mardi 28 octobre 2014

IT and engineering consulting services companies AKA, SII

1) Intro
The blog as remained silent for a few months, reflecting what I viewed as a relative lack of opportunities.
However small/mid caps have gone down recently.

I want to make an article on IT service companies (acronym: SSII in French).
As usual, I suppose that many readers will think that the article is too long.
However I'm not in a position where I need to pitch my ideas to a time-pressed fund manager.
I'm just running down my checklist.

See wikipedia article on SSII here (in French).

I'll focus this article on SII (SII: the company, not to be confused with SSII), because I have the impression that it's currently one of the cheapest (EV/2014 EBIT~6 for a quote of 7 €, well actually less since I started writing this article, it's now around EV/2014 EBIT ~5)
Is it a real opportunity or a value trap ?

2) Business model
Nate from Oddball stocks has nicely summarized it in a previous article:
"Technical consulting is a very straight-forward business model. A consulting company places a consultant at a client and bills them out at an hourly rate. The consulting company takes a large cut and pays the remainder to the consultant. As long as a consultant is billing a client both the employee and consulting company are earning money. If a client cancels a contract often a consulting company will let the employee go saving the ongoing expense."

Also the Value and Opportunity blog published a few months ago an interesting article on AKKA (AKA), a direct competitor of SII.
These companies are asset-light, so a potentially interesting return on capital.
They directly benefit from the heavy regulations on the French labor market ; it's long to fire someone, so client companies don't hire and prefer to outsource to these service companies, especially for relatively quick changing technologies such as IT.

On the other hand, they are directly exposed to business cycles; the client company can and will quickly cut the contract, especially new projects or if the service company provides a "commodity"-type service, as pointed out on the Value and Opp blog.

I don't work in this sector, so to get an idea I've spent some time exploring French blogs of people working for such companies (not specifically SII) to get an idea. Of course the more vocal are the displeased ones (a common derogatory nickname is 'meat sellers'), so all this needs to be taken with a grain of salt.

Common complaints:

- hiring mainly young engineers, they indirectly benefit form a relatively bad job market for some young graduates (translation: low pay, around 30-35 k€ starting salary)

- no investment (training) in their consultants. Turnover is high. No capitalization of knowledge or know-how
- consultant is left to himself (no or low follow-up) when working at the client site 
- when a consultant has no contract, company loses money. So the temptation is high to push this consultant on an available project even if he's not really qualified. Some reports of companies reverting to dirty tricks to pressure consultants to resign to avoid the costs of firing (i.e. repeated missions far from home or much under qualification, pressure to take unpaid vacations between contracts,...).

On the other hand these companies hire a lot, and can offer a variety of professional experiences in different sectors to a young graduate.

Competition and comparables
SII lists itself is main competitors in the annual report:
- divisions of big generalist IT companies (Steria, Sopra,...)
- "big" actors: Akka (AKA), Alten (ATE), Altran (ALT), Assystem (ASY)
- mid size actors: Alyotech, Astek, Ausy (OSI), Segula, SII itself
- small actors: hundreds on local markets or specialized applications.
The global market in France is estimated around 8.8 MM€, very fragmented.
SII estimates its market share around 1%.
I don't think that SII possesses any competitive advantage over its peers.

SII clients are mainly in Aerospace, Telecoms and banking+insurance.

SII hired 1400 people last year, on a total of 4400. Mean age is 34 years, almost nobody over 50. Around 200 job offers on their site when I looked.
Pretty high turnover, see above discussion on business model. Also points out on the vital importance of correctly anticipating new staff requirements in function the business outlook.

3) Financials
Balance sheet
SII finishes it year on 31 march.

LT debt 6 m€; short term debt 10 m€, around 28 m€ cash => 12 m€ net cash

Asset light (only 7 m€ fixed tangible assets vs 81 m€ equity ; 17 m€ of fixed intangible assets -mainly goodwill  and capitalized R&D costs).

Working capital
114 m€ receivables + 14 m€ other receivables - 62 m€ operating debt (suppliers, social security,...) = 66 m€ working capital, quite significant (66 m€ /294 m€ annual sales => 80 days).
Consultants are paid monthly but I guess that clients are much slower to pay.
SII operates not only on hourly rate contracts (technical assistance) but also on fixed price projects ("forfait", around 22% of 2014 sales). These projects carry an additional execution risk.
For instance working capital requirement has increased in 2014 even though sales are almost flat. SII explains that they haven't billed yet 5.4 m€ on a project in Spain.

2014 return on capital = 21 m€ operating result (after non recurrent items) x (1-34% tax rate, more on that later)/ (66 working capital + 7 m€ fixed tangible assets) ~around 20 %.
Pretty good, especially if trading at ~6 times trailing EBIT.
(Market cap 135 m€, using 18.5 m shares)

But why is it cheap ?

Income statement
Sales and EBIT (after depreciation) margins.

