Taking Stock: Sapient's Cost-Conscious Model Is Ready For IT Services Recovery

There must be a recovery coming in technology because I'm beginning to get excited about the IT services sector again.

Whenever we emerge from this technology winter (and we're not out of the woods yet), IT services will once again be in demand. Especially those services represented by Sapient (SAPE--Nasdaq) in Cambridge, Mass., an IT service leader that's focused on a fixed-time, fixed-price model. Its offerings include design and development for custom software, integration and implementation of packaged solutions, and traditional management consulting and product support.

Sapient, founded in 1991, has developed a reputation for helping IT managers design and implement solutions focused on improving business processes. The company has broad expertise in many emerging and leading technologies and can integrate that expertise into legacy systems. By promising fixed-time, fixed-price services, Sapient is on the economic hook for delivering what it promises.

The company also is trying to differentiate itself with a lower-cost global distributed delivery system, creating a large offshore services department in India (more than 400 people). Besides the ability to develop around the clock, the company benefits from lower labor costs.

In the overall economy, service demand is starting to pick up but it's still a long way from recovery. We're seeing improvement on the government side, but business IT spending is still flat or declining.

Sapient faces other risks, too: Due to the significant decline in its stock price--from almost $20 in January to a low of $3.15 in September--it may be removed from the Standard & Poor's 500 index. That would cause significant near-term selling pressure, since the stock is held by many index funds.

The company outlined the recent negative financial trends in its most recent financials. Sapient reported third-quarter revenue of $70 million and a per-share loss, excluding the impact of a tax accounting charge, of 7 cents. Revenue for the quarter ending Sept. 30 declined 49% year-over-year and was down 20% from the previous quarter, while average revenue per billable employee decreased to $156,000. Gross project margins remained stable due to lower cost structure.

Billing trends illustrate the tough pricing environment. The average annualized revenue run rate per billable employee for this year's first and second quarters was $170,000 and $181,000, respectively. Much of the stabilized gross margin can be attributed to the new global distributed delivery system, which affected about 34% of third-quarter revenue, up from 20% in the previous quarter.

Sapient continued to cut staff, ending the third quarter with a billable staff of 1,807, down from 1,859 in the second quarter (total staff was 2,364). Billable staff will be flat to slightly higher by year's end because of additional expansion in India. Voluntary turnover remains within the company's 15% to 20% guideline. The third-quarter utilization rate was around 60%, up from 55% in the prior quarter, primarily due to an increase in services from India. International sales were about 26% of total sales.

Sapient anticipates fourth-quarter revenue of $60 million to $65 million, a decline of 7% to 14% sequentially. This will result in a pro forma loss per share of 12 cents to 14 cents for the fourth quarter. Operating margins are likely to remain negative through next year. The hope is that those margins will reach 12% to 14% by 2004, still quite a bit below the 16.8% achieved in 1999.

Sapient had $236 million in cash on the balance sheet at the end of the third quarter, a total that's projected to fall to $220 million by year's end. One-third of the decline can be attributed to restructuring charges in the prior quarter. Given the high degree of uncertainty, a valuation above $6.50, or roughly two times book value, seems high. With the recent run-up in share price to $7, patient investors should wait to buy. Anything under $5 would be attractive.

William Schaff is chief investment officer at Bay Isle Financial Corp., which manages the InformationWeek 100 Stock Index. Reach him at [email protected].