CGI Group: How Much Money Did Logica Lose? (Part 2)

Please read our disclosure at the end of this entry. All figures in CAD unless noted otherwise.

This is our second in a series of entries on CGI Group, Inc. (GIB). We remain short CGI stock.

In this entry, we show how acquisition accounting can be used to manipulate earnings. We also explain how CGI re-marked the assets and liabilities of Logica PLC in accounting related to the acquisition, and we discuss what the re-marking implies about Logica's historical profitability.

Readers should begin with our first entry on CGI, in which we introduce the Logica acquisition and the concept of "cookie jar" accounting. We also suggest that investors read a recent article about CGI's accounting in Vanity Fair in which the author, Bethany McLean, compares CGI to Tyco International Ltd. under Dennis Kozlowski.

How did CGI account for the Logica acquisition?

CGI Group, Inc. ("CGI" or the Company) acquired Logica in an August 2012 deal that valued Logica's outstanding shares at $2.7 billion and the whole enterprise at $3.6 billion. In accounting for the acquisition, CGI followed accounting guidelines laid out in IFRS 3. IFRS 3 required CGI to make certain valuation adjustments to Logica's assets and liabilities in a purchase price allocation.

We focus our analysis on two types of adjustments that CGI made in the Logica purchase price allocation:

1. CGI adjusted the book value of Logica's accrual accounts to conform with CGI's accounting and revenue recognition policies: Logica and CGI had different revenue recognition policies. Differing revenue recognition policies result in different accruals for balance sheet accounts such as work-in-progress and deferred revenues.


2. CGI made further adjustments to mark the assets acquired and liabilities assumed to fair value: Logica's assets and liabilities were not carried at fair value on Logica's balance sheet before the acquisition. IFRS 3 requires that CGI adjust the assets acquired and liabilities assumed to their fair value.

The purchase price allocation resulted in post-acquisition book values for Logica's assets and liabilities that were meaningfully different than the pre-acquisition book values.

Importantly, the adjustments for the purchase price allocation depended on subjective assumptions and discretion from CGI's management.

Because of this subjectivity, IFRS 3 allows acquirers to retrospectively revise adjustments for a full year after the close of an acquisition. CGI revised the Logica purchase price allocation several times in the year following the acquisition.

Can balance sheet adjustments be used to manipulate earnings?

Our prior entry on CGI explored one method that companies use to engage in cookie jar accounting: Companies manipulate accrual accounts to create artificial losses in a target company during the stub period before an acquisition. After the acquisition closes, the acquirer can reverse the fake loss-making accruals of the stub period. The reversal of loss-making accruals generates inflated earnings and no corresponding cash flow.

Here we explore a similar method for earnings manipulation:

Just as an acquirer can create a cookie jar in the stub period preceding an acquisition, an acquirer can create a cookie jar by manipulating the post-acquisition balance sheet of a target company. The acquirer can make pro forma purchase price allocation adjustments to understate a target company's assets and overstate its liabilities.

Understating a target's assets and overstating its liabilities has the effect of artificially depressing the book value of the target company. In the periods following the acquisition, the acquirer can reverse the pro forma write-downs of assets and write-ups of liabilities to increase book value and generate fictional earnings but no cash flow.

From an accounting perspective, the two cookie jar accounting techniques we have discussed are equivalent to one another. This is because earnings (and losses) represent the change in the book value of a company from one period to the next. Thus, reporting fake losses in a stub period has the same impact as making pro forma acquisition accounting adjustments to artificially depress book values.

A company engaging in cookie jar accounting through acquisition-related adjustments would show a substantial reduction to the book value of a target company.

Following the close of the acquisition, we would expect to see margin expansion, inflated earnings, increased book value, but no corresponding increase in operating cash flow.

Is the Logica purchase price allocation consistent with cookie jar accounting patterns?

CGI made several rounds of pro forma adjustments to the book value of Logica's assets and liabilities over the course of one year following the acquisition, as permitted by IFRS 3. CGI does not provide a document that summarizes all pro forma adjustments to Logica's book value relating to the purchase price allocation.

We have constructed a table that shows all the purchase price allocation adjustments using information from five different CGI filings. Investors may download a PDF of this table here.

The cumulative effect of all the purchase price allocation adjustments to Logica's balance sheet is shown in the following table.

(click to enlarge)

We note that CGI's purchase price allocation reduced Logica's current assets by $737 million and increased Logica's liabilities by $276 million.

These adjustments had the effect of lowering the book value of Logica by over $1,013 million. $1,013 million of book value is equal to 60% of the market value of Logica's equity before CGI's acquisition offer, and is more than twice the earnings of CGI in fiscal 2013.

Going forward, if CGI reverses any of the $1,013 million markdown in book value from adjustments to current assets and liabilities, CGI will recognize higher earnings, higher margins, increased working capital, but cash flows will be unaffected.

Logica's total net book value (all assets less all liabilities) did not change significantly in the purchase price allocation because the markdown of tangible assets was offset with very large increases to goodwill and intangible assets. Goodwill was increased $603 million as a plug equal to the difference between the purchase price and the book value of Logica's other assets and liabilities; intangible assets were increased $304 million. We do not know CGI's basis for marking up the intangible assets by this amount.

