More than two-thirds of Gartner’s revenue is generated by the core research segment, which holds the dominant share in the IT research market; the remaining revenue is generated by the consulting (23.4% in 2010) and events (9.4% in 2010) segments. The research business is the crown jewel of Gartner’s business portfolio; this business is the key revenue growth and margin expansion driver for the company, offers the best visibility of Gartner’s three businesses, and provides the analytical foundation for all three segments.
Gartner has over 60,000 clients in over 7,700 distinct enterprises. The company operates in approximately 85 countries, deriving the largest portion of its revenue from the United States; 44% of FISCAL YEAR10 revenue came from outside the United States, including 30% from EMEA and what we estimate was 5-10% from emerging markets. The rest comes from the public sector.
The company’s business is divided into three segments: Research helps customers keep abreast of technology trends, issues, and best practices so they can make smarter IT purchases; consulting provides more customized services that help customers solve specific issues and find the best pricing for technology products and services; events leverages Gartner’s research assets and industry relationships, bringing together and educating customers and vendors at symposia and conferences
I believe that Gartner has several strong points:
a) Strong value proposition: Gartner’s IT research products and services play a valuable role for CIOs and other executives making mission–critical IT strategy and spending decisions in a rapidly changing environment. I believe the knowledge Gartner imparts has the potential to save clients money by helping them avoid poor IT spending decisions, make value enhancing decisions, and negotiate contracts with IT vendors. A typical client spends $80,000-$90,000 per year on Gartner products, which represents a small fraction of a typical IT spending budget; I believe this sometimes enables Gartner’s contracts to fly “under the radar” of spending cuts and makes the contracts easier for clients to justifiscal year even in a challenging corporate spending environment.
b) Dominant market position in a large market: According to research firm Boenning & Scattergood, Gartner has approximately 33% market share of its core IT research market, a share I believe represents more than double that of the next two closest competitors (IDC and Forrester Research) combined. Although Gartner is the largest provider of IT research in the world, I believe it competes in a large and underpenetrated market that affords ample opportunity to strong long-term growth for Gartner.
I estimate that the current global IT research market revenue is approximately $3.9 billion. However, in past 10-K reports, management estimates a $45 billion IT research market opportunity that comprises approximately 100,000 potential customers potentially spending an average of approximately $450,000 annually on IT research. This compares with Gartner’s approximately $7,700 research enterprise clients spending what I estimate is $80,000-$90,000 annually.
Importantly, even at $45 billion, the IT research market would represent a small fraction of the $3.0-3.5 trillion Gartner and IDC estimate that enterprises spent globally on IT hardware, software and services in fiscal year 2010. Both Gartner and IDC currently estimate that worldwide IT spending will average a approximately 5% CAGR from fiscal year 2010 through fiscal year 2015E, although I expect these forecasts may decline if the economic environment worsens further. The following chart shows a normal IT spending decline during recessions but the overall trend is positive for Gartner.
c) Strong FCF conversion: Gartner’s research and events customers tend to pay in advance, which affects the cash flow statement as a cash benefit from deferred revenue growth and typically causes working capital changes to benefit operating cash flow while the business is growing. In addition, Gartner’s business does not require significant facilities or technology investments to accommodate target growth rates, so capital expenditures are relatively low. In fiscal 208, 2009, and 2010, capital expenditures totaled 1.9%, 1.3% and 1.7% of revenue, respectively. Due, in part, to these factors, in fiscal 2009 and fiscal 2010, FCF totaled 177% and 191% of net income, respectively.
d) Scalability, superb management and no client concentration: I believe research, which comprised 67% of fiscal 2010 revenue and has the highest incremental gross margin, at approximately 70%, is the most scalable and has the potential for the most significant margin expansion over time given the “write once, sell many times” nature of the model. With thousands of clients distributed across its three business segments, Gartner has virtually no client concentration risk.
Summary of second quarter 2011 Results
Gartner reported strong second quarter 2011 results on Aug. 2, 2011; shares traded about flat that day as results were largely overshadowed by investors’ growing macro concerns. Revenue of $365.6 million and diluted EPS of $0.32 were ahead of consensus estimates. Revenue increased 16.4% year over year to $365.6 million (11% constant currency), 2.7% ahead of consensus, and growth accelerated from first quarter 2011’s 11.4% (10% constant currency).
Normalized EBITDA of $68 million rose 19% year over year; 18.6% normalized EBITDA margin improved 150 bps year over year. Research revenue increased 19.6% year over year to $250 million, (14% constant currency), in line with first quarter’s growth rate. Notably, the research segment’s contract value increased 15.4% Year over year (16% organically), an acceleration from first quarter’s 14% organic growth rate. Management also noted the highest level of new business (+26%, split between sales to new clients and sales of additional services and upgrades to existing clients) in Gartner’s history. Consulting revenue increased 2.9%
Year over year to $78 million (down 2% constant currency), an improvement from first quarter’s 3% Year over year organic decline. Events revenue increased 28% year over year to $38 million, (up 24% constant currency, an acceleration from first quarter’s 13% constant currency growth rate). During the quarter, Gartner repurchased over 930,000 shares at a cost of approximately $36 million; there is still $416 million remaining in the current share repurchase authorization. This shows that management is aligned with investor interests.
The chart presents an improving picture of both revenue and margin growth for this company.
There are two main risks. First, there is a potential impact of economic weakness. Second, non-recurring consulting engagements remains a significant portion of total revenue, representing 23% of total revenue in fiscal year 2010 and 25% in fiscal year 2009. Consulting revenue is project-based and is more discretionary from the client’s perspective.
During the past recession, Gartner’s core research business remained relatively resilient, with research revenue declining 3.7% in fiscal year 2009 and organic constant-currency contract value declining just 1% that year. The events business, typically driven by clients’ discretionary spend, declined 33.1% year over year in fiscal year 2009. The consulting business, which is also subject to discretionary client spending, declined 17.4% Year over year in fiscal year 2009, with backlog down just 6% year over year.
The stock has performed well, tracking the improvements in contract value growth; as we can see in the chart, IT performed better than SP&500. It is attractive from a valuation perspective that the forward P/E is low based on what historically traded.
At 25.2x 2011E EPS, Gartner trades at a premium to the comparable company group’s average but considering they are industry leaders and generate a big portion of EBITDA from non-recurring revenue, the multiple appears reasonable. Its 16.6x price-to-free cash flow multiple is more compelling, but in a future weak economic growth scenario could be fair. So, by doing peer comps valuation, current Gartner multiples give us a fair or balanced valuation. In the following table we can see that Gartner's business grew more than its peers but multiples are not below average.
I run a DCF analysis from the key assumptions:
- 2011-2016E revenue CAGR of 9.7%
- 2010 normalized EBITDA margin of 17.9% increasing to 22% by 2016
- Weighted average cost of capital (WACC) of 13%
- Terminal free-cash-flow growth rate of 3.0%
- Working capital changes and capital expenditures in-line with historical ratios
I derive a $38 price from my discounted cash flow (DCF) analysis. I will buy if the stock goes to the low $30s levels, giving me a minimum margin of safety of 20% from my DCF and peer comps valuation.