Description

 

Investment Thesis

1. Atos will face structural growth headwinds in Managed Services over the next 12-18 months due to outsourcing deflation as IT Infrastructure outsourcing contracts come up for renewal, driven by the cloud threat and offshore competition.  This is in dramatic contrast to management’s and the Street’s expectations for a growth acceleration over the next few years.

2. The gradual shift to cloud-based services in Europe will increase pressure on Atos’ Managed Services organic growth, free cash flow, and ultimately its terminal multiple.  HP and IBM are case studies for the obsolescence risk and terminal multiple pressure that Atos could face as investors shift focus from Atos’ adjusted EPS to its low-quality, structurally declining free cash flow.

3. Management’s “Ambition 2016” targets are aggressive and may be at risk, as its margin and FCF targets depend on a return to organic growth, which I believe is unlikely given Atos’ weak competitive position amidst the gradual industry-wide shift to the cloud.

4. At 17.5x CY16 EV/ULFCF for core Atos (incl. pension), ATO does not price in the major risks facing its legacy ITO business - vs. the U.S. peer group which trades at ~10x.  In my base case where the Managed Services segment (58% of sales ex. Worldline) returns to shrinking organically and de-rates, core Atos should be valued at 12x CY16 EV/ULFCF, for a target price of €54/share (~25% upside from my target €72/share entry price).  A bull case re-rating to 18x EV/ULFCF would have 18% downside. 1.4x up/down to the short.

 

Street Bull Case

1. Organic growth should improve to ~1% in 2H15 due to better Consulting & Systems Integration growth and to 1-2% in 2016 with improvements in all service lines.  The European outlook is improving and North America should be a growth driver with Xerox ITO (organic growth target of 3-5%).  Cloud is a secular headwind, but not in the near/medium term, and Atos does have private cloud exposure.  With gradual top-line improvement plus cost synergies from acquisitions, ATO should grow EBIT and EPS at a 15-20% CAGR over the next three years.

2. FCF quality should improve as restructuring and M&A integration costs normalize beyond 2016, and there is significant optionality relating to further value creation from a potential near-term Worldline M&A deal as well as longer-term Atos acquisitions.

3. At ~11x CY16 P/E on my target €72/share entry price, ATO is trading slightly below its all-time historical average (11.4x) and at a sizable discount (~30%) to IT Services peers, even though Atos is performing better than U.S. peers like HP and CSC.  Atos should trade at a more reasonable 13x CY16 P/E, for a bull case price target of  €85/share (18% upside for the long at my  €72/share entry price).

 

Company Overview

Atos SE (ATO FP) is a European IT Services company specializing primarily in data center infrastructure outsourcing, with lesser exposure to business process outsourcing (BPO), consulting & systems integration (CS&I), cloud, big data & cyber-security, and payment services.

• Founded in 2000; headquartered in Bezons, France

• 2014 pro forma revenue of  €10bn and 93,000 employees in 72 countries (post-Xerox ITO acquisition which closed on 6/30/15)

• Serves mostly the Public & Health, Transportation, and TMT sectors, as well as Manufacturing, Retail, Utilities, and Financial Services

• Has made several acquisitions & divestitures in the past few years:

• Acquired Siemens Information Services (SIS) in July 2011

• Acquired Bull (French cloud/big data/security company) in May 2014

• Divested 26% of its stake in Worldline (WLN FP), its payment processing unit, in June 2014 via IPO and still retains a ~70% stake

• Acquired Xerox IT Outsourcing (ITO), a former subsidiary of Xerox, in June 2015

 

What does Atos do?

• Atos generates most of its revenue from Outsourcing (60-65% of total revenue; 65% of Managed Services revenue; 35-40% of IT Services revenue)

• Within Outsourcing, Atos focuses primarily on Data Center & Desktop Outsourcing (50-55% of Outsourcing revenue; 30-35% of total revenue), the businesses most at risk from the growing cloud & automation threats in Europe

 

Data Center Infrastructure Outsourcing 101:

• Many organizations have realized that outsourcing their data centers is the best way to align IT and business in the most cost-effective manner

• Benefits from DC outsourcing include:

• Lower financial and operational overheads

• Ability to stay focused on core business areas and leave IT management to the experts

• Maximum freedom and flexibility in daily IT operations

• Protection of IT infrastructure from technology obsolescence

• Proactive monitoring and management of their hosted IT infrastructure

 

Atos Business Mix:

• Atos generates most of its revenue from Managed Services, especially from the Public & Health sectors

• The business is concentrated in continental Europe, with heaviest exposure to France, Germany, UK, and Benelux & The Nordics

• With its  €811mm acquisition of Xerox ITO in June 2015, Atos increased its U.S. revenue mix from <10% to ~20% (on PF 2014 #s)

 

 

What Else is Getting Outsourced?

• Typical areas delegated to managed and outsourced data center providers include:

• Full functionality and support of all elements within their data centers

• Troubleshooting and help desk

• End-user support and infrastructure operations

• Hardware maintenance and network operations

• Monitoring and management (server, systems, etc.)

