By just about any measure, it should not have been considered a huge setback.
Last month, CGI Group Inc. -- Canada's leading home-grown computer services firm -- announced the termination of its largest contract in the United States: a 10-year, $380-million (U.S.) deal to provide information technology support services to Fireman's Fund Insurance Co. of California. CGI was only three years into its relationship with Fireman's when the latter -- in the throes of major cost cutting under a new chief executive officer -- started demanding greater price reductions than the former was willing to concede.
But the net negative impact going forward is only $200-million (Canadian), a small dent in CGI's total backlog of contracts of $13-billion.
However modest the loss, the optics, as they say, aren't good. The result of CGI's $515-million takeover of IMR Global Ltd. three years ago, the Fireman's contract was billed as a foundation on which to build the business in the critical U.S. market. "The key account from IMR was Fireman's," says Nigel Wallis, senior analyst of professional services at IDC Canada Ltd., an arm of the international consultancy. Losing that contract may not have come as a huge surprise, given the drastically changed circumstances at Fireman's, "but it's not a good omen," Mr. Wallis concludes.
If nothing else, a parting of the ways with Fireman's -- not to mention the loss of more significant accounts the relationship might have brought down the line -- underscores the inherent uncertainty of long-term contracts with big-ticket clients: They aren't always bedrocks of reliability. All players in the fiercely competitive sector must live with the possibility of losing some big ones now and then. International Business Machines Corp. discovered that recently when J.P. Morgan Chase & Co. pulled out of a $5-billion (U.S.) seven-year outsourcing agreement after J.P. Morgan's merger with Bank One Corp., a union that brought new technology assets and a management decision to reel IT services back in-house.
But on a deeper level, the cancellation of the Fireman's deal is raising serious questions about CGI's leadership -- more specifically, about how effectively company founder, chairman and CEO, Serge Godin, is spearheading its global expansion.
It was Mr. Godin, who turns 55 next week, who orchestrated two major U.S. acquisitions: IMR Global in 2001 and, last May, the $586-million purchase of Fairfax, Va.-based American Management Systems Inc. (AMS). Those deals helped vault CGI into IT's major leagues, expressing Mr. Godin's single-minded determination to become one of the top players in global services, right up there with Electronic Data Systems Corp. and IBM Global Services.
But now, some observers are voicing doubts. Has Montreal-based CGI made the best use of its capital and resources? Did it pay too much for these acquisitions? Does too much of its revenue growth now derive from takeovers and too little from organic development of its markets?
"The stock has grown phenomenally" since CGI went public in 1986, concedes Paul Bradley, director of research at Fraser Mackenzie Ltd., the Toronto institutional investment brokerage. "Certainly, an investor in CGI was getting very good returns from the early '90s to the late '90s. But returns have not been very good between 2000 and now," he notes. "And that coincides with the IMR and AMS acquisitions."
The crux of the matter, as Mr. Bradley sees it, is that in its quest to play in the big leagues, CGI might be paying too high a price for its acquisition of high-profile players like AMS. Such firms bring critical mass and clout, but they also require an enormous amount of work and capital to be integrated.
"The amount of capital invested [by CGI]has gone up dramatically in the last four years," Mr. Bradley observes, "but the return is not much better than the cost of capital." That may leave savvy investors wondering if CGI is really the best place to park their cash, he adds. In integrating a company like AMS, which yields lower margins than CGI, "you need to make those assets work harder to generate higher rates of return."
Seated in his corner office at the low-rise headquarters on a posh stretch of Sherbrooke Street West, Mr. Godin offers a succinct analysis and defence of CGI's expansion logic: "We were condemned to grow." In other words, if you want to be taken at all seriously in the major leagues of IT's outsourcing and services business, you had better build the requisite critical mass.
According to Mr. Godin, CGI has been making a more concerted effort to renegotiate underperforming contracts and jettison those that fail to improve. And since the AMS deal, he boasts, CGI has doubled its size in revenues in the United States and Europe. This, along with its clout here at home, allows the company to pursue even bigger contracts, he says.
As for the IMR Global play, it yielded an important dividend: a beachhead in India, a software development and services centre in Bangalore, one of the capitals of so-called offshore IT outsourcing. At the time, some analysts questioned the wisdom of the acquisition. But Mr. Godin says the more relevant question to ask today is: "What would the cost be for CGI to not have any centres of excellence in India? It was a decision that we could not miss out on."
