It's a given that investors who wish to hunt for big returns generally have to take on outsized risks. IT provider Computer Sciences (NYSE:CSC) pushes that idea near its breaking point, though. Although this stock may well be very cheap, relative to its inherent earnings potential, "potential" is a dangerous word and there are very real issues with this company.
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An Unimpressive Fiscal Second Quarter
There was little to encourage bulls in Computer Sciences' second quarter, and the stock was quite weak immediately afterwards. Reported revenue rose about 1%, and none of the reporting segments were especially strong. The North American public sector was down about 2%, and managed services was up about 2%. It's just not that impressive when compared to results at companies like International Business Machine (NYSE:IBM), Accenture (NYSE:ACN) or Cognizant Tech Solution (Nasdaq:CTSH).
Profitability was even worse. Gross margin fell almost two points and GAAP reported operating income fell 53%. Even on an adjusted basis, which is supposed to make numbers look better, operating income fell 37%, and the company's own optimistic version of "pro forma" margins showed substantial erosion in profitability (from 7.8% to 5.6%).
Problems Left, Right and Center
It seems like Computer Sciences has its own portable cloud that it carries around. In the wake of industry-transforming events, like Hewlett-Packard (NYSE:HPQ) acquiring EDS, Dell (Nasdaq:DELL) buying Perot and Xerox (NYSE:XRX) buying ACS, Computer Sciences has really never been able to leverage its position as one of the largest platform-neutral service providers. Some of that goes straight to the executive suites, as this company was a laggard in moving many of its services offshore.
There are quite a few other serious considerations as well. The company had all manner of troubles in the mid-2000's (some tied to accounting), and now there are ongoing investigations into certain accounting irregularities. What's more, earnings trends have been weak and there is a lot of uncertainty around the big NHS contract in Britain.
Oh, but there's more. Like many other IT providers, including SAIC (NYSE:SAI) and CACI International (NYSE:CACI), Computer Science derives a significant amount of its revenue from governments, and even the purported cost savings of using outsourced providers won't spare them from budget cuts. What's more, many of Computer Science's large customers, in past years like Raytheon (NYSE:RTN), United Technologies (NYSE:UTX) and General Dynamics (NYSE:GD), depend upon the federal government and strong defense spending for their own revenue.
Reasons for Optimism?
It's not all darkness for Computer Sciences. The company booked new awards of $6.6 billion this quarter, nearly tripling the prior quarter's awards. What's more, the company's current CEO is stepping down and maybe a new management team (and new management philosophy) can fix some of what ails this large IT company. (For additional reading, check out: Evaluating A Company's Management. )
The Bottom Line
There's a lot of potential value here, as even low revenue growth projections, and historically average free cash flow margins produce an impressive price target. The problem with that is that struggling companies often struggle even more than analysts are willing to model, so further revisions in the wrong direction could still be on the way. That's especially relevant if the federal government really tightens its belt. (To know about free cash flow yield, read: Free Cash Flow Yield: The Best Fundamental Indicator. )
For now, Computer Sciences is just not a great idea in IT services - investors would likely do better with a name like IBM, Accenture or even CACI. That said, it's not hard to create an appealing price target here, and some investors will buy into CSC on the premise that things can't get much worse. While I see some of that same potential for value, the risk is just too high to make it worthwhile to me.
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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.