• Security

• HVAC

• Disaster recovery, storage management, and backup (power, data)

 

Global IT Services Industry Overview

• IT Services was a $955bn industry globally in 2014 (+1.9% growth, +3.5% ex-FX), projected to decline -3.7% to $919bn in 2015 due to currency headwinds (+3.8% ex-FX) per Gartner

• IT Services is expected to grow at a 4.3% CAGR from 2015-2019, driven by broader IT spending growth and supplanted by a shift from broader IT spending growth and supplanted by  shift from traditional IT infrastructure outsourcing to digital & cloud-based services

• With outsourcing contributing more than half of market growth in constant currency, the global IT Services market is expected to reach $1.1bn in 2019

 

 

• The forecasts for Infrastructure Outsourcing (Atos’ core Managed Services business) and Implementation services (each growing at 2.6% from 2015-19) are weaker than the overall IT Services market (4.3% CAGR)

• Increasingly, buyers prefer solutions that minimize time and cost of implementation, driving demand for more efficient delivery methods, out-of-the-box implementation, and lower-cost solutions

• This trend benefits Business Process as a Service (BPaaS) and Cloud Services (9.6% and 28.2% CAGR from 2015-19) at the expense of Infrastructure Outsourcing (the primary business in Atos’ Managed Services segment)

 

• For Atos’ other primary segment, Consulting & Systems Integration, research analysts expect MSD growth through 2019

• Gartner expects 7% growth in spending on IT consulting through 2019, driven by vendors who have demonstrated their ability to stimulate new demand from buyers looking for help with navigating business and technology complexities, particularly related to building a digital business

• IDC expects the global System Integration market to grow at a 3% CAGR over 2014-19

 

IT Services Market Outlook

Atos’ core business, Traditional IT infrastructure outsourcing, faces increasing secular headwinds over the next five years.

• Gartner expects continued pricing pressure and secular challenges in ITO spending as the market moves from traditional, on-premise, asset-heavy outsourcing models to virtual, asset-light, more-agile delivery models

• Increased adoption of offshoring in geographies, such as continental Europe, will exacerbate negative pricing trends

• 70% of CIO survey respondents indicated a desire to change sourcing vendors over the next 2-3 years (as of 3Q15)

 

 

Competitive Landscape

• The IT Services market is the most fragmented market of the technology industry, due to the segment’s low barriers to entry

• The U.S. is a more competitive market than Europe, where the global IT Services bellwethers have a stronger foothold and execution is key to remain competitive in that landscape

• The top two providers, IBM and HP, have continued to lose market share since 2011, struggling to both drive growth and maintain margins due to secular challenges and a hypercompetitive marketplace undergoing major digitalization shifts

 

 

• Although Atos has gained market share from 2011-14, Europe is becoming increasingly competitive as IT Services customers begin to focus on the substantial benefits offered by shifting from traditional to cloud-based outsourcing

• Increased penetration of offshore pure-plays in Europe (e.g. Indian competitors such as Tata/TCS) who are well-equipped with these cloud-based services also poses a rising threat to prices and margins for traditional ITO companies like Atos

 

Historical Financials

Atos’ organic growth has been muted over the past five years due to structural headwinds for its legacy IT solutions – while reported revenue growth and margin/EPS growth have been driven by acquisitions and their associated cost synergies, respectively.

• 2H11: Atos acquired Siemens Information Services (SIS), which had a major positive impact to EBIT margins in Managed Services and C&SI segments.

• 2H14: Atos acquired Bull (French company, primarily Big Data & Cyber-security), which created the Big Data & Cyber-security segment. Atos acquired this low-growth low-margin business for its cost synergy opportunities and its exposure to "all things digital” (e.g. Cloud, Big Data, Cyber-security)

 

 

Recent Stock Performance

• Atos’ stock price is trading near its last 10-year high and its forward P/E multiple trades in line with its last 5-year average, on increasing optimism from the Street around the company’s gradual top-line improvement (on company-adjusted organic growth figures after backing out recent contract losses) and margin expansion from acquisition cost synergies

 

 

Overview of the Cloud Threat

Gradually increasing threats from cloud trends in Europe should create a secular headwind for Atos’ core ITO market.

 

General Cloud Themes:

• The interrelated themes of cloud and automation are driving a transformation in Atos’ core market of infrastructure outsourcing (ITO) – significantly lowering price points, revenue visibility and – most importantly – labor intensity, while driving up capital intensity

• Over time, cloud applications reduce the demand for customized implementation and development, as well as infrastructure maintenance

• The average deal size for a cloud implementation is typically smaller than traditional on-premise systems integration work (often 25-50% of the size of an equivalent on-premise implementation)

• Today the high volumes of deals are offsetting the lower values, but this does not appear sustainable given increasing competition from offshore Indian pure-plays and given that Atos is lacking on the technological innovation front

• Cloud also reduces the tail of follow-on services, which would have historically accompanied on-premise applications

 

Cloud Challenges Driving Outsourcing Deflation

• Almost all European CIOs surveyed are expecting pricing declines on existing IT outsourcing contracts

• While an element of deflation is typically built into outsourcing contracts, the largest outsourcing providers face additional challenges from public and private cloud and the break-up of monolithic contracts into “multi-tower” contracts shared amongst multiple suppliers

• Given the threat of public cloud, CIOs have gained negotiating leverage with their outsourcing suppliers and are using this to put pressure on suppliers’ pricing even though large-scale shifting of legacy workloads to public cloud infrastructure-as-a-service (IaaS) is not a serious prospect near-term in most cases

• However, these threats are not idle – some CIOs have reduced outsourcing fees as a result of Office 365 and ServiceNow deployments, for example

• Given overall momentum behind the Cloud and increasing maturity of SaaS and IaaS offerings, IT services vendors are being compelled to offer pricing concessions to maintain existing contracts

• These trends are aligned with overall dynamics within the Outsourcing market, with most of the major listed vendors seeing flat to declining revenue over the last couple of years

• Only Accenture among the major Western vendors appears to be bucking the overall trend, likely based in large part on its high mix of BPO within its outsourcing business (supposedly ~1/3 of the outsourcing business per Accenture IR), which is relatively insulated from pricing pressure on IT since most of the value of the service is not tied to specific tech components in the majority of deals

 

 

 

 

Offshore Competition is Intensifying...

