Atos - Margins versus Restructuring Costs

All,

Please find our updated analysis on Atos here.

We have remained sceptical of the Atos turnaround story, but many of you have asked us to look at the name again. We have started our analysis from scratch, focusing on the operational aspect of Atos and its prospects over the coming years. Our view has not changed. Atos remains an equity-like story, and investors should receive equity-like returns across the capital structure.

Investment Considerations:

- We are not taking a position in Atos’ capital structure. We view Atos as an equity risk story, with investors expected to make a judgment based on two financial metrics: the level of cash restructuring costs and the speed and level of operating margin over the medium term. The company’s targets in both cases are best achieved scenarios over the last 10 years, but recent and trend levels remain far from these bullish targets.

- Our model shows that by the end of FY27, the net first lien debt will be approximately zero, which in normal circumstances would leave the 11% yield to maturity (9.4% to Dec-27 takeout) very attractive. However, trading at 111%, with a YTM of 11% it offers limited upside. We expect 4pts of upside if better numbers materialise, leaving yields at 10% to maturity. Any early take-out reduces the yield, with take-out in Dec-27 on the back of strong numbers, the yield falls to 7.6%. The downside is limited for the 1L, but with slightly weaker guidance for Q3 revenue, we expect a more favourable entry point.

- 1.5L: This is the real fulcrum instrument, with variations in operating margin and restructuring costs resulting in either 2x covered or zero recovery. The current 14% YTM at current prices is not sufficient for that volatility, and we view a fair price 20pts lower at 63% (20% YTM). Upside is potentially 10pts to an 11.5% YTM, but that would require some substantial margin improvement and a significant reduction in cash restructuring costs.

- 2L: A pure equity instrument, which at 4.3x LTM leverage, is barely in the money. This instrument won't see any major upside in the short term due to the substantial restructuring required.

- In addition, impacting all tranches, the business will still be free cash flow (after interest) negative in FY27, and with two years to maturity, a refinancing will not be straightforward. Additionally, we retain our doubts that restructuring costs can be reduced to 3%. If costs run at historic levels coupled with a slower margin expansion, 1L par recovery will be questioned.

- Company guidance would appear optimistic, and further top-line declines cannot be ruled out. Revenue guidance for H2 from the company is for flat revenue growth in Q3, with all of the growth expected in Q4. Therefore, there is limited motivation to take a position prior to Q3 revenue numbers.

- The business has consistently reported high cash restructuring costs, which, even prior to the balance sheet restructuring, were circa 3–4% of revenue. Ultimately, a view on this is the driving force for any investment decision. We have projected growing revenue and expanding margin, but even with reducing cash restructuring costs to circa 3%, the business will remain cashflow negative, after interest, for each year FY25, FY26, and FY27.

Sarria Model:

- The company has set itself an aggressive target for revenue and operating margin growth. We have modelled some growth, but H1 results don't justify using the company’s projections for FY25.

- Regarding operating margin, the Company has set itself a target of 10% operating margin by FY28. We don't see this as realistic, as the average margin was 4.3% since 2020, which is skewed by c.9% in FY20. FY21-FY25 average margins were 3.2%. However, in FY17-FY20, operating margins did average 10%. The Company is banking on returning to the pre-FY20 levels of margin over the next three years.

- Our model assumption is 5.5% in H2 27, with a linear improvement to that level in the intervening quarters. This would equate to 6.6% at the end of FY28, 300bps behind the Company’s target.

- However, we reiterate that a bigger issue for Atos is the level of cash restructuring costs. This has a significant impact on free cash flow, debt capacity, and interest coverage. Atos has been undergoing continuous restructuring, as reflected in the persistently high levels of cash restructuring costs since FY20. In 2020 and 2021, before the financial restructuring process, these costs averaged 3.5%. While we have assumed 3% in our base case, we remain sceptical about Atos’s ability to control this expense in the short to medium term.

- We have modelled 3% in FY26 and FY27, c. €260m p.a., which reduces our DCF multiple to 4.6x. An increase to 3.5% reduces it to 3.4x, a full turn of leverage. This line item is one of the most important factors in assessing the enterprise valuation of Atos.