Computer Sciences' Savvy Strategy


By Stephanie Crane Standard & Poor's Equity Research Services expects Computer Sciences (CSC

; recent price, $49) to benefit from upward momentum in demand for so-called business-process outsourcing and for info-tech infrastructure. We also expect Computer Sciences to take advantage of solid demand from government, where a focus on defense, homeland security, as well as cost savings and operational efficiency, is driving IT outsourcing contracts.

We also believe Computer Sciences' ability to use global positioning technology to leverage cost and pricing efficiencies across emerging markets will help it bolster operating margins in the face of competitive pricing. The stock carries S&P's highest investment recommendation of 5 STARS, or buy.

Computer Sciences offers a broad array of services to clients in global commercial and government markets. It specializes in complex IT -- such as business-process outsourcing, IT applications, and professional services -- to help its customers achieve their strategic objectives. In fiscal 2004 (ended March), 67% of revenue came from the U.S., 25% from Europe, and 8% from other countries.

DOING IT ALL. In March 2003, Computer Sciences acquired DynCorp, a provider of systems, services, and outsourcing to the U.S. government. In our view, the deal bolsters its position in the federal marketplace and provides an opportunity for diversification into new markets.

Outsourcing (45% of revenue in fiscal 2004) involves operating all or a portion of a customer's technology infrastructure, including systems analysis, applications development, network operations, desktop computing, and data-center management. Computer Sciences also provides business-process outsourcing, which involves managing key functions for clients such as claims processing, credit checking, logistics, and customer call centers.

IT and professional services (55%) includes systems integration, consulting, and professional services. Systems integration involves designing, developing, implementing, and integrating complete systems. Consulting and professional services includes advising clients on the strategic acquisition and utilization of IT, and on business strategy, security, modeling, engineering, and business-process reengineering.

BIG CHECK IN THE MAIL. Computer Sciences also licenses sophisticated software systems for health-care and financial-services markets, and it provides a broad array of end-to-end e-business services to meet the needs of large commercial and government clients.

The customer base is divided between the global commercial market (58% of fiscal 2004 revenues) and the U.S. federal government (42%). The former offerings are marketed to clients in a wide variety of industries, including aerospace/defense, automotive, and consumer goods. Computer Science's largest commercial contract award in fiscal 2004 was a 10-year, $2.4 billion deal to manage the IT operations of Royal Mail, Britain's postal service.

In the U.S. federal government market, Computer Sciences provides traditional systems integration and outsourcing for complex project management and technical services. It has extensive experience in developing software for defense and civil agency applications, and it provides systems engineering and technical assistance in network management, satellite communications, aerospace, and related high-tech fields.

SKITTISH CIOs. One factor in S&P's favorable opinion: recent comments from Computer Science's management reaffirming that it sees signs of stability within the consulting industry, which, specifically in Europe, had been showing some weakness. It also noted continued upward momentum in IT and business-process outsourcing in Europe and the U.S.

The weakness in consulting contracts, in our opinion, comes from corporate CIOs' hesitation to devote capital spending beyond the needs of security, disaster recovery, and Sarbanes-Oxley compliance. As a result, demand for consulting contracts is increasing within these three specific segments. We also believe CIOs are paying attention to replacing existing IT assets (particularly systems in operation prior to 2000) and transforming existing IT infrastructure to provide for operating efficiencies. Both of these trends are providing sustained demand for companies such as Computer Sciences.

At S&P, we see the IT services industry as a whole beginning a shift in the typical business model, which we believe should benefit Computer Sciences. According management, contracts are being negotiated so that clients take more ownership of the assets from the beginning, instead of the IT service provider having to make a capital outlay up-front. This change should significantly benefit Computer Sciences and others, as the new model eases some pressure on the balance sheet and free cash flow, and allows for the contract to see a higher return on investment (ROI) and an earlier payback period.

TOP-LINE SUPPORT. We also view positively Computer Sciences' strategy of moving its focus away from very capital-intensive applications (53% of sales in fiscal 2004) and toward less demanding outsourcing (47%), including business-process outsourcing. This category is a key growth segment of the IT outsourcing industry, with the potential for double-digit gains over the next five years, in our view, compared with expectations of single-digit growth from the more mature IT system-application market.

