Analyzing the BPO & ITES Wave

Analyzing the BPO & ITES Wave Steve Frambes (Principal) + 01 (415) 690-0607 www.JacksonCG.net [email protected]

October 5, 2004

Copyright 2004, Jackson Consulting Group, LLC - One Embarcadero Center, 5th Floor, San Francisco, California 94111-3610. All rights reserved.

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Industry Report Industry Views JCG

North America Equity Research Computer Services & IT Consulting Industry View: In-Line Weak fundamentals at industry bellwethers could limit stock price appreciation for our computer services coverage as a whole. Given superior free cash flow, we prefer the information processors over the IT services stocks.

Specialized IT Services Industry View: In-Line We see an IT spending recovery at hand, though the carry-through for services vendors should be modest in 2004. We generally prefer government providers over commercial vendors at this time.

Systems & PC Hardware Industry View: In-Line Hardware demand continues to improve, albeit at a slow rate. Choppiness prevails in many markets and we believe market shares are best positioned to outperform, with the group performing In-Line overall.

Europe Equity Research Technology - Software & Services Industry View: In-Line

Jackson Consulting Group Research Services www.JacksonCG.net P: +01 (415) 690-0607 F: +01 (415) 441-1381

Industry Report Key Conclusions JCG

For CY04, we estimate the offshore services market will represent about 4% of the $530 billion global IT services & BPO market, surpassing of our year-ago forecast.

By 2007, we expect offshore revenue to reach 8% of the global IT services & BPO market, driven by 37% compounded annual growth.

$ in U.S. Billions 2004E 2005E 2006E 2007E CAGR Global IT Services & BPO Market $531 $566 $607 $653 7% Average Global Offshore Revenue 19 26 35 50 37%

Year-over-Year Growth Rate 29% 33% 37% 41% Penetration Rate 4% 5% 6% 8%

Source: IDC, Gartner and JCG Research; E = JCG Research Estimate

Offshore market penetration should increase in several global IT service segments. For CY05, we expect offshore penetration to grow to 27% in custom application development, 20% in application outsourcing and 5% in business process outsourcing, ahead of our year-ago forecasts of 17%, 18% and 5%, respectively.

At the same time, the rate of revenue growth in key global IT services verticals appears to be slowing. In fact, 5-year projected compounded annual growth rates from Gartner and IDC have decreased to 3% from 4% in custom application development, to 7% from 8% in information systems outsourcing and to 12% from 14% in application outsourcing.


Industry Report Key Conclusions (continued) JCG

Capgemini (CAPP), Electronic Data Systems (EDS) & Keane (KEA) confront material earnings risk resulting from high “net” unit exposure and negative labor arbitrage. For CY05, Capgemini faces earnings exposure of 61%, EDS 28% and KEA 21%. For CY07, such earnings risk could be reduced to 33% for Capgemini, grow to 35% for EDS, and decrease to 17% for KEA.

In contrast, Perot Systems (PER) could benefit from positive labor arbitrage. For CY05, we estimate PER’s unit capacity should exceed its offshore demand, positioning the company for a potential 4% earnings benefit.

CY05E ACN BE CSC EDS PER CAPP IBM-GS KEA Base EPS $1.45 $0.44 $3.52 $0.64 $0.80 $1.08 $2.40 $0.90 Uncovered Risk (0.10) (0.01) (0.31) (0.18) 0.03 (0.66) (0.07) (0.19) % Impact -7% -2% -9% -28% 4% -61% -3% -21%

CY07E Base EPS $1.89 $0.65 $4.32 $0.89 $0.94 $2.50 N/A $1.47 Uncovered Risk (0.17) (0.00) (0.43) (0.31) (0.04) (0.83) N/A (0.26) % Impact -9% 0% -10% -35% -5% -33% N/A -17%

*% Impact for IBM-GS is for pro-forma global services EPS. Source: JCG Research; E = JCG Research Estimate



For Capgemini, earnings risk emanates from:

High revenue exposure to application outsourcing (16-17% of total revenue) Average offshore unit demand of 22% in CY05 and 29% in CY07 but … … Minimal offshore unit supply of only 7% in CY05 and 10% in CY07.