Operational margins went down in 2009-2010, just after the crisis. SII attributes this to the price pressure on technical assistance contracts, and the time needed to adjust its hiring to new conditions.
Since 2010, SII faces a slow business environment in France (pressure on prices in telecoms, reduced defense spending, end of Airbus A350/A380 program development,...), but operational margins seem to be stabilized.

Around 12%-13% annual growth over the last years, and going back to SII IPO in 1999, growth is pretty impressive.

What is the source of this growth ? Organic or based on acquisitions ?
Unfortunately SII does not provide this information in its annual report (or I've missed it) so I've used what I've found in the analyst presentations.

A recent external acquisition is Rücker Aerospace in Germany. AKKA is also investing in Germany, I wonder if it's a coincidence or if there's some underlying common reason.

SII has a opened a number of branches and international growth seems impressive (double digit).

To sum it up, it does not seem to me that SII is a "serial acquirer" with the associated risks. There's about 11m€ goodwill, compared to 183 m€ total assets.

Taxes and CVAE
I've learned my lesson with my Group Crit failure on this one.

Here is a graph giving the "apparent" tax rate (income taxes/EBIT).

The CVAE tax was deducted from the operational result before 2012. Recently the CICE has made its apparition. Messy. I'll take an average tax rate of 34%.

Where goes the cash ?
CAF = capacite d'autofinancement = cash flow
BFR = variation du besoin en fonds de roulement = change in working capital
flux exploit = cash flow from operations, taken from statement from cash flow
CAPEX = investment in fixed assets
FCF = cash flow from operations - CAPEX

The big drop in 2012 is linked to taxes.
What to make of this ?
Well my interpretation is that these companies are maybe asset and CAPEX-light, but need a large (and growing) working capital. So SII growth is not accompanied by a very large FCF generation.

Capitalized R&D costs
Apparently there's 7 m€ capitalized R&D costs on the balance sheet, mainly linked to software developped by a subsidiary named Concatel in Spain. I'm unsure and wary about the effect of capitalized R&D costs on the operational result, but in SII case it seems relatively secondary.

4) Shareholder structure and management

Who owns the capital
The founder family (Bernard Huvé) owns 55%, Fidelity 8%, Oddo Asset Management 5 %. Only 16% float. Fidelity had previously declared to have crossed the 10 % treshold in september 2013, so they've apparently sold some shares ?
Bernard Huvé stepped down from its operational functions in 2007; the current manager is Eric Matteucci, an internal promotion.
Theoretically, as a minority investor my interests are aligned with the founding family (no excessive risk taking, no major dilution, no excessive stock options for managers), except for the risk of squeeze-out at a low price. The presence of Fidelity and Oddo is quite reassuring on this point.
Another potential issue is when the main shareholder manages to catch a good part of profits before it gets to the bottom line. The founder salary is around 70 k€ in 2014, quite low. No other indirect compensation found in the "conventions reglementees" (regulated agreements and comitments) section.

Is the management renumeration aligned with the shareholders interests ?
The 3 top managers earned around 400 k€ each last year. No golden parachute or retirement package. No "special conventions". The determination of the variable part is not disclosed for "confidentiality reasons".

Dilution due to stock options
20 m shares, around 300 k shares in stock options and free shares for managers, minus 1.8 m shares owned by the company itself.
If I understand correctly, around 150 k free shares + 150 k performance related shares have been issued this year => 300 k shares => around 1.5% annual dilution.
However looking into the past dilution was more significant (up to 800 k potential shares in 2010...).

There is no apparent dilution, because SII buys back and cancels shares to offset stock options and  free shares.  If I understand correctly the annual report, 700 k€ have been charged in 2013-2014 to shareholders to offset this dilution, which is not unsignificant relative to FCF.

5) Valuation
Relative valuation
Comparison table (I'm not sure about my Assystem numbers because of the recent financial operations, convertible bonds and the associated potential dilution)

 At the beginning of this year, Assystem offered a buyout to minority shareholders.
The following table is extracted from the independent expert report.

So SII appears to be somewhat cheaper than its competitors.
This discount can maybe explained by some size effect, maybe in combination with the relatively low liquidity of the stock.

Also SII sales/people ratio is the lower of this sample. I have no explanation for his and wonder how they manage to have an operating margin in the mean.

Historical valuation
I've used approx high/low prices for each year. Looks that SII valuation has always been quite low.

6) Tying it up all together

I don't think that SII has any competitive advantage over its peers.
Likewise, we're not talking about a high-quality or a "moat" business situation. I don't think that SII clients can incur high switching costs.

On the other hand, SII valuation appears quite low in absolute terms, given the respectable return and growth, the robust balance sheet, and an apparent resilience in the crisis years.

SII is also somewhat cheaper than its comparables (especially around 5x EBIT).

Historically, SII valuation has always been quite low.

So maybe SII is doomed to remain eternally cheap, for some reason that escapes me but not Mr Market (maybe I'm underestimating the cyclicality of the business, or the liquidity/size effect).

I bought my 1st shares around 4 € in feb 2013 and some more during the recent downturn.
Maybe it's yet another value trap I've fallen in, however I'm willing to take this risk, which seems moderate to me.

As usual , feedback welcome.

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