Description

Investment Thesis

Atos is a quality company at a bargain-bin price. Atos is a French IT services business with a 10-year history of double-digit earnings growth, trading at only 7.3x forward earnings, with a slight net cash balance. It is a technology outsourcing and consulting company that helps its clients manage mission-critical services, like cloud migration, cybersecurity, and app development and maintenance. 70% of revenue is recurring in nature, the retention rate is high, and it is a people-based business, resulting in a mostly variable cost structure. A few recent controversies, which I discuss below, have depressed the stock price, which creates a great opportunity.

I think of Atos as a problem solver and IT partner for its clients. It is a high-quality business that also benefits from secular growth in outsourced technology services, as companies need help evolving in the digital world. Atos should benefit from several secular tailwinds, including momentum in digital, cloud, cybersecurity, and decarbonization. In fact, their business mix has shifted from just 40% of sales in 2019 tied to these segments, to over 50% today and a target of 65% over the next few years.

Atos will also benefit from the increased interest in responsible investing. Atos is a global leader in environmental sustainability, with the most aggressive decarbonization goals in its industry and a consulting group to help customers reduce emissions.

Business Overview

Before I get to the controversies, I will give you a quick review of the business. The company now reports by industry, but their prior segments are most useful for describing the business.

Infrastructure & Data Management – 55% of sales. Atos handles a wide range of tech and communications services, predominantly for larger, multi-national corporations. This includes cloud and data center management, workplace services like remote desktops, and network operations. This segment has been, and is expected to have flattish sales as the composition has shifted towards fast growth in cloud management, offset by datacenter and mainframe sales declines. In this segment they compete with IBM, DXC, and other local (regional) companies.

Business & Platform Solutions – 34% of sales. Atos manages a mix of recurring and project-based solutions like app development and maintenance, AI and Analytics services, and other professional services. Sales in this segment should grow mid-single-digits over time.

Big Data & Cyber-Safety – 11% of sales. This is Atos’s fastest growing segment, which has grown by about 15%, annualized, over the past five years and is expected to grow at a double-digit rate for the medium term.

Overall, the business should grow low-single digits, supported by bolt-on acquisitions, which should drive further revenue growth. 

Controversies

There are three main controversies that have weighed on the stock recently, driving it down 25% year-to-date.

#1: Exposure to Legacy Datacenters

Despite a history of strong execution and exposure to durable future growth, Atos trades at a discount because of its legacy exposure to private data centers, which are disappearing in favor of the cloud. But this exposure is overstated, in our opinion. Only 10% of total company sales are exposed to classic data center and mainframe operations. And more than 70% of their customers have already converted to a hybrid cloud architecture.

Atos has more exposure to the fast-growing area of cybersecurity—where it is #1 in Europe—than it does to legacy infrastructure, but the market valuation does not seem to reflect this yet.

Part of this misunderstanding comes from comparisons to DXC, which we estimate has at least one-third of its business tied to declining legacy data center infrastructure. The other part of the misunderstanding is that when a company shifts their platform/services to the cloud, they still need a partner like Atos to manage that cloud architecture. With AWS, Google, or Azure, larger clients often need someone to help manage the business. The large cloud providers offer capacity and flexibility, but there is still customization that needs to be layered on top of that relationship. This is labor intensive and lower margin than what the cloud providers enjoy, so they are not looking to come after this piece of the supply chain. 

#2: Accounting Issues

On April 1, 2021, Atos releaseda statement that its auditors issued a qualified opinion on its financial statements for the year-ending 2020. The issue was isolated to just two legal entities in the US (both at the same street address), which account for about 10% of both sales and operating profit. It appears to be related to timing of revenue recognition, related to contracts with multiple elements. While this is a negative, I have seen similar situations at FLEX and TECD in the past, that ultimately were not material. With the 1Q21 results announcement in late April, the company confidently stated that the misstatements were not material to the consolidated financial statements.

On top of the qualified opinion, CFRA has been vocal about issues with Atos’ accounting, specifically around “recurring, non-recurring items”. To some degree, I agree and hit the company for about 1% of sales tied to ongoing restructuring efforts. Yet, I also think many of Atos’ accounting choices make economic sense and are tied to its transition away from traditional IT infrastructure and towards a digital world. Below are two examples.

