Description

Sopra Steria is an IT consulting and system integration services provider which trades on the Paris stock exchange.  The company’s revenues are split 50%/30%/20% between France, Western Europe and the UK.  Our Long thesis for SOP is that it is a decent business, that can grow earnings at 10% cagr in our downside case and up to 25% cagr in our upside case over the next five years yet trades for a PE multiple of about 10.5x on 2018 earnings and 8.5x on 2019 earnings. 

The market is offering us this business for such a cheap multiple due to recent issues at a segment that makes up only 12% of the company’s EBIT. We think the problems there are temporary and fixable.  Even if this view turns out wrong, we see the rest of the company supporting 10% or more total company earnings growth per year. An investment in SOP today is therefore a case of heads we win and tails we don’t lose (and probably win as well), thanks to the low entry multiple and the favorable performance of the bulk of the business.

            Shares of SOP fell 35% in October when the company announced a reduction of its EBIT target for 2018 from e340mm to at least e300mm, or a drop of 12%.  The cause for the reduction in guidance was in the company’s Banking Solutions division.  This is a unit that develops software in-house at SOP.  While 85% of the SOP’s total business is consulting and system integration services, 15% is tied to home grown software offerings. The Banking Solutions division makes up about 65% of the software operations, or 10% of Sopra’s total business. As such, the problems that drove the sharp decline in SOP’s multiple were related to a narrow and standalone part of the company’s operations.  The rest of SOP performed at or better than expected.

            The issue in the Banking Division originated from two sources – one, is management failure to secure enough license sales for 2018. This shortfall accounted for e17m of revenues at around 90% drop through margins. Another e10m of negative EBIT effect rose from failing to meet implementations at customers for a product SOP acquired two years ago when it took over a company called Cassiopeia.  Cassiopeia has benefited from accelerated growth of around 50% since Sopra integrated it into its sales force. However, management did not establish good controls of the delivery of projects to implement Cassiopeia’s products at new customers (these are large products for specialized credit loans used by banks).  As a result, management realized they needed to beef up their delivery team and slowdown recognition schedules for ongoing engagements in the pipeline.   In total management’s screw up forced them to increase spending by e15m beyond budget.  Consequently, they had to reduce the Banking Solutions expected EBIT outlook for 2018 from 30m to negative e12mm euro.

            We view the issue at Banking Solutions as transitory. We recognize they indicate the possibility of weak managerial talent at the divisional level and lax performance on behalf of the CEO of SOP. However, Sopra is really led by its founder and active Chairmen, Mr. Pierre Pasquier, who still owns 20% of the business. Mr. Pasquier has proven to be a talented businessman and capital allocator over time and has built Sopra into a dominant no 2/3 player in the French IT services market. Sopra is his life’s work. We doubt he will let the Banking Solutions division kill his “baby” and destroy 40% of his net worth. Mr. Pasquier will see that the Banking Solutions division returns to profitability (Sopra target 15% margin), or he will close this operation, thereby zeroing out e12mm of negative EBIT loss. 

In our downside case we assume SOP earns no EBIT from the Banking Solutions division by 2021. In our upside case we assume SOP turns around this division and manages it for 13% margin in line with with past performance and below management Long-term goals. We also think 13% EBIT margins are reasonable levels to expect from a software operation with >e400mm of revenue and 50% sales from licenses and maintenance.

In terms of the rest of the business, we see SOP as a decent company. The consulting sub-segment is growing at double digit rates, while the System Integration unit is growing at mid-single-digits.  Together they make up 80% of the company’s EBIT. SOP commands a leading brand in France which makes up 40% of its overall EBIT. France is a closed market for most offshore IT providers due to language barriers (business is done in French and not in English) and SOP’s competitive standing is strong in its core market. In the rest of Europe, SOP is growing share from a small base with revenues expanding at 11% in 2018. Overall, we see the Consulting and System Integration operation in Europe growing revenue and EBIT at 5%/8% in the next five years. As for the UK, which makes up 15% of companywide EBIT, around 60% is tied to long-term government BPO mandates and 40% to commercial work.  We underwrite this business to be about flat over the next five years as the commercial business gets hit by Brexit, while the government business benefits from continued outsourcing of IT processes at a moderate rate.

Taken together our downside case is for SOP to expand EPS by 10% into 2023, from a combination of single-digit revenue and EBIT growth coupled with use of cash.  In the event of a recession in the interim, we note that Sopra’s business fell only 3.5% in terms of organic revenues and 14% in terms of EBIT in the 2008 recession (viewed on a proforma basis for the large Steria acquisition SOP did in 2014).  This resiliency is based on the sticky operational nature of the systems that SOP maintains for its clients. A mid-cap business driving 10% EPS growth, which is resilient to the macro environment, should command at least 14 times forward earnings. That would yield a target price of e200 or +110% upside to SOP’s current share price in four years for an IRR of 20%.

In our upside scenario, SOP will drive EPS growth of 25% thanks to a positive swing of 89m in the EBIT of the Banking Solutions division between 2018 to 2023.  Applying a multiple of 16x we get a target price of e440 or an IRR of 45%.

All in we think the risk-reward for owning SOP at its current price is very favorable with limited downside over time.

Catalyst

Fixing Banking Solutions or closing it down

Disclaimer: we are long the stock