluted EPS of $1.34, up 13.6% year-over-year; Net earnings of $341.9 million and diluted EPS of $1.35, both excluding specific items*; Cash from operating activities of $572.6 million, up 44.4% year-over-year; and Bookings of $3.89 billion, for a book-to-bill ratio of 126%. *Specific items in Q2-F2021 include: $0.6 million in acquisition-related and integration costs net of tax; Specific items in Q2-F2020 include: $23.3 million in acquisition-related and integration costs and $0.2 million in restructuring costs, both net of tax; Note: All figures in Canadian dollars.

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