In the middle of a consensus trade favouring value names, it is very painful to see a text book case of value stock taking a 15% beating in a day. We are talking about our investment in Atos SE. Lately the company has been attracting quite a bit of negative news flow, which obviously does not help the stock performance. What proved to be one of the most resilient names in the IT sector during the Covid-19 pandemic is turning out to be a laggard when the track is set for the company to run its course in this consensus theme. As with any other convoluted investment cases, the first question we ask ourselves “Is it a self-inflicted wound?” if the answer to the question is “Yes” then our decision tree becomes much cleaner and has less variables affecting the outcome of the case. As per our understanding, the case of Atos is an internal issue. However, the market participants who were quite enthusiastic about Atos during Covid times have turned to;
“Rainbow in the mornings give you fair warnings”
Atos SE is one of the European pioneers of IT consulting and outsourcing. Throughout its history the company has attracted high profile names to its management board and executive committee, such as ex-French Finance minister Mr. Thierry Breton who served as a CEO of the company close to a decade before moving on to represent France in EU council. In the past, these affiliations did help Atos in securing some highly sensitive EU and European sovereign contracts against the competition, from Asian players in particular. Up until the middle of last decade, Atos was just like other big American and European IT consultants, providing on-premise IT infrastructure consulting and related services to multi-national corporations and government bodies. Also, the company was home to one of the major financial transaction service providers, Worldline. However, in the second half of the decade Atos started lagging behind the other IT consulting providers due it being still largely dependant on older IT infrastructure services while the industry landscape was changing due to increasing adoption of cloud/hybrid infrastructure. Although bit late, but Atos did acknowledge and made required changes to business to orient itself more towards digital and cyber security segments in order to derive growth and compensate for ex-growth on-premise segments, which is still close to half of the business. In the meantime, it divested from Worldline, which has been a phenomenal investment for the company, thus the shareholders.
At the time of our investment, the company had just come out with the profit warning and, in their true spirit, the market players had ticked off Atos as a highly levered company with obsolete expertise. Why? because the Cloud infrastructure was a theme of the moment. What was not being factored in was that on-premise IT infrastructure would continue to stay here with us in the foreseeable future and it is highly cash-generating business segment. Also, Atos was amidst divestment of its stake in Worldline, which in combination would generate enough cash to pay down the debt and yet leave sizable amount to be returned back to the shareholders. Our investment case did play out and Atos has been contributing quite positively since then.
Fast forward to Q3 2020 and we have seen strings of negative news flow from Atos; fines related to US subsidiaries business practices, friendly take-over offers for US peer DXC technology and recently accounting practices related to, again, two of the US subsidiaries. The concerns regarding the first two have been addressed. The latest one, as per our understanding is related to the application of IFRS-15 in the accounting books, which amounts to 11% of the revenue and 9% of the operating profits as per the estimates from the company. The said US subsidiaries have booked the passthrough revenue (related to 3rd party hardware and software licenses that Atos utilises as part of the service) on a gross basis, instead of net basis as mandated by IFRS-15. Other issue is related to timing of the booking of some outsourcing contracts and methodologies used to do the same.
Under our own ESG policy at ECP, we don’t take governance issues lightly. Our ESG officer is closely monitoring the case and every effort will be made to convey our dissatisfaction at the next AGM meeting of the company when we vote on the governance related resolutions floated by the company management. With that said, it is also true that internal investigation is not yet over and Atos has already made changes in the concerned division. The company annually generates roughly 8% of the revenue from passthroughs and at the time of the warning management did believe that there won’t be any need for restatements of annual accounts. If there were to be restatement and adjustment to the accounts, it would be neutral to cashflow and operating profits. However, the treatment given to Atos’s share price is an extreme, their big data & cyber security business (10% of the group revenue) at the peer multiple covers the current market cap of the group when the company is estimated to generate more than EUR 2 billion in FCF over next two years.