Sapient (NASDAQ:SAPE) is one of the few pure-play information technology (IT) consulting firms to survive the bursting of the Internet bubble. Although 2002 revenues were only about one-third of 2000 revenues, the company aggressively cut costs and restructured to get through the downturn in the industry. The firm is now rebounding solidly. Its first-quarter 2004 revenues, announced last week, were 14% above the year-ago quarter and above analysts' expectations.
In its earnings release, the company highlighted significant new engagements at blue-chip clients such as BP (NYSE:BP), Comcast (NYSE:CCZ), and Exelon (NYSE:EXC). As a result, the company is now breaking even and is increasingly focused on making progress towards its operating margin target of 10%. That's in line with industry leader Accenture (NYSE:ACN), which has an 11% operating margin.
The IT consulting business is inherently a good business. The business model is simple -- all consulting ultimately boils down to "renting out" smart people on a project basis. It doesn't require much capital, and once basic fixed costs are covered, it provides good operating margins. Barriers to entry are high, as the business is based on long-standing customer relationships and high-caliber consultants, both of which are difficult to develop.
However, the business does not provide opportunities for extraordinary economic returns, unlike some other parts of the broadly defined IT industry, which have "winner-take-all" characteristics driven by network effects (one "standard" naturally emerges in the industry). The classic example is operating systems software, as Microsoft (NASDAQ:MSFT) has demonstrated.
At the height of the Internet bubble, IT consultancies were valued as if the business model shared some of these characteristics. At that time, previously unknown firms like Scient, Viant, and Razorfish boasted multi-billion market capitalizations and traded at huge multiples of revenues. Sapient stock traded as high as $140 in 1999 and 2000. The firm's 52-week range now is $1.89 to $7.33, and shares are currently trading at $5.79.
In addition, the growth rate of consultancies is limited by the fact that the business hinges on the quality of its people, and that it simply takes time to hire and train good people. Lastly, as was recently argued in a Harvard Business Review article titled "IT Doesn't Matter," IT's importance as a strategic differentiator may be diminishing -- like electricity, IT may become a ubiquitous piece of a company's infrastructure, but it will no longer be a source of competitive advantage.
Even with its stock price down to $5 to $6, Sapient still trades at lofty multiples -- more than 3.5 times sales, in contrast to Accenture, which trades at 1.6 times sales. While survival is no longer an issue for Sapient, the current valuation still reflects remnants of delusions from the Internet bubble. The stock still has quite a bit of room to fall before it is in line with a valuation that accurately reflects the inherent characteristics of a consulting business.
Want to uncover small undervalued companies? Sign up for a free trial of Motley Fool Hidden Gems to learn more.
Fool contributor Salim Haji lives in Denver, Colo. He does not own shares in any of the companies mentioned.