India-based ITO competitors are the lowest-cost providers and are finally starting to take market share in Europe.

• Indian competitors are pushing into the European outsourcing market and are increasingly involved in a large portion of final selection rounds for outsourcing deals, causing Atos to face increasing pricing pressure and competitive threats related to deal wins

• Although at a slower pace than in past years, India-based vendors continue to grow above the market average, making incremental market share gains

• In a market that grew 3.4% in 2014, the top five India-based vendors collectively grew~15% (and are poised to grow even higher in 2015), yet still represent only ~4% of the total market

 

 

• Of the leading India-based providers, the fastest market share gainers of this group include not only TCS (now in the Top 10 of all global IT Services vendors) but also Cognizant and HCL

 

“The Indian players are increasingly showing up in the final rounds of contract negotiations.  They’re putting a ton of pricing pressure on apps and apps-as-a-service markets.  It’s inevitable that Atos feels pricing pressure here.”

- Former Deputy CEO of Capgemini (9/21/2015)

 

...and Atos’ Offshore Mix is Uncompetitive

Atos remains competitively disadvantaged due to its high mix of relatively expensive onshore labor.

• For onshore vendors, competition from offshore vendors at the more commoditized end of Applications Management, in particular, represents an ongoing headwind in a highly competitive pricing environment

• Vendors need to cross a certain threshold of offshore headcount ratio for this pricing pressure to level out – however, Atos was only at 23% in 2014, only half the level of main peer Capgemini (46%)

• The bull case is that Atos will continue to improve its offshore ratio to mitigate the pricing pressure

• While competitive advantages in the Managed Services segment (traditional IT infrastructure-related services) require a more local workforce, Atos believes it has room to increase offshore leverage in its Consulting and System Integration (C&SI) business

• Management expects offshore leverage in C&SI to increase to 50% by end of 2016 from 40% currently

• However, even at 50% offshoring in C&SI, Atos would still be only 25-30% offshore on aggregate, significantly below the global IT Services bellwethers, which have over 70% offshore leverage

 

 

Atos’ Contract Economics will Erode

As a result of these structural competitive headwinds, Atos’ ITO contract structure is changing dramatically.

• Historically, Atos has benefitted from a high ratio of recurring revenues (~70%) due to multi-year contracts in:

• Most of Managed Services (51% of total)

• ~1/3 of C&SI, from application management (35% of total)

• 75% of Worldline, from payment processing and merchant business (13% of total)

• Legacy Managed Services contracts have been 4-5 years, meaning only 20-25% were up for renewal each year, typically at high renewal rates (80-90%))

• Today, these contracts are decreasing in length (to 0-3 years) as clients shy away from long-term commitments and shift to cloud-based services which are primarily pay-per-use model

• As a result of these changes in traditional IT outsourcing contract structure, Atos’ revenue is becoming less predictable

 

“Not a positive outlook for contract renewals at Atos over the next 1-2 years…even out 6 months, their qualified pipeline looks weak and they will see UK & France contracts up for renewal at lower prices.  They may hang where they are with organic growth being flat/slightly down, but it will be very difficult to accelerate.”  - Former CFO of Managed Services at Atos (2009-2012)

 

Managed Services Contract Economics

Atos faces major erosion in the unit economics of its core Managed Services contracts over the next few years.

• Atos only keeps ~25% of the business moving to the public cloud at renewal, vs. 80% for private cloud

• I assume Atos wins 90% of renewals for its legacy on-premise solutions – an assumption which seems conservative based on conversations with former Atos executives

• Atos faces pricing cuts of 15-25% over the life of a newly renewed contract (~5% per year) vs. 10-15% historically

• As a result, Atos faces declines in contract value of ~10% in Year 1 post-renewal and ~20% over the life of the contract for each core Managed Services contract

 

 

Managed Services Growth is Deteriorating

True organic growth is not only declining but getting worse as Managed Services contract economics erode at renewal.

• The Street believes Atos is showing improvements in organic growth trends driven by its business model transition to digital

• However, these organic growth trends are based on management’s adjusted figures which add back recent contract losses considered to be non-recurring events

• My variant view is that recent contract losses (Siemens pricing cut, DWP WCA ramp-down) are structural and representative of ongoing secular headwinds and should accelerate in the coming quarters

• Including these contract losses, true organic growth has been worsening over the last few quarters

 

 

Cloud & Automation Headwinds

Increasing threats from cloud and automation trends should create a secular headwind for Atos’ core ITO market.