First, I think it makes sense to exclude amortization of intangibles. It’s true that the company has completed a series of deals over the past several years and will likely complete additional deals going forward. But, these deals are not required to support organic growth, so I believe the expense should be excluded from earnings and naturally from free cash flow. Second, Atos has shown an increase in capitalized development costs, compared to amortization. But, again, this is being supported by the transition away from on-premise IT infrastructure to a digital business focused around cybersecurity and application development. In spirit, capitalizing some of these expenses makes sense.

I think this is a case of missing the forest for the trees, especially in light of the stock’s valuation. If Atos were a shrinking business, these findings would be concerning. But, it is an organic grower and a lot of these accounting decisions align with the transition and investment in future growth.

#3: DXC Acquisition

Last, Atos created a stir when, in early January, the press leaked that Atos was conducting due diligence into acquiring DXC, driving the stock down 13%. Yet, in early February, when Atos announced that it was walking away from the deal, the stock did not budge.

Historically, Atos has been a good capital allocator and we view this decision process is consistent with that. Atos explored a stock that is down 70% from its peak but walked away because it didn’t like what it found. In short, after looking deeper into the business, they found a much higher concentration of traditional, declining IT infrastructure assets and relationships. They also realized that DXC had been starving the company of new investments, to support profits, and that strategy has left DXC in a challenging position.

I think the market got spooked by the announcement earlier this year but failed to reassess the situation after Atos removed interest.   

ESG/Impact Opportunity

As we all know, the market is becoming increasingly focused on responsible investing, putting a premium on businesses that help solve the world’s problems. Atos is a classic sleeper impact stock that’s generating positive change but has not yet been rewarded for it.

Atos’ core business attacks three key global problems: growing IT emissions, increasing cybersecurity breaches, and decarbonization challenges. These problems are outlined below:

IT Emissions: the rapid growth in data consumption, globally, results in a need for more and more data centers and infrastructure. The IT sector already accounts for 4% of total global emissions and this is expected to rise to 8% in 10 years.

Cybersecurity breaches: as we shift more critical data online and to the cloud, we are creating more risk around cyber attacks, which cost enterprises an annual $600 billion in lost value. 57% of companies worldwide reported an IT breach of some kind from 2017 to 2019.

Decarbonization challenges: While companies are more eager than ever to reduce emissions, they also typically have limited internal ability to implement emissions reduction plans.

Atos helps solve these problems in the following ways:

IT Emissions: Atos digital solutions can reduce customer carbon emissions by 20% or more, through programs including: cloud migration, IOT initiatives and edge computing, more efficient data center utilization, energy and consumption analytics, recycling protocols, hardware upgrades, and more. Just shifting a customer to the cloud from on-premise data management can reduce total emissions by 28%.

Cybersecurity breaches: Atos is the #1 Cybersecurity services company in Europe and #3 in the world. Atos helps to protect what is often their customer’s most valued assets: their IP and data. The company also helps to safeguard the privacy of our personal data around the world. Beyond simply being defensive, Atos’s cybersecurity business is also an enabler of global commerce as it allows companies and people to feel safer transmitting and storing data. Security concerns, for example, are a key roadblock for firms to transition data away from on-premise storage. 65% of organizations globally report a shortage of staff to help with cybersecurity, indicating that Atos fills a critical need.

Decarbonization challenges: With its EcoACT business, Atos has a consulting and analytics division that focuses purely on helping its customers attack their own ESG initiatives. While this is small relative to the size of Atos, they are an early leader in the space and are growing rapidly. 77% of Atos customers have set their own internal decarbonization efforts, and Atos is uniquely positioned to help them achieve their goals as a data and analytics partner with a long history of successful decarbonation and circular economy initiatives.

Valuation

With a deep value stock like Atos, I like to use the concept: “Enough precision for the decision”. At under 8x and no net debt, the stock is cheap. Even after adjusting for “recurring non-recurring items” I believe there is significant upside.

Giving them credit for their 11.5% target margin (current margins are depressed, connected to COVID), but hitting them 1.00 per share for exception items, results in five-year forward earnings power of about 12.00. 

Putting a 9x multiple on that (consistent with ~15x forward earnings) results in about 90% upside to fair value.

Catalyst

Resolution of accounting issues

Organic sales growth