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CGI's 'build-and-buy' strategy has firm on the offensive

CGI CEO Michael Roach.

A year ago, shares of CGI were flying high on rumours that Canada's largest independent IT services company might be fodder for bigger players.

Cisco Systems Inc., Microsoft Corp. and International Business Machines Corp. were billed as potential acquirers, but CGI's boss dismissed the chatter, vowing to be the consolidator rather than someone else's dinner. Chief executive officer Michael Roach said his "build-and-buy" strategy would bring far more value to shareholders than a sellout.

Today, CGI has a $903-million (U.S.) offer on the table for Stanley Inc., a mid-tier firm that would significantly increase CGI's presence in the U.S. market, especially for federal government contracts. And although Mr. Roach hasn't yet come close to his goal announced three years ago to double the company's size by 2012, the market has rewarded his strategy with solid, steady gains.

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Shares of CGI are up 53 per cent over the last year and up 28 per cent since last September when Mr. Roach dismissed the rumours and re-affirmed his acquisition plan.

Among the 15 analysts covering the stock, nine rate it a buy and six a hold. Yesterday, Dushan Batrovic, of Dundee Securities Corp., lowered his rating to "neutral" from "buy." Similar to some other analysts who are cautious on the stock, he says his concerns are the valuation of the shares as well as the broader economic climate, rather than significant worries about CGI's performance.

Mr. Batrovic has a 12-month price target of $17 (Canadian) on the stock. At its most recent price of $15.86, the stock trades at about 13 times future 12-month earnings. "While we like the Stanley acquisition and CGI has historically proven to be a solid defensive holding, we believe that valuation levels are reasonable," he wrote.

CGI provides technology services such as systems integration, consulting and outsourcing, deriving most of its revenue from government contracts as well as business from the health care sector and financial services companies.

Conditions over the past year have been rough in the global IT services market, with organizations delaying implementation of projects during uncertain economic times, or negotiating lean prices. The sector actually shrank on a global basis last year by 2 per cent, according to the research firm Gartner Inc.

We believe Stanley is a solid acquisition for CGI and a good use of its cash flow to generate profitable growth. Maher Yaghi, Desjardins Securities analyst

CGI, based in Montreal, has managed only slim growth, expanding by about 3 per cent over the past three years. As a result, it remains a small player in an industry that is dominated by a handful of consolidating goliaths, which include International Business Machines Corp., Hewlett-Packard Co. and Accenture PLC.

The growth rate is a long way short of Mr. Roach's ambitions. While CGI has spent about $2-billion on acquisitions over the past decade, it has not completed any significant acquisitions in more than three years.

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In May, CGI finally stepped up to the plate, with its almost $1-billion offer for Stanley Inc. The Virginia-based firm supplies defence, intelligence and cyber security IT services to the U.S. government. At about $37.50 (U.S.) a share, the transaction would represent a 29-per-cent premium to Stanley's stock price at the time of announcement. CGI says the deal will be accretive to earnings in the first year. It has extended its tender offer until July 9.

Mr. Batrovic said he has "modest enthusiasm" for the deal, but added that the true value of the marriage remains to be proven. "While we find the qualitative factors compelling, we are not enamoured by the numbers. We calculate that the combined entity is only modestly more accretive than a standalone CGI that is aggressively repurchasing its own stock," he wrote.

The proposed Stanley deal will tip the balance on geographies, making the U.S. CGI's biggest market, followed by Canada. Maher Yaghi, an analyst with Desjardins Securities Inc., estimates that the deal will boost CGI revenue by 25 per cent in 2011, to $4.84-billion (Canadian), and raise share profit to $1.37 from $1.25. The transaction will leave CGI with a net debt to capitalization ratio of less than 30 per cent. Strong cash flow and $600-million of liquidity under $1.5-billion credit facility will leave the company in a good position to make further acquisitions, he said.

"We believe Stanley is a solid acquisition for CGI and a good use of its cash flow to generate profitable growth," Mr. Yaghi wrote. He initiated coverage on the stock last month with a "hold" rating and a price target of $19.

Without the acquisition, the consensus among analysts is for CGI to see revenue decline nearly 3 per cent this fiscal year, ending September, and profit rising 14 per cent.

"Over all, we believe industry trends and recent events are positive for CGI's future growth prospects," Mr. Yaghi said. "[But]we would rather wait for a better entry point before becoming more bullish on the stock."

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