For EDS, we attribute offshore earnings exposure to:

Execution risks in growing its offshore capability -- we do not expect the company to reach its goal of 20,000 offshore personnel by year-end CY05.

Low offshore unit demand of 16% in CY05 and 23% in CY07, should exceed … … Minimal offshore unit supply of only 9% in CY05 and 13% in CY07.

For KEA, its earnings pressure reflects:

High revenue exposure to application outsourcing (47-50% of total revenue) and custom application development (10-11% of total revenue);

Substantial offshore unit demand of 53% in CY05 and 72% in CY07; should surpass … … Highest offshore unit supply of 35% in CY05 and 53% in CY07.



Our analysis reinforces our cautious stance on Underweight rated EDS, and increases our concerns for Equal-weight rated Capgemini and Equal-weight rated KEA.

-We have increasing concerns for Capgemini. CAPP's current offshore plans look the least ambitious given the risk. We expect the company to have 10% of total staff in low-cost markets by 2007, versus the group average of 23%. In addition to this, CAPP has a record of poor execution, limiting potential to aggressively expand offshore.

-Our analysis reinforces our Underweight rating of EDS. We believe there are significant execution risks to EDS’s current aggressive offshore headcount plans through CY05, which should leave the company exposed to negative offshore labor arbitrage.

-Offshore wave could be a high-risk sea change for Keane. While the company appears to be making progress in its turnaround, offshore represents a lingering risk of both revenue cannibalization and margin pressure. Mitigating this pressure over time is our expectation that Keane can aggressively add to India headcount and win incremental new business.

In addition, we are incrementally more positive on Equal-weight rated PER, and believe the company could generate positive earnings leverage in CY05 from its high offshore capacity.



ANALYTICAL FRAMEWORK

“Net offshore” unit exposure subtracts planned capacity (headcount) from future expected demand to measure a multinational IT services company’s vulnerability to the rapid growth of global service delivery requirements. For CY05, “net” work unit exposure for our coverage ranges from -3% to +18%, while revenue exposure ranges from and -1% to +4%.

For 2005, PER’s offshore capacity of 30% could exceed estimated demand of 27%.

CY05E (+ 1 Year) ACN BE CSC EDS PER CAPP IBM-GS KEA Avg. Offshore Unit Demand 28% 15% 11% 16% 27% 22% 13% 53% Offshore Unit Supply 18% 13% 6% 9% 30% 7% 10% 35%

Net Offshore Unit Exposure 10% 2% 5% 6% -3% 15% 3% 18% 7% Net Offshore Revenue Exposure 2% 0% 1% 2% -1% 4% 1% 4% 2%

CY07E (+ 3 Years) Offshore Unit Demand 43% 20% 15% 23% 39% 29% 18% 72% Offshore Unit Supply 27% 20% 9% 13% 35% 10% 15% 53%

Net Offshore Unit Exposure 15% 0% 6% 10% 3% 19% 4% 20% 10% Net Offshore Revenue Exposure 4% 0% 1% 2% 1% 4% 1% 5% 2%

Source: JCG Research; E = JCG Research Estimate


Industry Report Ranking Offshore Strategies JCG

Ranked from strongest to weakest: 10/04 ▲ from

6/03

PER Could benefit from positive labor arbitrage in CY05 #1

IBM-GS Mature offshore presence with robust growth plan #2

ACN Increased exposure to highly penetrated offshore areas #3

BE Growth planned in China & India, potential execution risks #4

CSC Stepped up capability, still exposed to earnings pressure #5

KEA Large application development / outsourcing exposure #6

#7 EDS Poor execution of offshore expansion plans

CAPP Insufficient offshore capacity #8


Industry Report Earnings Impact Framework JCG

Steps # 1-4 Calculate Offshore Revenue & Unit Demand

Step # 5 Project Offshore Unit Supply

(utilize current & planned low unit cost headcount as a proxy)

Step # 6 Determine Net Offshore Exposure

= Work Unit Exposure (Demand) - Capacity (Supply)

