Description

Headquartered in Paris, Altran Technologies (“Altran” or the “Company”) is a global leader in innovation and advanced engineering consulting, an industry also described as “Research & Development (R&D) outsourcing”.  With 28,000+ employees and a presence in over 20 countries in Europe, Asia and the Americas, Altran provides its services to customers in the aerospace, automotive, energy, railway, finance, healthcare, and telecom sectors.  Led by a strong CEO with a track record of creating shareholder value, and bolstered by both terrific secular tailwinds as well as barriers to entry, Altran represents an opportunity to double invested capital over the next three to four years with very limited downside.

The R&D outsourcing industry

R&D outsourcing services emerged during the mid-1980s in response to European engineering-driven manufacturing companies’ (or OEMs) need to expand their engineering capabilities while managing their fixed cost structure.  Europe’s strict labor laws and employee regulation discouraged (and continue to discourage) companies from hiring new full-time engineers in response to needs which ebb and flow with product and economic cycles. As a result, many OEMs started hiring engineers “as needed” from independent engineering companies, such as Altran, on a time and materials basis, which was less expensive than retaining full-time employees who weren’t being utilized, depending on the stage of a particular project. These engineers have traditionally taken on very specific analyses or development projects, often while located at the customer’s facilities and reporting directly to the customer.

As the need for innovation and engineering capabilities continues to increase due to the growing complexity involved in the development of products, manufacturing companies have become increasingly reliant on third parties for non-core capabilities, and have gone through the process of internally dividing their capabilities between core and non-core over the past few years.  In France alone, outsourcing penetration has increased from less than 15% of total R&D spending in 2000 to 22% in 2014. Moreover, OEMs are increasingly requiring third party R&D providers to deliver full “work packages” or full product components, rather than utilizing the time and materials, or technical assistance, delivery model.  R&D outsourcing companies are therefore developing their own internal capabilities and growing into Tier 1-type suppliers.

Outside of Europe, where labor laws are typically more business-friendly, R&D outsourcing continues to grow – for example, in the United States, the largest R&D market in the world, penetration has steadily increased from ~4% of total R&D spend in the mid-1990s to more than 11% today.  The transition to higher levels of outsourced R&D is a global secular phenomenon due to the drivers described above and, like information technology (IT) and business process outsourcing (BPO), makes economic and strategic sense for global manufacturers across industries.

Altran background

Altran was founded in 1982 as an engineering consulting business to address the need for engineers in the aerospace and defense industries.  Over the ensuing years, the business grew through the consolidation of other European engineering consultants across the continent, eventually developing into a network of independent businesses.  In 2006, subsidiaries across Europe were merged into Altran Technologies and organized for the first time under four reporting segments.  Altran has since evolved into the global leader in R&D outsourcing, generating over €2bn in revenues for the twelve months ending September 2016.  Altran generates the majority of its revenues (93%) in Europe (France, 41%) and maintains a diverse client base with over 500 major clients, such as General Electric, Siemens, Novartis and Boeing.

Investment thesis

(1)     Attractive and fragmented growth industry

Global R&D spend has historically grown at approximately 5% annually, which provides a secular tailwind for Altran.  However, R&D outsourcing penetration continues to steadily increase worldwide, resulting in Altran’s addressable market expanding at a higher rate than global R&D spending.  Based on the factors outlined herein – as well as the fact that certain highly R&D dependent industries such as pharmaceuticals and biotechnology are just beginning to shift towards outsourcing more of their R&D - the R&D outsourcing industry should grow an estimated 100-300 bps faster than overall R&D spend, or approximately 6-8% per year.

Additionally, the R&D outsourcing market is fragmented, providing strategic and accretive growth opportunities for Altran.  Although Altran is the world’s largest R&D outsourcing business, the ten largest players control less than 10% of the R&D outsourcing market, and only 1% of total R&D spending.   Given its scale advantages, strong balance sheet, and experienced and disciplined management team, Altran should be able to, and more recently has begun to, capitalize on consolidation opportunities as the industry matures.   

(2)     Top tier company and leader in R&D outsourcing

Prior to the current CEO’s appointment (more on that below), former CEO Philippe Salle led a significant restructuring of the Company, which included divesting its cyclical management consulting business, Arthur D. Little, shifting the Company’s entire focus towards R&D outsourcing and innovation, and reducing expenses by lowering purchases and outside services from ~23% of revenue in 2010 to less than 20% in 2014.  The restructuring has enabled Altran to become the largest pure play R&D outsourcing provider in Europe and expand adjusted operating margins from 5.4% in 2010 to approximately 9.8% for the twelve months ending June 30, 2016, placing the Company in-line with peers such as Alten and Bertrand. Altran has a dominant footprint across Europe, serves most of the large manufacturing companies, and is uniquely positioned in a fragmented market where most competitors are subscale.  In conversations with customers – and competitors – it is apparent that Altran is very well-regarded and maintains strong, long-term relationships with its customers.

