CGI Inc

CGI's third-quarter constant-currency revenue growth of 1% and operating margin of 16% were both in line with our expectations. More importantly, US federal revenue expanded 3% this quarter, marking a return to positive growth after two consecutive quarters of double-digit decline.

Why it matters: We applaud CGI's effort to deliver a timely turnaround in its US federal business, even as government IT budgeting remains complex to navigate. The US federal segment's book/bill ratio this quarter also reached 115%, much higher than the company-wide quarterly book/bill ratio of 100%. CGI continues to benefit from its strong switching costs from its decadeslong managed IT history. We are also glad to find more artificial intelligence elements across new client contracts. CGI's total service pipeline with AI-based services is approaching CAD 10 million, doubling the size since last year.

The bottom line: We raise our fair value estimate for narrow-moat CGI to CAD 126/USD 90 from CAD 119/USD 87, as the company's performance outperformed our initial projections amid a tough operating environment. Shares look undervalued despite the stock rallying 4% after earnings. CGI's full-service capabilities across managed IT and system integration make the firm a go-to choice for the government's AI-based IT modernization efforts. Cybersecurity and defense are both areas where CGI can benefit from vendor consolidation in protecting mission-critical intelligence.

Between the lines: This is the first earnings call for CGI's new president and CEO, Tim Hurlebaus, who took office in May after Francois Boulanger's retirement. Tim was previously the COO for CGI, bringing over 35 years of experience across both commercial and government sectors. We do not foresee any notable strategy changes with CGI's new CEO. Hurlebaus' experience as the President of CGI Federal should reinforce the company's close relationship to win contracts from the US federal government.

Our USD 90 fair value estimate implies an adjusted price/earnings of 15 times and an enterprise value/adjusted EBITDA of 10 times. We model a 3% cumulative annual growth rate for CGI over the next five years, primarily driven by secular IT upgrade demand from governments and industrial customers.

We think government business should take the central role for CGI’s baseline growth, with demand from private-sector enterprises fluctuating a bit more based on economic cycles. Emerging technologies, including cybersecurity, sovereign cloud, aerospace, and defense, are gaining traction among governments and should account for the majority of CGI’s future growth. Although CGI’s build-and-buy business model relies on acquisitions, we do not foresee any transformational acquisitions that would materially change the company’s revenue streams and outlook. However, there is still a possibility for such deals to appear over the horizon, given that CGI’s last major acquisition happened over a decade ago and that the company has sufficient resources to pursue a more aggressive acquisition strategy.

We forecast moderate margin improvements for CGI, with gross margin expanding around 100 basis points and operating margin expanding around 250 basis points over the next five years. Although the company has been slowly increasing its offshore leverage, wage hikes across major offshore centers and customer mandates to process sensitive workflows at domestic delivery centers should largely offset any efficiency gains for CGI. Also, we do not foresee a meaningful change to CGI’s revenue mix between managed IT services and consulting. Managed IT services should remain the bigger part of the business, which underpins our evaluation of CGI’s strong switching costs that support a companywide narrow moat.

We believe CGI warrants a narrow economic moat due to significant switching costs and intangible assets associated with its delivery model. CGI offers a broad portfolio of consulting, systems integration, application maintenance, and business process services. As a leading IT-services provider, the company enjoys strong switching costs derived from its decadeslong experience of providing managed IT services that consistently meet customer expectations. We also think CGI’s balanced delivery model is differentiated from other IT-services companies that rely heavily on offshore labor, as the ease of reach and faster response time of CGI’s onshore consultants lead to better customer experience. Having most consultants sitting close to the customer helps CGI accumulate the trust and knowledge necessary for the intangible assets that support a narrow moat.

CGI derives around 55% of its revenue from the managed IT and business process services segment, which includes application maintenance, infrastructure management, and workflow outsourcing. These services are generally primed for strong switching costs because of their high degree of customization based on customer needs. During the service period, contractors like CGI will fine-tune the workflow as they gain more knowledge about clients’ specific needs. All these marginal improvements and knowledge accumulation can make it more difficult for clients to switch their service providers when a contract nears its end date.

Typically, the duration of a managed service contract is five years or less. However, CGI has a record of securing service contracts of 10 years or longer, especially from government customers. Stability and security are the priorities when governments operate their online services, which means they have a stronger incentive to work with the incumbent service provider as long as the system’s performance has met their expectations. Switching to another vendor can potentially expose clients to service disruptions and cost overruns due to the new vendor’s unfamiliarity with existing business processes and information systems, which are scenarios that governments would like to avoid at all costs, since many services they provide are part of the essential services linked to public welfare.

With one or two contract extensions, CGI can easily build business relationships with customers that last 20 years or longer. Some examples we have seen include visa processing services for the US State Department and IT infrastructure management for the Scottish Borders Council. We believe CGI’s switching costs with governments are some of the strongest we have seen across our IT-services coverage. The company’s switching costs with private-sector customers are also on par with those of its narrow-moat peers like Cognizant.

CGI adopts a proximity-based operating model to form and maintain customer relationships; this is different from other similar-size IT-services firms. We think this is an effective approach that has helped the company accumulate intangible assets necessary for a moat. In general, we see two types of intangible assets among IT-services companies: institutionalized industry knowledge and customer relationships that are hard to duplicate. We believe CGI’s intangible assets are the latter. With about 400 offices in over 40 countries, the majority of CGI consultants deliver services from locations close to customers. This is an upgrade to the customer experience, compared with other vendors that try to remotely troubleshoot any client issue from a different time zone.

We think CGI’s lasting relationships with key government agencies, such as the US State Department, show how the company can build trust by meeting performance obligations for governments and commercial customers with high reliability requirements, leveraging its intangible assets to reinforce switching costs that the company already enjoys. In addition, having consultants work at client locations also mitigates data privacy and security concerns, as sensitive data no longer needs to travel across borders. This is also a reason many clients keep coming back to CGI for different IT projects. Even if one of CGI’s competitors decided to open a new office close to a client’s headquarters, it would still take years for that competitor to build the trust and expertise that lead to lasting business relationships.

CGI has an outsize presence in the government vertical, which positions it well to capture incremental IT demand as governments modernize their tech stack.

As cybersecurity products advance, CGI’s customers may become more comfortable with offshore service delivery, bringing a potential opportunity for margin improvement.

CGI’s build-and-buy strategy should make it easier for the company to expand in emerging markets like Eastern Europe and Asia-Pacific.

Government customers usually allocate a limited budget to IT projects, which can negatively affect CGI’s unit economics.

CGI may acquire smaller IT-services firms at a price premium that brings a low return on investment if the deal’s timing is not appropriate.

Governments are not known as early adopters of new technologies, meaning that CGI has limited opportunities to work on cutting-edge projects that have the highest margins.