Step # 7 Assign Net Offshore Margin Impact

= Offshore Price - Onsite Cost (-38% to -45%) Onsite Price

Step # 8 Estimate Offshore EPS Impact

= Base Revenue X Net Revenue Exposure X Margin Impact


Industry Report Step #1 - Offshore Penetration of Global IT Services JCG

October, 2004 Forecast Assumptions: Estimated Global Penetration 2004E 2005E 2007E

Application Outsourcing 18% 20% 25% • Application Outsourcing and Custom

Custom Application Development 25% 27% 33% Application Development (CAD) demonstrate the highest penetration levels Business Process Outsourcing 3% 5% 14% through 2007

Packaged S/W & Systems Integration 3% 3% 4%

Consulting 1% 1% 1% • BPO penetration exhibits the strongest

Information Systems Outsourcing 1% 1% 1% growth from 2005 to 2007

• Consulting and IS Outsourcing could remain the least penetrated segments Forecast from June, 2003 Offshore Report

2005E Application Outsourcing 18% • Industry vertical growth rates have been

adjusted to reflect recent NASSCOM Custom Application Development 17% data, conversations with industry analysts

Business Process Outsourcing 5% (Gartner & IDC) and dialogue with offshore operations executives for Packaged S/W & Systems Integration 7% companies under coverage.

Consulting 1%

Information Systems Outsourcing 1%



Industry Report Step #2 - Identifying Revenue Composition JCG

Company Specific Revenue Composition

1) KEA, PER, ACN and Capgemini have significant exposure to the application outsourcing vertical

2) On a relative basis, KEA is the most exposed to the custom application development and application outsourcing segments, the two highest offshore penetration areas.

3) In the near-term, CSC, EDS, PER and IBM benefit from large and under-penetrated concentrations in information systems outsourcing.

CY2004E Revenue Composition

ACN BE CSC EDS PER CAPP IBM-GS KEA Consulting (IT & Business) 26% 23% 8% 13% 6% 20% 6% 5% Custom Application Development 4% 5% 4% 6% 6% 5% 3% 11% Packaged S/W & Systems Integration 29% 65% 31% 5% 9% 39% 29% 20% Application Outsourcing 21% 7% 8% 9% 23% 16% 5% 47% Information Systems Outsourcing 4% 0% 35% 56% 39% 14% 40% 0% Business Process Outsourcing 16% 0% 6% 12% 13% 5% 4% 7% Other 0% 0% 8% 0% 4% 0% 13% 10% TOTAL 100% 100% 100% 100% 100% 100% 100% 100%



Industry Report Step #3 - Offshore Revenue Demand JCG

Offshore Revenue Demand: = (% of Revenue Composition) X (Offshore Penetration Rate)

CSC Example CY05E CY05E Gross X =

IT Service Segments % Revenue Penetration Exposure

Consulting (IT & Business) 7% 1% 0% Custom Application Development 4% 27% 1% Systems Integration 30% 3% 1% Application Outsourcing 9% 20% 2% Information Systems Outsourcing 36% 1% 0% Business Process Outsourcing 6% 5% 0% Other 8% 0% 0%

TOTAL 100% 5%

X Adjustment [ (1 - Government Exposure) ] 59% X

= Adjusted Offshore Revenue Demand 3%

Note: CSC's Adjustment is for U.S. Government Exposure of 41%; Adjustment = (1 - 41%) Source: JCG Research; E = JCG Research Estimate


Industry Report Step #3 - Offshore Revenue Demand (cont’d) JCG

Company Adjusted Offshore Revenue Demand

1) KEA, ACN and PER have the highest adjusted revenue exposures (demand).

2) CSC and BE benefit the most from adjustments, both possessing relatively high revenue concentration with the U.S. federal government, which will not permit IT service vendors to utilize offshore resources.