Conceding that CGI may have overpaid a little for IMR Global, he insists the return on investment has been excellent -- if, for nothing else, than the lucrative contracts ($85-million) with the U.S. Department of Housing and Urban Development (HUD). The work is actually performed in India -- there, CGI now has about 650 people and expects to have 1,000 by the end of next year -- a rapidly rising market for "offshoring." U.S. customers are especially enamoured of the high-quality, low-cost work available from the Indian subcontinent, Mr. Godin says.
More broadly, he adds, CGI can't afford not to be right in the thick of battle against its competition -- including the likes of EDS, Perot Systems Corp. and Computer Science Corp. -- offering a full mix of onshore, near-shore and offshore services that clients can choose from like a cafeteria menu.
(Mr. Godin, by the way, doesn't like the politically charged word "offshore." The loss of high-paying computer services jobs to India and other overseas locales was a hot issue during the U.S. presidential election campaign and is a growing topic of debate here in Canada. Mr. Godin prefers to refer to it as doing work "remotely.")
One example of a near-and-offshore combination is a CGI contract to provide risk-management services to a New York City financial services firm. A smattering of low-cost work is performed offshore in Bangalore, but the client also benefits from the lower Canadian salaries of about 80 people stationed in Montreal. Working with the New York company, the Montreal team is a hybrid of MBAs, PhDs and IT types, CGI spokeswoman Eileen Murphy says.
In this way, CGI can do lower-margin commodity stuff -- basic computer services like software applications -- in India, while honing and selling skills in more advanced, higher-margin areas like financial services, business planning and accounting in Europe and North America.
A key element in CGI's strategy of climbing the value chain is deepening the customer relationship. First, you win a basic contract, such as providing payroll processing. Then, after establishing a solid bond, you are -- in an ideal world -- positioned to offer other, more lucrative deals.
Consider the case of GrafTech International Ltd., a carbon and graphite products manufacturer in Wilmington, Del. After wedging its foot in the door with an IT outsourcing contract, CGI went on to forge a new agreement to assume control of GrafTech's finance and administrative functions, setting up international service centres in Canada, Mexico and Europe as a virtual support network for the company's financial management team.
All well and good, but CGI's continued reliance on growth by acquisition remains a source of concern. Since going public 18 years ago, CGI has made more than 60 takeovers and has a proven track record as a disciplined, careful manager of acquired companies and their integration.
However, "CGI's growth has historically been balanced between organic and acquisition-related expansion," Merrill Lynch & Co. Inc. analyst Edward Maguire wrote in a recent research report. "As organic growth has slowed in recent quarters, acquisitions have become the primary contributor to growth. Greater reliance on acquisitions increases risks as integration efforts (including divestiture of unattractive businesses) weigh on margins and organic growth efforts."
Another analyst, Research Capital Corp.'s Wojtek Nowak, defended the strategy. "I'm sure a lot of investors don't like the fact [CGI]has been growing by acquisition," he allowed. "But does it really have a choice?" CGI lacks the brand-name recognition of some of its bigger rivals and is at an awkward stage in its development, Mr. Nowak said. "They're too big to be one of the small local guys, but too small to be one of the big global guys. So continuing to grow by acquisition seems to make sense."
For Mr. Paul Bradley of Fraser Mackenzie, CGI could do worse than follow the lead of rival Computer Science. The U.S. giant has embarked on a well-received campaign to improve capital efficiency through more selective investments and the upgrading and pruning of assets. CGI has reached the stage where it would make good sense for it to reassess the way it integrates its merged companies, Mr. Bradley says.
"As you get bigger and bigger, it becomes harder and harder to run a decentralized empire. You need to become more centralized. I understand their not wanting to quash the entrepreneurial spirit in the companies they acquire," he continues, but at what cost to capital efficiency, and thus to the stock? "To achieve their objectives, they've paid a high price."
CORPORATE OVERVIEW
Revenue $-million
Q3-'03
$707.1
Q3-'04
$867.1
EBIT margin $-million
Q3-'03
11.3%
Q3-'04
9.7%
Cash reserves: Provided by continuing operating activities ($-million)
Q3-'03
$117.3
Q3-'04
$67.2
Backlog of signed contracts: $-million, annual results for fiscal year ended Sept. 30
2000: $7,000
2001: $9,300
2002: $10,400
2003: $12,300
Q3-'04: $13,200
Business mix
By revenue
Systems integration and consulting 42%
IT and business process services outsourcing: 58%
Geographic mix
By revenue
United States: 31%
Canada: 62%
Other regions: 7%
Client sectors
By revenue
Government & health care: 25%
Telecom & utilities: 24%
Financial services: 35%
Retail & distribution: 10%
Manufacturing: 6%
CGI Group
Daily close, GIB.A - TSX
Yesterday's close: $7.95, up 5¢
Bertrand Marotte