We leave it to the reader to decide whether the acquisition write-down of Logica's tangible book value (offset by increased intangibles and goodwill) is consistent with cookie jar accounting methods.

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Have any of the write-downs to Logica's tangible book value been reversed?

CGI's final purchase price allocation, shown in the table above, does not give us visibility into all working capital accounts.

However, the Company provides a table that shows the effect of applying CGI's revenue recognition policies to Logica's assets and liabilities in its first preliminary purchase price allocation in Schedule C of a Business Acquisition Report filed on November 11, 2012.

In this table, we learn that CGI's revenue recognition adjustments to Logica's work in progress and deferred revenues reduced Logica's book value by $384 million and $118 million, respectively.

(click to enlarge)

To the extent these adjustments are reversed, CGI will record additional earnings, higher margins, increased working capital, but no additional cash flow.

We do not know whether CGI has reversed any of these adjustments, but we are able to track how CGI's consolidated work in progress and deferred revenue accounts have changed in the past fiscal year.

Page 10 of CGI's FY 2013 financials shows how these accounts have contributed to a substantial increase in the book value of CGI in fiscal 2013: work in progress increased by $169 million, and deferred revenues decreased by $164 million. Both these changes increased working capital at CGI.

We think it is interesting that the increase in working capital from these line items in fiscal 2013 generated earnings but did not generate operating cash flows.

(click to enlarge)

We leave it to the reader to determine whether the purchase price allocation markdown of Logica's working capital accounts, followed by growing working capital at CGI in fiscal 2013, is consistent with the use of cookie jar accounting techniques.

Did Logica make any money in the five years before the acquisition? What are the implications of CGI's purchase price allocation adjustments?

CGI marking down the book value of Logica's net assets is equivalent to re-stating Logica's pre-acquisition financials to show lower earnings. This is because earnings simply represent the growth of a company's book value over time, adjusted for distributions to shareholders.

We think it is interesting to consider what Logica's earnings would have been if Logica's financials had been restated to align with CGI's final purchase price allocation.

Logica's tangible book value was marked down by $765 million in CGI's purchase price allocation. Therefore, restating Logica's financials would have eliminated $765 million in historical Logica earnings related to tangible assets. (We exclude CGI's $304 million mark-up of intangibles because we do not understand the basis for this adjustment.)

A $765 million adjustment would have effectively eliminated all of Logica's profits going back to 2007, as shown in the table below.

In other words, CGI's purchase price allocation adjustments imply that Logica may have been much less profitable than previously reported and was likely producing large losses for several years.

Summary

In this note, we have discussed the following:

• Cookie jar accounting is when a company understates profits in one period, so that it can overstate profits in a subsequent period.


• Re-marking the book value of a company is equivalent to re-stating earnings from prior periods.


• CGI made a series of adjustments to Logica's balance sheet in accounting for the acquisition that reduced Logica's tangible book value by $765 million.


• These adjustments are equivalent to writing off $765 million of Logica's earnings, which is equivalent to more than all of Logica's combined earnings from 2007 to 2011.


• Working capital, which was marked down in the Logica purchase price allocation adjustments, has grown at CGI since the acquisition.


• Growth in working capital has generated earnings for CGI but has not generated additional cash flow.

In subsequent notes we will look at topics such as CGI's organic growth and bookings.

Full Disclaimer:

This article is for informational purposes only and is not investment advice, and does not constitute an agreement, offer, a solicitation of an offer, or a recommendation to purchase or sell any particular security or pursue any investment or trading strategy. This article should not be construed as legal, tax, investment, financial or other advice. This analysis reflects our current opinions regarding CGI Group, Inc. Funds managed by us have an economic interest in the price movement of CGI Group, Inc.'s securities and specifically a decrease in the price of CGI Group Inc.'s shares. Our views and these economic interests are subject to change and we expressly disclaim any obligation to update the data, information or opinions contained in this analysis. We acknowledge that there may be confidential information in the possession of the companies discussed in this presentation that could lead such companies to disagree with our conclusions. Although we may do so, we do not expect to announce subsequent changes in our thinking or economic interests regarding CGI Group, Inc., but it is possible that there will be developments in the future that cause us to change our holdings in CGI Group, Inc.'s securities. We have based this analysis on public sources, including CGI Group, Inc.'s public filings, which can be obtained at sedar.com and sec.gov. While we believe the information presented in this article to be accurate, we make no representation or warranty to that effect, and we cannot guarantee that any projection or opinion expressed in this article will be realized.

Source: CGI Group: How Much Money Did Logica Lose? (Part 2)

Disclosure: I am short GIB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

Additional disclosure: Please see full disclaimer at the bottom of this article. This article is for informational purposes only and is not investment advice, and does not constitute an agreement, offer, a solicitation of an offer, or a recommendation to purchase or sell any particular security or pursue any investment or trading strategy. Funds managed by us have an economic interest in the price movement of CGI Group, Inc.’s securities and specifically a decrease in the price of CGI Group Inc.’s shares.

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