(3)     Barriers to entry

As companies rely more on third party providers of R&D, they have a vested interest in the financial and operational fortitude of their suppliers. Accordingly, OEMs are increasingly running formal processes to concentrate their projects among a smaller number of suppliers to ensure that those selected are financially stable and have the scale to develop the necessary and mission-critical capabilities to grow with the OEM’s needs.  These “authorized suppliers” are selected only after a tedious, complex and lengthy process that can last three to five years.     

Furthermore, the continued shift towards more complex work packages and away from technical assistance contracts favors more substantial companies such as Altran that can deliver large, coordinated and experienced teams, provide several levels of responsibility and risk-sharing, and invest in the infrastructure to support such work packages. 

(4)     Margin expansion opportunity

Altran should be able to expand its operating margin by 3% to 5% over the next three to five years (the company has targeted 13% pursuant to its “Altran 2020. Ignition” business plan  based on several initiatives including a shift in business mix, emphasis on world class centers, operational excellence (encompassing the turmaround of its money-losing German operations, rationalizing SG&A and increasing its invoicing ratio), and offshoring additional operations.

In fact, the margin would probably be 100-200 basis points higher today, excluding the German operations.  The CEO has made progress towards turning around Germany nonetheless, recently replacing the management team in Germany and making two strategic acquisitions, Benteler Engineering and Swell – both leading providers of design and engineering for the automotive industry in Germany.

(5)     High quality, shareholder-oriented management team

Though CEO Dominic Cerutti had a very successful tenure at his prior company Euronext, his background is actually better suited to leading Altran.  Specifically, Mr. Cerutti spent most of his career at IBM in the 1990s and 2000s, and was head of the IBM Global Services division for Europe, the Middle East and Africa.  While at IBM, he also worked directly under Lou Gerstner, and developed a unique and informed view with regard to the growth and transformation of the BPO and IT Services industries.  It was the belief that R&D would be the next wave of outsourced services to permeate global corporations that spurred Mr. Cerutti to join Altran.

Since his arrival, Mr. Cerutti has bolstered his management team, including the key addition of Daniel Chaffraix as EVP in charge of Transformation.  Mr. Chaffraix previously served as CEO of Infrastructure Services at Cap Gemini, and also worked with Mr. Cerutti at IBM Global Services.  More recently, the company announced the hiring of a new CFO, Albin Jacquemont, who appears to be better suited for the remainder of the Ignition 2020 plan (growth, M&A) than the former CFO, Olivier Aldrin, who nonetheless prepared the company well for the next phase.

Finally, Mr. Cerutti has a track record of creating shareholder value. During his tenure at Euronext, he consistently met and raised stretch goals and presided over the company as its shares nearly doubled from its original IPO price in the span of 18 months.

(6)     Margin of safety: mission critical expenditure that is relatively acyclical

Research & Development is the lifeblood of any engineering-focused manufacturing concern. Accordingly, during economic downturns, R&D is one of the last expenditures that companies curtail, as doing so would jeopardize the company’s ability to protect its market position and ultimately its long-term viability.  Put simply, significant R&D reductions are usually only implemented when a business faces a liquidity crisis.   Global data supports this view: R&D spending has steadily increased at ~5% CAGR over the past 15 years with its trough year in 2002, when it contracted by 4.1%

Even during the financial crisis, when companies were cutting costs across the board, R&D spending only declined 3%, with Altran’s R&D outsourcing revenues decreasing by ~4.4%.  Altran has since divested its most cyclical assets, such as its management consulting (Arthur D. Little) and its architectural design businesses, making it more resilient in the face of an economic downturn.   This has proven out over the last few years, as Altran grew revenues in 2012 and 2013 despite the negative GDP growth in Europe.

Altran also maintains a diversified end-market exposure (no industry accounts for more than 25% of revenues), which, unlike an OEM, reduces its dependence on a particular product cycle or industry. 

(7)     Attractive M&A target

As the R&D outsourcing market gains traction, Altran should become an attractive target for large global service providers such as Accenture and IBM (with whom Mr. Cerutti has a deep relationship) as they explore new avenues of growth. Altran has a €2.3 billion market capitalization, a size that could be easily digested by such companies.   At the same time, Altran itself has demonstrated a good ability to roll-up smaller R&D outscouring companies in this fragmented industry, leveraging both its brand and customer relationships.

Valuation Case and Price Target

Assuming that Altran meets its 2020 targets and (a) generates €3bn of revenues, and (b) expands operating margins by 300-400 basis points, Altran would generate adjusted EPS of €1.60+ per share. At a relatively conservative multiple of 15x adjusted EPS, the stock should be worth approximately €24 per share.  At the same time, even if Altran falls short of reaching its targets, given its strong balance sheet, market position, leadership, and progress to-date against its plan, there is limited downside at current levels.

Risks

Prolonged macro downturn

Ill-advised/value-destructive acquisition

Failure to turnaround Germany operations

Actions that may impair reputation (given that its a human capital business)

Catalyst

M&A (either way)

Execution on Ignition 2020 plan

Turnaround of Germany ops

Further progress in U.S.