Pre-Adjusted Offshore Revenue Demand

ACN BE CSC EDS PER CAPP IBM-GS KEA Avg. CY05E 8% 6% 5% 5% 8% 7% 4% 14% 7% CY07E 11% 7% 6% 7% 11% 8% 5% 18% 9%

X Adjustment


= Adjusted Offshore Revenue Demand




Industry Report Step #4 - Offshore Unit Demand JCG

Offshore Unit Demand:

= Offshore Revenue Demand X Offshore Pricing Ratio

Offshore Revenue Demand


X Pricing Ratio

ACN BE CSC EDS PER CAPP IBM-GS KEA CY05E 4:1 4:1 4:1 4:1 4:1 4:1 4:1 4:1 CY07E 4:1 4:1 4:1 4:1 4:1 4:1 4:1 4:1

= Offshore Unit Demand




Industry Report Step #4 - Pricing Ratio Estimate JCG

• Our pricing ratio expands from 1 : 4.1 in CY04 to 1 : 4.3 in CY07, given our forecast for increasing multinational billing rates and static offshore rates. Our estimates are based on current and forecasted (2004 through 2007E) blended billing rates from U.S. and India pure play offshore firms.

• For U.S. multi-national firms, we project 2% annual pricing growth. For offshore billing rates, we forecast flat pricing.

Blended Billing Rate Comparison

Multinational Companies India Pure Play Firms

(U.S. $/hour) 2004 2005E 2006E 2007E CAGR (U.S. $/hour) 2004 2005E 2006E 2007E CAGR ACN $101 $103 $105 $107 2% HCLT $26 $26 $26 $26 0% BE 82 84 86 87 2% INFY 27 27 27 27 0% CSC 48 49 50 51 2% SATY 23 23 23 23 0% Deloitte 140 143 146 149 2% WIPR 23 23 23 23 0% IBM 128 131 134 136 2%

Average $100 $102 $104 $106 2% Average $25 $25 $25 $25 0%

Pricing Ratio (Multinational : India Pure Play):

2004 2005E 2006E 2007E

4.1 4.1 4.2 4.3 2%

Source: Company Data and JCG Research; E = JCG Research Estimate


Industry Report Step #5 - Offshore Unit Supply JCG

Offshore Unit Supply:

= Average Low Unit Cost Headcount / Average Billable Headcount

1) KEA, PER and ACN have the highest offshore unit capacity (supply).

2) Over the next three years, BE, KEA and ACN plan for the most aggressive offshore headcount growth

CY04E ACN BE CSC EDS PER CAPP IBM -GS KEA Avg. Avg. Billable Headcount 86,076 13,806 80,996 116,235 12,785 50,866 164,908 7,831 Avg. Low Unit Cost Headcount 10,400 688 3,545 9,200 3,091 2,450 11,750 1,702 Offshore Unit Supply 12% 5% 4% 8% 24% 5% 7% 22% 11%

CY05E Avg. Billable Headcount 101,875 15,771 83,221 110,970 13,571 53,672 172,757 9,084 Avg. Low Unit Cost Headcount 18,500 2,050 5,310 10,350 4,108 3,550 17,250 3,150 Offshore Unit Supply 18% 13% 6% 9% 30% 7% 10% 35% 16%

CY07E Avg. Billable Headcount 130,875 17,946 90,020 100,170 15,625 54,842 190,299 12,013 Avg. Low Unit Cost Headcount 35,500 3,500 8,170 12,950 5,483 5,600 28,250 6,350 Offshore Unit Supply 27% 20% 9% 13% 35% 10% 15% 53% 23%

Compounded Annual Growth Rate Billable Headcount 15% 9% 4% -5% 7% 3% 5% 15% Low Unit Cost Headcount 51% 72% 32% 12% 21% 32% 34% 55%

Source: Company Data & JCG Research; E = JCG Research Estimate


Industry Report Step #6 - Net Offshore Exposure JCG

Net Unit Exposure = Gross Unit Exposure (Demand) - Planned Capacity (Supply)

Net Revenue Exposure = Net Unit Exposure X Inverse of the Pricing Ratio

1) KEA, Capgemini and ACN have the highest net offshore unit & revenue exposures.

2) From CY05 to CY07, average offshore unit exposure grows from 7% to 10% - indicating expanding gaps between multinational offshore demand and supply.