We're also positive on Computer Sciences' increased focus on the government sector, as we believe it will offer significant support the top line. Devoting more attention here will allow Computer Sciences to take advantage of growing demand as a result of security issues, while, at the same time, allowing for diversification away from the commercial arena.

In addition, we like the global aspect of Computer Sciences' business. The company reports that it's seeking to spread components of its contracts over all its markets in order to achieve efficiency, lower costs, and help boost margins, which are in the 19% to 20% range.

ROBUST PIPELINE. We see revenues increasing about 8% in fiscal 2005 and 2006, following 30% growth in fiscal 2004. The slower growth rate in fiscal 2005 is due to more difficult year-over-year comparisons, particularly since 2004 results included the acquisition of DynCorp, which boosted Defense Dept.-related revenue by 70% in fiscal 2004. For the fiscal second quarter (ended September), we expect revenue to grow 7%, reaching $3.8 billion, taking advantage of a robust pipeline in contracts from both the federal and commercial customers.

We expect Computer Sciences to see continued strength from the government business in fiscal 2005 and fiscal 2006. It says its addressable federal market pipeline of opportunities consists of $33 billion in awards that are expected to be allocated over the next 20 months, with nearly $19 billion to be awarded in fiscal 2005. We anticipate improving demand for global outsourcing services, with particular strength in the U.S. commercial and federal government segment, outweighing consulting and systems integration projects. We also expect Computer Sciences' focus on business-process outsourcing to augment IT applications contracts.

Gross margins should widen, in our view, as results benefit from higher volumes and from a shift toward business-process outsourcing contracts, which provide higher margins, as well as from a move toward more global sourcing to take advantage of cost efficiencies among human resources. As a result, we look for gross margins to range from 18% to 19% in fiscal 2005 and fiscal 2006, with operating margins from 12% to 14%. We estimate fiscal 2005 earnings per share of $3.19, up 16% from fiscal 2004 EPS of $2.75. For fiscal 2006, we project EPS of $3.64.

A HANDLE ON DEBT. Computer Sciences continues to make improvements to its balance sheet and cash flow. Accounts receivable in the June quarter reached 90 days outstanding, an improvement over the prior year, aided in part by revenue increases. We also see better management of debt, with a debt-to-total-capitalization ratio at 29.8% at the end of the June quarter, currently below Computer Sciences' target rate of 30%. We expect to see free cash flow for the full year from $350 million to $400 million, in line with company guidance.

Our fiscal 2005 Standard & Poor's Core Earnings estimate is $3.06 a share, vs. our operating estimate of $3.19. The 4% difference reflects estimated stock-option and pension expense. In fiscal 2004, Computer Sciences' S&P Core EPS was $2.70, vs. operating EPS of $2.76.

Our 12-month target stock price of $60 is largely based on our analysis of the p-e multiple relative to that of the S&P 500-stock index. We've applied a p-e of 19 to our fiscal 2005 EPS estimate of $3.19. This multiple is based on a blended peer average and is slightly higher than the market multiple.

MARGINS COME FIRST. We believe the shares are attractively priced, trading at 15 times our EPS estimate for fiscal 2005 and 13 times our forecast for fiscal 2006, below the multiples of the S&P 500 and Computer Sciences' peer group, which has a blended average p-e multiple of 19. Our

discounted cash-flow analysis results in a value of $59 a share, slightly less than our relative multiple analysis.

Risks to our recommendation and target price include increased competition for large and long-term contracts in IT infrastructure and outsourcing markets, which could affect pricing and thwart the upside for gross and operating margins. Competition on the high end remains prevalent, with Computer Sciences vying with the likes of IBM (IBM), EDS (EDS), and Accenture (ACN), as well as up-and-comers such as India's Infosys (INFY). (We believe EDS has become more selective in competing for contracts due to its efforts to protect its balance sheet and cash-flow situation against further losses.)

We expect to see Computer Sciences continue to gain market share, although management has noted that it won't impair margins at the expense of pricing. Analyst Crane follows shares of data processing and outsourced services companies for Standard & Poor's Equity Research Services


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