 

Cloud & Automation Headwinds to Atos:

 

1. Cloud & automation offer lower price points

1. Cloud-based services and automated IT storage are fundamentally cheaper ways of providing IT infrastructure – involving less headcount and more automation

2. Savings can be significant in hardware (68-80% per Amazon) but labor is likely to be an even bigger cost saving on an absolute basis)

2. Therefore, the industry is becoming less labor intensive

1. Labor makes up the bulk of traditional infrastructure spending (2/3); automation is lowering the need for these roles

2. That puts incumbents at risk of restructuring in the long term

3. Industry is also likely to get more capital intensive as scale becomes the main cost differentiator

4. Revenue visibility is lowered as clients pay based on usage rather than fixed fees

3. Incumbents such as Atos risk losing out

1. Incumbents face a deflationary ‘mark to market’ of their installed base as these new themes take root

2. The U.S. is at the vanguard of this shift and incumbents there (HP, CSC, IBM) are declining at 15%/year and resorting to restructuring to future-proof their offerings

3. Revenue compression among those U.S.-based peers has a good chance of spreading to Europe ultimately

4. European CIOs cannot ignore the savings from cloud and automation

 

As the competitive threats from cloud & automation increase, ATO’s core Managed Services business will become less labor intensive but more capital intensive, thereby putting pressure on FCF

 

The Shift to Cloud is Underway in the U.S...

The $130bn data center services market is undergoing a transformative shift to cloud-based services.

• Traditional models (‘data center or infrastructure outsourcing’ – or the more general term of ‘managed services’) are being replaced by significantly cheaper, less labor intensive cloud-based service

• Gartner expects data center outsourcing to shift from 52% of spend in 2014 to 32% in 2019, with the cloud-based ‘Infrastructure-as-a-Service’ (IaaS) market displacing it

 

 

...and Europe is Starting to Follow Suit

The U.S. shift to cloud-based services has set a precedent for European companies to follow suit.

• The U.S. is typically at the vanguard of technology change, and this transition has been no differen

• As shown below, incumbents in the traditional data center outsourcing and managed services sector such as IBM, HP, and CSC have seen major revenue declines and if anything that seems to be accelerating

• HP’s 1Q15 infrastructure outsourcing was down -20% yoy, and the average across the three was -15%

 

• These issues have been apparent in the U.S. market for a while, so some might think the threat has passed – however, the CEOs of HP and CSC disagree:

 

“There is no question that there is much greater headwinds in that infrastructure business.”  “…[the shift to cloud] is accelerating and that had a bigger impact than what I had thought it was going to have in 2015.” - CSC CEO Mike Lawrie, 5/19/2015

 

“…the ITO industry challenges have accelerated and are driving risk in the sustainability of this profit level if we don’t do further cost reductions.” – HP CEO Meg Whitman, 4/21/2015

 

• This shift to cloud will likely take time, as big corporations won’t shift their infrastructure overnight – however, incumbents such as Atos face having their current profit centers steadily eroded as this headwind permeates the European market

 

Cloud-Based Services Provide Significant Cost Savings

Cloud-based infrastructure is a superior product to traditional ITO models, providing a similar output at a much lower cost.

 

Hardware Cost Savings

• Amazon cites the ability to rapidly scale up and scale down computing resources dependent on demand as a key driver of reduced overall costs

• The savings offered by cloud-based services vary depending on:

• Size of the implementation (smaller  higher savings due to higher incremental scale economies from the cloud)

• Amount of ‘control’ the client wants on where the application can and cannot run (fewer rules  higher savings)

 

 

 

 

Labor Cost Savings

• Even if infrastructure/hardware savings are not huge (e.g. for very large clients with tightly controlled private clouds), the automation of tasks is a major driver of savings

• Today, ~2/3 of traditional infrastructure outsourcing costs are built up by labor rather than hardware/capex

• Even when hardware costs in cloud and traditional outsourcing models are equal, the reduction in staff costs can lead to a halving of overall cost

 

 

“On GIS [Global Infrastructure Services], we’ve said this before.  But there’s probably a 2% or 3% headwind every year, just with price-downs that are built into the contracts.  The other thing in that business is there’s still a lot of labor manual costs associated with that business.  And the way to expand margins as we go forward is not only moving some of that work to low-cost locations…but also, the automation of a lot of those tasks.” - CSC CEO Mike Lawrie, 5/19/2015

 

“…there is a definitely accelerated move to a consumption model, which is going to require us to make a faster labor mix shift to low-cost resources, and frankly, the transformation of the physical data center footprint to much more streamlined footprint that are far more automated.” - HP CEO Meg Whitman, 4/21/2015

 

Atos will Require More Capital Intensity

The shift to cloud-based services is forcing Atos to become capital intensive, rather than less.

• The principle drivers of cost savings in IaaS deployments are (1) more automation and (2) large scale, which allows average server utilization to be driven up

• Both of these features mean the IaaS industry is likely to be highly capital intensive

• Amazon will spend $2bn in capex this year to support their AWS rollout (excluding new capital leases)

• Similarly, in January 2014 IBM committed $1.2bn to drive its shift towards IaaS

• This capital intensity should also trend towards higher concentration, which may not be a bad thing for incumbents in the long run – if they are willing to commit to investment

• Atos will see upward pressure on its capex spend, and thus pressure on FCF, over the next few years as they aim to compete effectively in the market and become the European champion

 

 

 

Impact to Atos Managed Services

Atos has its highest exposure to this traditional data center outsourcing business, which will cannibalize its Managed Services segment growth over the next few years.