CY05E (+ 1 Year) ACN BE CSC EDS PER CAPP IBM-GS KEA Avg. Offshore Unit Demand 28% 15% 11% 16% 27% 22% 13% 53% Offshore Unit Supply 18% 13% 6% 9% 30% 7% 10% 35%

Net Offshore Unit Exposure 10% 2% 5% 6% -3% 15% 3% 18% 7% Net Offshore Revenue Exposure 2% 0% 1% 2% -1% 4% 1% 4% 2%

CY07E (+ 3 Years) Offshore Unit Demand 43% 20% 15% 23% 39% 29% 18% 72% Offshore Unit Supply 27% 20% 9% 13% 35% 10% 15% 53%

Net Offshore Unit Exposure 15% 0% 6% 10% 3% 19% 4% 20% 10% Net Offshore Revenue Exposure 4% 0% 1% 2% 1% 4% 1% 5% 2 % Source: JCG Research; E = JCG Research Estimate


Industry Report Step #7 - Offshore Margin Impact JCG

Negative Gross Margin emanates from a mismatch of offshore billing rates and onsite labor costs:

Negative Gross = Price (offshore) - Cost (onsite) Margin (% of revenue) Price (onsite)

= Price (offshore) - Cost (onsite)

Price (onsite) Price (onsite)

= Price ratio - ( 1 - Gross Margin)

Assumption Company / Industry Data

= 25% (1:4 ratio) - ( 1 - ~35%)

= -40%


Industry Report Step #8 - Offshore EPS Impact JCG

= Base Revenue X Net Offshore Revenue Exposure X Margin Impact

CY05E ACN BE CSC EDS PER CAPP IBM-GS KEA Revenue Estimate $15,774 $2,634 $17,237 $20,767 $1,899 $8,070 $48,600 $996

X Net Revenue Exposure 2% 0% 1% 2% -1% 4% 1% 4%

Pricing Ratio 1/4 1/4 1/4 1/4 1/4 1/4 1/4 1/4

- [(1 -Gross Margin)] -65% -70% -70% -70% -70% -69% -70% -69%

X Negative Margin -41% -45% -46% -46% -46% -45% -46% -45%

= Pre-Tax Gross Profit Impact -160.0 -4.4 -86.5 -145.7 6.5 -130.5 -168.6 -19.3

Base EPS $1.45 $0.44 $3.52 $0.64 $0.80 $1.08 $2.40 $0.90 Uncovered Risk (0.10) (0.01) (0.31) (0.18) 0.03 (0.66) (0.07) (0.19) % Impact -7% -2% -9% -28% 4% -61% -3% -21%

CY07E Base EPS $1.89 $0.65 $4.32 $0.89 $0.94 $2.50 N/A $1.47 Uncovered Risk (0.17) (0.00) (0.43) (0.31) (0.04) (0.83) N/A (0.26) % Impact -9% 0% -10% -35% -5% -33% N/A -17%



Industry Report Rating, Valuation & Risks - Accenture Ltd JCG

Accenture Ltd (ACN.N)

We maintain our Overweight rating on Accenture stock, and our $31 per share price target. Our valuation is based on a 10-year discounted cash flow (DCF) model: conventional DCF yields $28 per share, to which we add $3 per share from the reinvestment of free cash flow as follows: 25% toward share repurchases and 75% into projects earning a 15% return on invested capital. Our DCF analysis incorporates the following key assumptions:

A. five-year forecast of 9% compounded annual growth rate (CAGR) with 5% terminal growth for net revenue;

B. five-year forecast of 13% CAGR in earnings per share; C. five-year forecast of 14% CAGR in capital spending; D. ACN’s weighted cost of capital (WACC) remains at 10.4%

Risks to this investment thesis include: 1) a resurgence of pricing pressure in the consulting segment; 2) an increased operating expense margin or higher capital intensity driven by Accenture’s greater dependence on outsourcing; and 3) difficulty in executing cost reduction / working capital efficiency initiatives.


