Gen AI Investment And European Weakness Will Pressure Margins And Earnings Outlook

Catalysts

About Capgemini

Capgemini is a global consulting, technology and engineering services group that designs, builds and operates digital and AI enabled transformation for enterprises and public sector clients.

What are the underlying business or industry changes driving this perspective?

• The rapid shift of enterprises to cloud first architectures is now mature. As a result, incremental migration and modernization work risks decelerating just as Capgemini has scaled its Applications and Technology Services, which could cap revenue growth and pressure utilization driven net margins.
• Client focus on using data and artificial intelligence to extract productivity gains is embedding contractual expectations of cost savings. These savings may increasingly be passed back through pricing and rebasing of large vendor consolidation deals, structurally weighing on gross margin and earnings growth.
• Heavy investment in Gen AI and Agentic AI platforms and frameworks ahead of broad based monetization, combined with clients demanding tangible efficiency benefits from these tools, risks an unfavorable balance of R&D and commercial returns that dilutes operating margin and slows EPS expansion.
• Weak or declining activity in structurally challenged European markets, notably France and Continental manufacturing and automotive, may offset stronger growth in North America and APAC. This may keep group revenue around flat while fixed cost absorption limits any improvement in operating margin.
• Rising restructuring charges to resize the European workforce and increase offshore leverage, together with wage inflation and competitive pricing, could make the 13.3% to 13.5% operating margin target difficult to sustain and constrain free cash flow available to fund the planned EUR 2 billion buyback without increasing leverage.

Assumptions

This narrative explores a more pessimistic perspective on Capgemini compared to the consensus, based on a Fair Value that aligns with the bearish cohort of analysts. How have these above catalysts been quantified?

• The bearish analysts are assuming Capgemini's revenue will grow by 4.5% annually over the next 3 years.
• The bearish analysts assume that profit margins will increase from 7.1% today to 7.6% in 3 years time.
• The bearish analysts expect earnings to reach €1.9 billion (and earnings per share of €11.13) by about December 2028, up from €1.6 billion today. However, there is some disagreement amongst the analysts with the more bullish ones expecting earnings as high as €2.4 billion.
• In order for the above numbers to justify the price target of the more bearish analyst cohort, the company would need to trade at a PE ratio of 15.1x on those 2028 earnings, down from 16.5x today. This future PE is lower than the current PE for the GB IT industry at 15.8x.
• The bearish analysts expect the number of shares outstanding to remain consistent over the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 9.2%, as per the Simply Wall St company report.

Risks

What could happen that would invalidate this narrative?

• Sustained client appetite for cloud first architectures, ERP enabled digital core and data and AI programs could translate the current solid book to bill of 1.08 and Q2 bookings growth of 1.5 percent into an acceleration from flat constant currency revenues to mid single digit growth, lifting group revenue and utilization driven operating margins.
• The fast rising demand in Gen AI and Agentic AI, already representing over 7 percent of Q2 bookings and supported by proprietary frameworks like Resonance AI and the RAISE platform, could scale profitably as assets are reused across clients, improving pricing power and mix and therefore net margins and earnings.
• Structural momentum in high growth regions such as Asia Pacific and Latin America, which delivered 8.7 percent constant currency growth in H1, together with 6 percent growth in the U.K. and Ireland and 1.6 percent in North America, could more than offset European weakness over time and drive higher consolidated revenue and operating margin.
• Capgemini’s positioning in high value segments like intelligent operations, defense and sovereignty in Europe and industry specific AI enabled transformations could increase the share of higher margin work in the portfolio, stabilizing or expanding the gross margin beyond the current 26.4 percent level and supporting faster earnings per share growth.
• The multiyear EUR 2 billion share buyback program funded by resilient organic free cash flow and stable net debt of EUR 2.8 billion could reduce the share count by more than the approximately 1 percent annual stock based dilution, boosting earnings per share even if net profit grows only modestly.

Valuation

How have all the factors above been brought together to estimate a fair value?

• The assumed bearish price target for Capgemini is €130.0, which represents up to two standard deviations below the consensus price target of €171.93. This valuation is based on what can be assumed as the expectations of Capgemini's future earnings growth, profit margins and other risk factors from analysts on the more bearish end of the spectrum.
  
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of €225.0, and the most bearish reporting a price target of just €130.0.
  
• In order for you to agree with the more bearish analyst cohort, you'd need to believe that by 2028, revenues will be €25.2 billion, earnings will come to €1.9 billion, and it would be trading on a PE ratio of 15.1x, assuming you use a discount rate of 9.2%.
  
• Given the current share price of €151.85, the analyst price target of €130.0 is 16.8% lower. Despite analysts expecting the underlying business to improve, they seem to believe the market's expectations are too high.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.