• As Atos attempts to migrate its traditional IT outsourcing installed base to private cloud deployments, it will face near-term pricing pressure of 15-25% (~5% per year for 3-5 year contracts) and a significant transfer of implementation/capex risk from customers to suppliers

• This transition to private cloud will be cannibalistic to the traditional IT outsourcing business as shown below

 

 

Industry Commentary on the Cloud Threat

Commoditization Threat

“At the end of the day, the entire Managed Services business is commoditized…running the data centers is not the core differentiation.  Only 10-20% is higher value services, the other 80-90% is essentially becoming a commodity.”

 

“Atos has been quite successful historically at driving down costs, but there is limited incremental room from here.  Atos lacks critical mass in C&SI, for example.  They cannot provide a global solution to the large international players.  Won’t be able to deliver a cost-competitive near-term solution.  So they cannot afford to compete at lower prices, which is where Managed Services is moving as customers shift to the cloud.”

 

- Former CFO of Managed Services at Atos (2009-2012)

The Shift to Cloud

“About 10% of large customers’ infrastructure is moving to the public cloud at renewal, and prices are getting squeezed.  The leakage is closer to 20-30% for smaller customers. Total infrastructure outsourcing volume industry-wide is flattish, but Atos is losing wallet share at renewal.”

 

“Service companies, even in the Public & Health sectors which are Atos’ bread and butter, are positioning themselves as hybrid public/private cloud solutions.  Atos is not very advanced in this sector, not going in the direction they need to go in.  And public cloud prices are so low that Atos cannot compete here versus Amazon Web Services and other cloud players.

 

– Former Senior VP and Head of Cloud Services at Atos (2011-2013)

 

“It’s fascinating to see that the digital rotation we’ve seen in Europe is as strong, even slightly stronger than the one we could see in the U.S.  It appears that our target clients, mainly the premium brand in the G2000 we are serving in Europe, are really accelerating their investments in terms of digital rotation.”

 

- CEO of Accenture (competitor to Atos’ Consulting & Systems Integration) on 4QFY15 Earnings Call

 

The HP Services Bear Case

Longer term, HP Services is the ultimate bear case for Atos if it does not successfully transition its business model.

• The HP Services organization is the ultimate bear case – i.e. that Atos today looks a little like HP Services circa 2012, largely pre cloud adoption

• For HP, BAML models FY15 infrastructure outsourcing revenues to be ~24% below where they were in FY12

• In addition, there is then $2bn cash restructuring cost and a potential de-rating

• Applying these risks to Atos would drive an ultimate bear case value of €42 per share

• This still doesn’t factor in the difficult-to-quantify risk that Atos’ restructuring may cost more given its European exposure

• If it costs Atos 2x what it cost HP (relative to its size), it would cut another €9 from the fair value

 

 

 

 

Long-Term Restructuring Risk

If Atos were to follow the path of HP Services, it would likely require a much larger, more expensive restructuring program.

• The structural changes now gathering pace in the U.S. may ultimately drive a need for more concerted restructuring at Atos

• HP recently announced that it would need to take an additional $2bn of cost out of its managed services organization (at a cash cost of a similar $2bn amount)

• For HP, this represents ~15% of the revenues earned in that division

• While Atos bulls will argue that it already spends regularly on restructuring, so has HP, as in 2012 it announced a plan to lower headcount by 45-50k employees

• Relative to the size of its managed services practice, the latest HP restructuring round implies Atos could need about a €950mm plan in a ‘black skies’ scenario

• The risk is that Atos’ spending might be higher, given that is has a higher mix of employees in heavily regulated European labor markets

• Even so, €950mm would equate to ~15% of Atos’ current market cap

 

 

While I do not expect Atos to follow in the steps of HP near-term, I do believe its organic growth trajectory will turn negative again in 2016 and core FCF growth will slow materially in coming years, putting its terminal multiple at risk.

 

Management has an “Ambition 2016” Plan...

In November 2013, management announced a slate of ambitious financial targets for 2014-2016.

• Acquisitions have been a clear part of management achieving its ambitions, and over 50% of the anticipated 5% CAGR from 2014-16 for the IT Service segment will be acquired

• The recent Bull and Xerox ITO acquisitions (closed in July ‘14 and June ‘15, resp.) have clearly been steps toward this goal

• However, Atos has been trailing its ambitions with continued organic growth declines for the overall business since 2014

 

 

 

 

...and Recently Raised the Bar for 2016 Guidance

At its June 2015 Analyst Day, Atos provided updated 2016 targets based on its recent Xerox ITO and Bull acquisitions.

• Despite its weak organic growth, management has been running ahead of its Bull cost synergy targets

• Also, Atos recently closed its acquisition of the ITO business from Xerox (in June 2015)

• These two incremental events led management to raise their 2016 guidance at the June 2015 Analyst Day

• Net income is now expected to double over two years, driven by:

• 35-45% from profitability improvement in underlying businesses (industrialization, cost synergies, better mix)

• 25-35% from acquired companies’ margin contribution

• 10-20% from completion of Bull related restructuring by end of 2015 and slower restructuring in onshore countries

• 10-20% from lower group tax profile following acquisitions (tax loss carry forwards in France utilized by Bull)

• FCF is now guided to €500-550mm in 2016 (vs. prior €450-500mm), increased for acquired Xerox ITO FCF of ~€60mm

 

 

 

 

Management’s Organic Growth Prospects

Management bases its 2016 targets on its “digital transformation”, cross-selling opportunities, and business mix shift.