Industry Report Rating, Valuation & Risks - BearingPoint JCG

BearingPoint (BE.N)

We maintain our Equal-weight rating on BE shares. Although EMEA regions could soften over the next 6-12 months, we expect U.S. markets to remain stable and potentially strengthen. BE shares trade at a 40% premium to our $7 estimate of intrinsic value. Our valuation is based on a 10-year discounted cash flow (DCF) model and, in BE’s case, does not assign additional credit for the successful reinvestment of free cash flow. Our DCF analysis incorporates the following key assumptions:

A. five-year forecast of 25% annual earnings growth (from a depressed CY04 $0.25 base); B. five-year forecast of 6% annual revenue gains; C. after FY09, we assume revenue growth slows to 4%, and eventually to a terminal

growth rate of 3%;

D. BE’s weighted average cost of capital (WACC) is 10.5%.

Risks to BE achieving our valuation include: 1) greater than expected weakness in EMEA and other international segments; 2) pricing pressure driven by lower unit-cost offshore business models that exceeds our expectations; and 3) CY04 decreases in U.S. IT spending.


Industry Report Rating, Valuation & Risks - Capgemini JCG

Capgemini (CAPP.N)

We have an Equal-Weight-V rating on Capgemini. Our earnings-based valuation framework leads us to a price target of €20. Our core assumption is that Cap trades inline with a sector rating on a pure P/E basis. Applying a sector average rating to our 2005 and 2006 EPS estimates (15x in 2005, 12.5x in 2006) points to a valuation range of €14-19. We take the average of this and add in €3.5 value for Cap’s French and US tax assets to arrive at our price target of €20.

Our DCF valuation underpins this, pointing to €23.3 per share, using a WACC of 9.1% and a terminal growth rate of 3.5%. We assume a mid-term EBITA margin of 6%, trending down to a 5% long-term margin and we forecast modest top-line growth (4% CAGR 2004-12). We believe these assumptions are generous, particularly on the margin given the execution uncertainties, which still surround the outsourcing business.

Risks to price target: There are a number of risks to our price target for Cap. 1) persistent execution risk remains around Cap’s shift into outsourcing, 2) We would highlight long-term margin issues (from the secular issue of price deflation and a changing business mix toward lower-margin outsourcing as well as earnings quality issues and the threat from offshore vendors. 3) New management or Cap participating in sector consolidation could result in a change in strategy, affecting earnings and valuation.


Industry Report Rating, Valuation & Risks - Computer Sciences JCG

Computer Sciences (CSC.N)

We maintain our Equal-weight rating on CSC shares, given our view that CSC shares trade in-line with our DCF-based valuation. Our estimated valuation for CSC stock is $40: discounted cash flow analysis for CSC yields a value of $39 per share, and reinvestment of free cash flow adds $1 per share. Our discounted cash flow analysis incorporates the following key assumptions:

A. five-year forecast of 10% annual earnings growth; B. five-year forecast of 8% revenue gains; C. after FY08, we assume that CSC’s revenue growth slows to 6%, and eventually to a

terminal growth rate of 4%; D. weighted average cost of capital (WACC) of 8.0%.

Risks to CSC achieving our valuation include: 1) greater than expected capital intensity resulting from pursuit of larger IT outsourcing contracts; 2) pricing pressure that exceeds our expectations; and 3) earnings and free cash flow shortfalls from underperforming contracts.


Industry Report Rating, Valuation & Risks - EDS JCG

Electronic Data Systems (EDS.N)

We maintain our Underweight rating on EDS stock, based on several concerns: 1) its deteriorating market share; 2) declining free cash flow; 3) unstable credit rating; 4) weak strategy to address the high growth business process outsourcing (“BPO”) market; 5) track record of poor execution; and 6) high executive turnover. EDS stock trades above fair value based on our discounted cash flow analysis. Over the next 12 months, we believe EDS faces many fundamental risks. Based on our 10-year discounted cash flow (DCF) analysis, we estimate EDS’s intrinsic value to be $17 per share. Our discounted cash flow analysis incorporates the following assumptions:

A. five-year forecast of 60% annual earnings growth (from a depressed CY04 $0.16 base); B. five-year forecast of 2% revenue growth, followed by 3% increases in years 5-10 and 3% terminal growth; C. five-year forecast of 7% capex growth; D. weighted average cost of capital (WACC) of 7.9%.

