gilaxia
Summary
Following my coverage of Gartner Inc. (NYSE:IT), I recommended a hold rating as the valuation was too high at 33x forward PE. This post is to provide an update on my thoughts on the business and stock. While the upside is quite attractive even at this valuation (32x forward PE), I am reiterating a hold rating as I think a larger margin of safety will work better for my investment philosophy. Hence, I advocate for a long position when the valuation dips to 29x forward PE (this happened on August 18, 2023), as the margin of safety is higher.
Investment thesis
As I mentioned before, IT is doing well from a business perspective, and this has not changed with the most recent update. A 9.2% year-over-year increase in 2Q23 revenue to $1.5 billion surpassed expectations for growth of 7.6%. Increases in both Global Technology Sales (up 7.3%) and Global Business Sales (up 14.8%) contributed to the 5.7% year-over-year growth in Research revenue. Revenue from Consulting increased by 4.8% y/y, while revenue from Conferences increased by a whopping 49% y/y. Despite what one might expect based on the headline news (an impending recession, rising interest rates, a tight labor market, etc.), these growth figures suggest that the overall IT spending environment is still healthy.
In a recent bullish outlook (6 September 2023) on the industry, management predicted that enterprise IT spending would increase in the current climate, estimating that worldwide IT expenditures would rise by 4% in 2023, reaching $4.7 trillion. They singled out the double-digit growth in spending on enterprise software and the high single-digit growth in spending on IT services as examples of this trend. When discussing IT’s clientele in particular, management has noticed that spending by enterprise function heads has shown remarkable resilience, increasing by double digits. This is because the firm plays a vital part in its clients’ technological strategies. There is, however, still some pressure, particularly from customers in the technology vendor sector, who are in the midst of cost realignment initiatives.
That said, I personally still hold a pessimistic view on the overall environment, as I expect the selling environment to become incrementally more challenging compared to several quarters ago as the Fed continues to signal further hikes in rates. Management has explicitly mentioned this in the 2Q23 earnings call:
I will say, while we’re growing there, that there are more decisions getting escalated and there’s more scrutiny than there was like a year ago. So it’s a tougher environment in terms of what relations. 2Q23 earnings results call
I’d also like to mention that the marketing budgets of technology vendors continue to be squeezed, and that management mentioned at the GS conference that the industry’s CV has slowed from double-digit growth to low single digits this quarter. Tech vendor transaction revenue is another area feeling the pinch, having dropped by the high single digits year-over-year from $104 million to $95 million as a result of pricing pressure brought on by fewer companies competing for sales leads in light of tighter marketing budgets.
The good news here is that GBS is still doing well. On the 4Q21 earnings call, management mentioned that they estimate a $145 billion market opportunity, of which IT is still only a small portion. The addressable market for GTS is estimated at $55 billion (4Q21 earnings), making this opportunity significantly larger. Consequently, in the long run, as GBS represents a larger portion of the pie, IT will become a much more macro resilient business worthy of a higher multiple. In addition, IT’s share of this market is still relatively small (LTM revenue was $3.9 billion), leaving plenty of room for expansion. Also, management stated at the GS conference that they expect each GBS functional area to generate $1 billion in revenue. This includes human resources, finance, and supply chain.
Finally, I think IT will benefit from the increasing popularity of AI. This advantage will arise in two ways. First, it would improve IT ability to retain current customers and attract new ones (companies rely heavily on IT for research, etc.). Internally, IT can use it to boost productivity, which is the second advantage. Since IT is in possession of the necessary research data, it shouldn’t be too difficult to programmatically extract the pertinent data and assemble it for the sales rep. Call centers (technical support staff) and customer service are two other examples where it can leverage AI to reduce the number of employees needed.
Valuation
Own calculation
Given that the multiple has come down by 1x from 33x to 32x and the valuation gap between IT and peers has widening, I believe the valuation today is certainly more attractive than in June. I believe the fair value for IT based on my model is $417. My model assumptions are that IT will grow 7% in FY23, which is what management is guiding, and similar growth strength will be seen in FY24 and FY25 as the selling environment remains challenging (unlikely to recover to the double-digit range seen historically). However, I expect adjusted margins would gradually grow as IT invested in IT to increase productivity and also from operating leverage (note, my margin estimates are based on consensus estimates). However, my model assumes no steep recession, so this is something a potential investor needs to take into account, as in a steep recession, the entire market is going to be dragged down (IT valuation will be hit for sure). As for multiples, I assume it would trade back to 33x, its historical average. While the upside is attractive at 19%, I am personally waiting to buy at 29x forward PE, as it is the low end of IT’s historical trading range which will give me more margin of safety.
Peers include: Costar Group, Dun & Bradstreet Holdings, Moody’s, MSCI, Fair Isaac Corp, and Factset Research Systems. The median 1-year forward PE multiple is 34x forward PE.
Conclusion
While the company continues to perform well, with strong revenue growth in various segments and a positive outlook for the IT spending environment, there are several factors to consider. The overall economic landscape remains uncertain, with potential challenges arising from rising interest rates and a tightening labor market. Management’s expectation of increased enterprise IT spending is promising, but there is still some pressure, especially among technology vendor customers who are undergoing cost realignment. Marketing budgets in this sector are being squeezed, affecting transaction revenue. Valuation-wise, while the current multiple has improved from 33x, a better entry point may be at 29x forward PE, considering historical trading patterns. In summary, Gartner Inc. shows promise, but waiting for a lower valuation may align better with an investment strategy that prioritizes safety and long-term potential.