 

Management’s Organic Growth Drivers

• Digital Transformation:

• Atos has a poor organic growth track record (avg. -0.2% p.a. since 2011), but management is focused on acquiring its way into higher-growth markets like Cloud, Big Data & Cyber-security, which accounted for 8% of IT Services revenue in 2014

• Management expects this digital portfolio to grow HSD in addition to general European IT market improvement, driving DD aggregate growth in Big Data + Canopy (Cloud) and more than offsetting any continued weakness in core Managed Services infrastructure outsourcing

• Cross-selling Opportunities:

• Atos plans to do more cross-selling within its installed base, especially among large customers, as two-thirds of its big accounts currently operate in a single service line

• Minimal overlap of its client base with Xerox ITO provides Atos with cross-selling potential within the Xerox installed base

• Management intends to incentivize the sales force by including cross-selling of additional product lines as mandatory criteria for discretionary compensation

• Mix Shift:

• Atos is adding higher-growth segments to its portfolio, such as Cloud services and Big Data & Security, and should see natural growth improvement from faster-growing Worldline

• The Cloud & Big Data segments should benefit from secular trends of increased awareness that data, access to data, and enterprise have to be secured from outside the firm as well as from within the firm

• Worldline should benefit from the standardization of non-cash transactions and higher adoption rates for its digital wallet solution, which management claims is already a leader in wallet solutions for banks in the EU

 

Street View: Organic Growth will Accelerate

• The Street believes in management’s organic growth strategy and expects a significant acceleration over the next few years despite anemic historical organic growth and worsening trends in 1H15

 

 

Variant View: Organic Growth Will Decline

I believe organic growth will decline over the next five years, while the Street expects top-line growth to improve.

 

 

 

Variant View: Organic Growth Model

Atos’ IT Services business will decline at an accelerating rate, driven by declines in traditional ITO within the Managed Services segment, only partially offset by growth in Canopy (Cloud), Xerox ITO, and Big Data & Cyber-security.

 

 

Variant View: Organic Growth Model

Cost synergies and a modest organic growth acceleration underpin the guidance for margin expansion & EPS growth.

 

Management’s Operating Margin Drivers

• IT Services (ex-Bull, ex-Xerox ITO)

• On an underlying basis, management believes they can expand margins through operational efficiency measures and structural factors such as improving offshore leverage in system integration

• As high-growth IT service segments (cloud, big data, etc.) become a larger part of the mix, this should augment margin expansion as pricing in these segments is relatively higher

• Management is also trying to improve underlying margins with initiatives such as restructuring the bonus criteria for the salesforce (i.e. make cross-selling mandatory for discretionary compensation)

• Margin expansion in acquired assets

• Management sees significant potential for margin expansion in Bull and Xerox ITO, primarily through cost optimization measures

• Apart from operational value creation through the consolidation of common corporate functions, real estate, procurement, etc., management believes there is room for underlying margin expansion in Bull and Xerox ITO

• Management expects margins for both assets to move structurally closer to the Atos group level

• Worldline

• The payments business has structurally higher margins relative to IT Services

• Management expects Worldline to benefit from its cost reduction initiative, “TEAM,” which targets cost optimization synergies, while the rollout of the WIPE technology platform standardizes overlapping software modules

• Management believes the key initiatives in TEAM that should aid margin expansion include industrialization of development methods, optimization of development and customer service organizations, and more streamlined infrastructure

• Larger outsourcing deals, faster time to market, sales effectiveness, and better contract profitability should also allow better revenue growth to drop to the bottom line

 

Street View: Margin Expansion Will Continue

• Given management’s strong history on cost cuts / synergy achievement, the Street gives management full credit for their €110-120mm Bull cost synergies and $35mm Xerox ITO cost synergies

• The Street also assumes core Atos IT Services margin (ex-Bull, ex-Xerox ITO) will stay roughly flat yoy in 2016 and increase 40-60bps per year thereafter based on underlying improvement from initiatives     

 

 

Variant View: Margin Expansion Will Be Limited

Operating margin expansion will be limited to acquisition synergies, as core incremental margin opportunity is muted.

 

 

Free Cash Flow Trends Remain Weak

Per my estimates, true Atos FCF is ~30% lower than reported (after backing out one-time items) and continues to weaken, in contrast to the Street’s perception that FCF quality is improving of late.

 

 

Street View: FCF Quality Will Improve

The Street thinks FCF quality will improve as restructuring charges normalize, resulting in 15-20% FCF CAGR for 2014-19.

 

 

Variant View: Free Cash Flow Will Miss Guidance

I believe core Atos FCF growth (ex. M&A) will slow after 2015 and miss management’s targets, even assuming they do a Worldline M&A deal and giving them credit for continued declines in restructuring costs and other one-off charges.

• I believe Atos FCF will miss management’s €500-550mm target 2016, even after a likely Worldline M&A deal and assuming they get continued tailwinds from SBC exercise, asset sales, and declining restructuring costs

• Although FCF conversion will decline to low 70s in 2015-16 due to provision charges, I give them credit for improving cash conversion in 2017 onward as provisions and restructuring charges roll off

• I struggle to hit management’s €500-550mm 2016 FCF guidance, as weak organic growth and operating margins should more than offset the one-off / “Other” FCF tailwinds

 

 

Variant View Summary

I believe Atos will miss its 2016 targets for organic growth, operating margins and FCF due to structural headwinds.

