Capgemini: not enough visibility in current climate

Capgemini has gone back on its previous expectations of modest growth in the first half of 2009, following a significant deterioration in the wider economic environment since the third quarter.

The company now expects to see a modest decline in first-half sales, while maintaining an operating margin of 6.5%. Worryingly for investors, CEO Paul Hermelin said in a statement, 'In a climate of high uncertainty, the Group considers that it does not have enough visibility beyond the first half.'

This is hair-raising stuff, and certainly backs up what we've been expecting for some time now - that IT service providers will find life decidedly tough from now on. Investors thought so too, sending Capgemini's share price down 6% once the company released its year-end results.

Hitting the numbers in 2008, but 2009 will be tough

Capgemini performed well in FY08, in line with expectations. The operating margin (before any write-offs and related business charges) was 8.5%, while revenues were up 5% to €8.71 billion. However, this growth in revenues was largely down to benefits gained from the appreciation of the euro against the US dollar and pound sterling, where Capgemini makes more than 40% of its revenues. At constant currency revenue rates, the company would actually have been flat in 2007.

It is in 2009 when Capgemini will come under considerably more pressure. On a geographic basis, North America (full year 2008 up 3.4%) is already under pressure, having seen a drop in revenues in Technology Services as a result of difficulties in the financial services sector, as well as a strategic shift to use resources in India.

Meanwhile, UK revenues fell 0.5% due to the expected reduction in spend from main customer HMRC. Likewise, Germany and central Europe look weak following a flat 4Q08 versus Q308.

TXU termination will hit outsourcing pipeline

One of the significant issues likely to affect Capgemini in 2009 is the early termination of its $3.5 billion mega-deal with US energy group EFH (formerly TXU), following the decision by new owner EFH to bring the service back in-house. Capgemini will now have to remove €1.15 billion from its outsourcing pipeline.

Despite this, outsourcing remains an extremely strong performer for the group. Excluding the impact of EFH, the pipeline was up 33.6% at €6.6 billion in FY08. Factoring in the EFU impact, however, brings the pipeline down to €5.4 billion (7.8% growth). Either way, it demonstrates that the group's outsourcing activity remains relatively buoyant, at least for the moment.

Capgemini expects to take a $180 million revenue hit from EFH in FY09, and this has already been factored into the first-half revenue expectations.

Taking pragmatic steps to counter downturn

Capgemini is focusing its attention on some key areas. The group is aggressively going to push sales, and has a €70 million fund put aside to drive forward on new opportunities. We expect the focus to be on IT outsourcing, offshoring and business process outsourcing, particularly in the public and energy and utilities sectors.

As we have said before, in times of economic recession, IT service companies are going to need to focus their attention firmly on counter-cyclical activities such as these, which are able to deliver rapid and tangible cost reductions for clients (as well as industries that still have growth potential in a recession, such as government).

 

Perhaps the most important steps to be taken are going to be offshore. In a conference call, group strategy director Martin Cook said that demand for offshore services is 'higher than ever,' and he consequently plans to accelerate the company's plans for offshoring during 2009. Cook's ambition is to have 40,000 people located in lower-cost locations such as India by 2010, which will mean growing significantly during the next two years from its current offshore headcount of 25,000.

Capgemini is doing this with a close eye on maintaining its margins, and a focus on globalising its internal processes (such as moving 220 support staff offshore).

Where we see weakness for Capgemini is in its exposure to local professional services or body-shopping (Sogeti), as well as consulting and technology services. Revenues from local professional services, for instance, were down 1.7% from 1H to 2H08; consulting fell 10%; and technology services were flat over the same period.

We see this trend only continuing in 2009. How severely it impacts Capgemini and its competitors will depend in part on just how long customers delay funding decisions on short-term or discretionary IT and consulting projects. Fortunately for Capgemini, more than half of its business is from its more stable areas such as outsourcing, public sector, and energy and utilities. The company's plan to accelerate its sales efforts in these areas is a reasoned approach to weathering the ongoing economic storm.

John O'Brien, Analyst and Service Manager

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