This Undervalued Firm Can Service Investors

We believe  Computer Sciences Corporation (CSC) at its current price levels offers attractive risk/reward opportunities. The company has struggled recently, and its stock has fallen 42% (vs. 8.3% for Nasdaq and 7.5% for S&P) since the beginning of the year. However, in our opinion, the market took its eye off the company's underlying solid fundamentals and instead focused more on its near-term misses. We think CSC has been making the right moves to remain one of the dominant players in the IT services industry, and its recent sell-off provides a nice entry point for investors.

CSC's Recent Troubles Aren't Game-Changers, and They Have a Short Life Span
CSC derives about 40% of its revenue from its federal business, and this practice came under pressure when budget uncertainties and Continuing Resolution forced government agencies to tighten their spending. The company's issues were further compounded by Department of Defense spending cuts. That said, we think the magnitude of these issues was overblown. While CSC did see a slowdown in its government bookings, we think it has more to do with delays in awarding contracts than outright cancellations.

A look at the bookings trend clearly shows the impact of the slowdown in the last two quarters (fourth quarter fiscal 2011 and first quarter fiscal 2012): bookings in the last two quarters totaled $1.8 billion, slightly higher than the company's historical quarterly average. Nonetheless, management commented that, based on current awards, pipeline, and historic winning rates, CSC is in line to book $3 billion in its second quarter. We think the chances of the company closing these deals are very good and expect CSC's bookings picture to revert to normal in the near term.

CSC's recent performance has also been hurt by difficulties in U.K.-based National Health Service contract implementation. The firm's current problems began when it missed an implementation milestone in its fiscal 2011 third quarter. Since the company recognizes revenue from NHS based on milestone completion, the delay in deployment impacted its revenue and margins in the last two quarters. CSC is in the midst of renegotiating its contract (scope and volume of work) with the U.K. government, and we believe the company is close to signing a Memorandum of Understanding with its client. We expect to see a change in pricing terms and scope of work in the new contract, but we believe its impact on CSC's growth will be minimal. When signed, the new contract is expected to add some stability to the company's top- and bottom-line numbers.

Current Price Levels Exaggerate the Recent Hiccups and Don't Portray the Real Picture
We believe CSC's current price levels significantly understate its growth potential. For us to get to the company's current trading range of $28-$30 using a discounted cash flow model, we had to assume that revenue will decline by an estimated 2% on average over the next five years. In our opinion, this would only happen if CSC were to face major hurdles across both its federal and commercial business practices. However, we think business trends in the commercial space are actually stabilizing and improving, with more and more companies willing to invest in developmental projects. According to market research firm IDC, the demand for IT services is expected to remain strong in the medium term, and IDC forecasts worldwide IT and business services spending to grow at a CAGR of 4.9% during the next five years. This places the company's commercial practice on a stable footing. Additionally, CSC's increased focus on emerging technologies like cloud computing, cyber security, and health-care IT should help it remain at the forefront of the industry trends.

In terms of operating margin, we believe CSC has room to expand (or at least maintain its margin in the 7%-8% range) by effectively leveraging its offshore delivery network. CSC's hands are tied when it comes to its federal service business (due to the nature of the contract and limited offshoring opportunities), but it can drive wider margins in its commercial business. Compared to its global peers, CSC was slow off the blocks in setting up its offshore centers, and this has had an impact on its margins. However, the company's recent margin expansion trends indicate that it has been making steady progress in utilizing its offshore centers. We would like to note that CSC's margin levels declined in the last few quarters, but this was mainly due to accounting issues in its Nordic region and issues with its NHS contract.

CSC Remains Attractive in Terms of Valuation Multiples
Finally, in terms of multiples, CSC trades at a discount to both its peer group and its historical trading range. Given its relatively lower revenue growth and margin profile, the company has historically traded a notch below its peers--low-double-digit P/E for CSC--while its competitors trade at the high-teens level. However, following the recent sell-off, the company trades at 6 times our fiscal year 2012 earnings and, in our opinion, the current discount vastly underestimates its future performance.