• With pricing pressure on upcoming contract renewals from offshore competition and the secular headwinds from cloud/automation, I believe organic growth will turn negative again starting in 2016

• I believe that eroding contract economics and natural operating de-leverage from negative organic growth will more than offset synergies from Bull & Xerox ITO acquisitions and mix shift, leading to flat operating margins from 2015E levels

• Declining organic growth, flat margins, increasing capex, and declines in cash tailwinds such as SBC exercise will cause FCF to peak in 2016, more than offsetting potential continuation of asset sales and declining restructuring costs

 

Valuation and Risk/Reward

While the Street tends to value ATO on a P/E basis, I believe EV/ULFCF is the proper way to value this business given the recurring nature of restructuring charges and other cash items not captured in Non-GAAP EPS.  On my estimates, ATO is currently trading at 17.5x 2016 EV/ULFCF (incl. Pension, ex. Worldline) at my target €72/share entry price.  At what I believe to be the fair-value multiple of 12x 2016 EV/ULFCF on my estimate of €340mm 2016 ULFCF for core Atos, plus the current market value of the 70% Worldline stake, I believe ATO is worth €54/share (25% upside from my target entry price of €72/share).

 

In a downside case where ATO hits its guidance (and Street’s assumption) for €550mm 2016 FCF, I believe ATO could potentially re-rate to 18x EV/ULFCF which would imply a €85/share valuation (18% downside from my target entry price), so I believe the risk/reward is 1.4x up/down for the short.  The €54 target price would represent a 9x 2016 P/E multiple and an 8.5% 2016 FCF yield on my estimates, which I believe are fair multiples considering ATO traded as low as 8x in 2011 before the cloud threat materialized.  I provide further justification for my valuation multiples below.

 

 

 

 

 

Historical P/E Multiple

ATO trades at 10.7x CY16 consensus P/E – broadly in line with its all-time average P/E of 11.4x, but almost 40% above its last 5-year trough of ~8x (in Sept. 2011) despite growing secular headwinds – and restructuring/one-off charges are increasingly obfuscating earnings.

 

Comps Analysis

ATO trades at a discount to comps on both a P/E and EV/EBITDA basis, but with growing capital intensity and ongoing restructuring charges, I believe a FCF multiple is the proper way to value the business.

• Capgemini (CAP FP) is the closest peer to Atos in terms of geographic and service line exposure

• ATO trades at 10.7x CY16 P/E and 5.1x CY16 EV/EBITDA on Street estimates, a ~30% discount to Capgemini

• However, as restructuring charges and one-off items continue to obfuscate EPS and required capital intensity grows, I believe more Street analysts will begin to value Atos on an free cash flow basis

• Atos currently trades at 14.7x CY16 EV/ULFCF (incl. Pension, ex. Worldline) and 13.2x CY16 P/FCF on Street estimates

• Capgemini trades at 14.2x CY16 EV/ULFCF and 16.3x CY16 P/FCF

• U.S.-based peers HP, IBM, and CSC trade at ~10x CY16 P/FCF

• While an HP-type multiple may not be warranted near-term, I believe 12x CY16 EV/ULFCF is a fair multiple for Atos’ IT Services business given the secular headwinds and peak FCF profile in 2016

 

Atos is Poorly Positioned relative to Capgemini

Capgemini will manage better through the cloud transition than Atos, warranting a higher multiple premium.

• Bulls think ATO’s teens EPS growth over the next three years warrants a multiple more in line with Capgemini (15.6x forward P/E, 16.3x P/FCF), albeit a slight ~15% discount given Atos’ lower growth and margin profile

• However, I believe the historical gap between Atos and Capgemini is only getting wider – CAP has always had higher organic growth, a larger offshore footprint and stronger FCF conversion, but over the next few years, CAP’s scale and industrialization will become more important in allowing it to offset the structural cloud/automation headwinds to a greater extent than Atos can

• Further, ATO has much higher exposure to the primary area of IT spending which is earmarked for savings by CIOs in 2015-16 – Infrastructure Management – as shown below

 

 

Investment Risks and Mitigants

The primary risk to the short is an accretive M&A deal for the Worldline business

1. Accretive M&A at Worldline

1. Management has been looking for an M&A opportunity at Worldline for several years now and is rumored to have at least two potential deals in the pipeline, and they hope to close a deal by 1H16

2. As the highest growth, highest margin segment, accretive M&A at Worldline could drive some 2016 EPS accretion for Atos’ 70% stake and thus some upside to Atos’ stock

3. Mitigant: Atos/Worldline has been routinely outbid by private equity in its search for M&A targets, limiting likelihood of a majorly accretive deal (if any).  Further, Worldline already trades at 12x 2015 EV/EBITDA and 23x 2015 P/E, likely already embedding  a decent probability of a deal in the next few quarters.

2. Better than expected revenue growth and/or margin improvement

1. Meaningful new contracts in MS, projects in CS&I, and/or customers in Big Data, Cloud or Worldline could drive upside to near-term quarterly organic growth estimates and improve operating margins through better segment mix

2. Mitigant: Numerous conversations with Atos formers and experts suggest that business will get materially worse, and the aforementioned secular headwinds will remain a mid/long-term threat even if Atos beats Street estimates for a quarter or two

3. Faster integration and/or higher than expected synergies from the Bull and Xerox ITO acquisitions

1. CEO Thierry Breton is perceived as a merciless leader who has relentlessly and successfully driven costs out of Atos’ organization and its acquisitions (e.g. Siemens, Bull), and current Bull/Xerox ITO synergy guidance could be conservative

2. Mitigant: I model 100% of management’s guided cost synergies from acquisitions, and also layer in Worldline and IT Services acquisitions in coming years at higher margins than Atos’ corporate average for conservatism.  Further upside to synergy guidance is possible but likely not enough to achieve the 50-100bps margin expansion per year guidance.