Risks to EDS achieving our DCF valuation include: 1) greater than expected capital intensity resulting from large IT outsourcing contracts; 2) large unbilled receivable write-downs reflecting continued shortfalls in contract execution; 3) pricing pressure that exceeds our expectations; and 4) revelation of new problem contracts.


Industry Report Rating, Valuation & Risks - IBM JCG

IBM (IBM.N)

We maintain our Overweight on IBM, with a $100 price target. At 15.2x our 2005E EPS - a 4% discount to the S&P 500 - IBM now trades below its historical 5-year multiple range (17-19x forward EPS). This is despite a solid strategy and an improving product portfolio in 2H04. Our $100 price target is based on an average of Residual Income, P/E and Relative P/E ranges (see Exhibit below). Upside to these value estimates exist if we assume IBM shares trade to peak valuation but given uncertainties in the demand environment, we think IBM shares will trade closer to historical averages, for now.

Valuation Method Implied Value Comments P/E $110 Based on 5-Yr average P/E Relative P/E $84 Based on 5-Yr average relative P/E Residual Income $107 Based on Management Guidance Average Value $100


Industry Report Rating, Valuation & Risks - IBM (continued) JCG

IBM (IBM.N)

From a discounted cash flow perspective, our current model doesn’t give management full credit for its long-term revenue and EPS guidance (high single digit revenue growth and low double digit EPS growth) on an operating basis. Under our current assumptions, IBM’s intrinsic value is roughly in-line with where the shares trade today in the low $80 range (assumes a 7.7% WACC, 3% long-term revenue growth and peak EBITDA margins of 19.5% in 2010). If we assume revenue growth in the high single digits (7-8%) and an EBIT CAGR in the low teens - which is where we think numbers will trend with better execution in Microelectronics and Services margins, IBM’s intrinsic value shifts to roughly $107 (assumes a 7.7% WACC, 3% long-term revenue growth and peak EBITDA margins of 20.5% in 2010).

Key risks to our target include 1) company specific mis-execution relating to microelectronics, server product cycles and managing services margins, 2) greater than expected hardware pricing pressures in a tough demand environment, and/or 3) a slower than expected IT demand environment making it difficult for IBM to meet its high single digit revenue growth and low double digit EPS growth long-term guidance targets.


Industry Report Rating, Valuation & Risks - Keane JCG

Keane (KEA.N)

We maintain our Equal-weight rating on Keane.

We find KEA’s valuation attractive, but not compelling, at current levels. On a P/E multiple basis, KEA shares are trading at 17.5x our 2005 EPS estimate — a slight premium to the JCG IT Services Aggregate P/E. If we adjust our estimate for potential dilution from a proposed change in accounting policy regarding Keane’s convertible bonds ( = $0.04/share), the premium widens to 7%. Our long-term, residual income model values KEA shares at $17. Risks to our $17 price target include: (1) Slower-than-expected rebound in IT spending and continued extension of sales cycles; (2) Execution risk as Keane grows rapidly offshore, enters the BPO business, and works to strengthen its sales model.


Industry Report Rating, Valuation & Risks - Perot Systems JCG

Perot Systems (PER.N)

We maintain our Equal-weight rating on PER shares. Our $13 per share valuation is based on a 10- year DCF model, and assumes the successful reinvestment of free cash flow. Standard DCF generates an intrinsic value of $11 per share, to that we add $1 per share, based on our expectation that PER’s management will reinvest the company’s free cash flow accretively. Our DCF analysis incorporates the following key assumptions:

A. five-year forecast of 13% annual earnings growth; B. five-year forecast of 8% revenue gains; C. after 2007, we assume PER’s revenue growth slows to 6%, and eventually to a

terminal growth rate of 4%; D. PER’s weighted average cost of capital (WACC) is 8.3%

Risks to PER achieving our valuation include: 1) continued weak demand for discretionary IT services; 2) acquisition risks related to recent additions in PER’s government and offshore practice; and 3) IT outsourcing capital intensity that exceeds our expectations.


Analyzing the BPO & ITES Wave

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