4. Shareholder-friendly capital return

1. Increased share buybacks and/or dividends could positively surprise investors who have been suffering from M&A fatigue

2. Returning cash flow may demonstrate the value of ATO’s FCF to shareholders in a clearer way given the uncertain timing and impact of value creation from a potential Worldline M&A event (if any)

3. Mitigant: Management has clearly made Worldline M&A its primary (and IT Services its secondary) capital allocation priority for the foreseeable future

 

Future M&A (not modeled by the Street)

• In the near/medium term, management has been clear that any M&A would likely be for the Worldline payments business

• Per Worldline management, the company is looking to pursue a €500mm-1bn EV transaction, and they are willing to lever up to 2.5x net debt/EBITDA and use existing B/S cash in order to complete such a deal and still maintain their credit rating

• Management has been looking for an M&A opportunity at Worldline for several years now and is highly confident that they can sign and announce a Worldline deal before the end of 2015

• Competition for M&A in the payment space remains high, especially from private equity, and management stated that it would carefully weigh the synergies generated from any acquisition with the price/multiples paid

• As the highest growth, highest margin segment, accretive M&A at Worldline could drive some 2016 EPS accretion for Atos’ 70% stake and thus some upside to Atos’ stock

 

• The Street does not model in any M&A in their estimates

• For conservatism, I model a Worldline deal at year-end 2015 (hitting the P&L in 1H16) and an IT Services deal in 2018

• However, as I show below, even assuming Worldline closes a €750mm EV deal by year-end 2015, the deal would likely only be MSD accretive to Atos FY16 EPS at current M&A multiples – an upside risk that I’ve embedded in my base case financial projections

• Worldline and IT Services deals would likely only yield ~6-7% accretion per deal to core Atos EPS based on Atos’ M&A capacity and IR commentary on recent transaction multiples

 

 

Management and Organizational Issues

• Atos’ CEO’s Thierry Breton is known in France as a “turnaround whiz”, having turned around several sluggish French businesses (Groupe Bull in 1993-96, Thomson-RCA in 1997-2002, France Telecom in 2002-2005, Atos from 2008-Present)

• Breton is worshipped in France – he is very well plugged in, supported by the former AXA CEO (the “Godfather” of French business), and was French finance minister from 2005-2007

• Upon joining Atos in 2008, the CEO believed it was “managed too compartmentally” with operating margins well below peers, requiring a complete transformation plan

• Since joining as CEO, Thierry Breton has lifted margins by 480bps between 2008-2013 (on a pro forma basis), continuing the record of tight cost discipline he started in the 1990s

• Analysts believe that, with the CEO remaining at the helm, Atos can achieve gradual top-line improvement and ongoing margin expansion through acquisition cost synergies (1)

• However, my checks indicate that the Atos organization is very French-centric, bureaucratic and slow to innovate and react to market changes like the shift to cloud/digitalization

 

“The CEO is coming toward the end of his dream…he probably has another 18-24 months before he takes a supervisory role or gets back into politics.  He has been a merciless leader…his style has been very aggressive but this will have to change for them to continue to compete. They’ve already hit all their previous long-term targets…they will struggle to compete against CGI and others globally.

 

“If you look at the board, these key people need to see some attrition for Atos to get global perspective.  The Board is too local and French-centric to be a global competitor.  No clear replacement for the CEO who can keep taking out costs like they have been.”

 

- Former VP and Head of SAP at Atos Origin, 2011-2013

 

Capital Allocation History & Priorities

Capital Allocation History

• Historically, ATO has used FCF primarily to fund capex (~4% of sales) and acquisitions in IT Services

• In May 2014, ATO approved a share buyback program of up to 10% of outstanding shares

• ATO repurchased shares for €116mm and €235mm in FY13-14 (5% of market cap), using all of its buyback authorization, and has done no buybacks in FY15 YTD (they are building cash for a hopeful Worldline deal)

• ATO pays out 25%  of diluted EPS in dividends and currently has a ~1% dividend yield

 

Capital Allocation Priorities

• Management does not expect sizeable acquisitions in the IT Services business in the near term, as they are busy integrating the Bull and Xerox ITO deals

• However, M&A remains a key focus in Worldline (10% of ATO’s 2014 revenue) as it tries to build scale

• From a balance sheet standpoint, at year-end 2016 ATO should have €900mm-1bn in net cash, providing it with sufficient firepower to pursue incremental M&A

 

 

Catalyst

 

While I believe ATO will be much more of a “slow grinder” type short over the next 12-24 months, I would not be surprised by one of the following catalysts:

• Company suffers a recurrence of recent large customer contract losses or renewals at weak economic terms in 2016
• Company continues to incur restructuring costs in excess of guidance (especially if/when Worldline completes an acquisition which will require integration costs), pressuring FCF and derailing buls’ hopes for improving FCF quality
• As a result of any of the above, the Company misses and/or reduces its 2016 organic growth, EBIT margin and/or FCF targets
• CEO Thierry Breton leaves the Company (possibly to go back into politics) within the next 18-36 months, derailing management’s ongoing restructuring and margin improvement plans