In December 2018, I published my first and only article about Accenture plc (ACN) as part of a series I called “Preparing for the end of the cycle”. In this series, I covered several high-quality companies with a wide economic moat, which I considered still overvalued at that time. Last week, the company released its annual results for the full-year 2020 and it might be time for an update.
(Source: Accenture Media)
In the following article, I will start by looking at the business as well as the numbers Accenture reported last week. Following that, we will look at some of the company’s strengths – mainly the balance sheet and wide economic moat. Finally, we look at the company’s dividend, the growth potential and end with an intrinsic value calculation.
Accenture missed analysts’ expectations for revenue as well as earnings per share and obviously, investors were also not pleased with the guidance for 2021 and sent the stock about 7% down last Thursday. At the time of writing, Accenture is trading about 13% below its former all-time high.
And while the full-year results were not great, they were not bad either. While revenue could increase only 2.6% for the full year, net income could increase 6.9% and diluted earnings per share could increase 7.2%. We have to keep in mind that we are in the middle of one of the worst pandemics in history and in a pretty severe recession. And considering the horrible second quarter (from April till June 2020) and the numbers many other companies had to report, a revenue decline of 2% for Accenture in the last quarter and 13.9% increase in net income are pretty solid.
The biggest part of revenue (almost half) is generated in North America and Accenture could grow its sales still by 5% in the past year. While Europe stagnated, the “growing markets” could report 8% growth.
(Source: Accenture Infographic)
Accenture is reporting its revenue in five different industry groups ranging from “Products”, which is responsible for almost 28% of revenue to “Resources”, which is responsible for 15% of revenue. The highest growth rates came from “Health & Public Services”, which grew 13% in the past year. Aside from industry groups, Accenture is also differentiating between two different “types of work”. On the one side, we have consulting services, which cover areas like strategy and fields like blockchain, technology, and digital transformation and generated $24.2 billion in revenue. On the other side, we have outsourcing services, which include services as accounting, procurement services, and application services and generated $20.1 billion in revenue.
(Source: Accenture Infographic)
Accenture is also reporting part of its revenue as “The New”. This is including services like digital, cloud, and security and is now responsible for approximately 70% of revenue. For fiscal 2021, Accenture will no longer report this as “The New” as digital is now embedded everywhere – according to the company’s new growth model.
Accenture is also growing by acquisitions. The acquisition strategy of Accenture not only seems to work very well in the past few years, but I also consider it a great strategy for the years to come. Accenture almost never makes huge acquisitions (as some other companies) but is mostly acquiring small businesses, for which it has to pay relatively small amounts. Even if Accenture should make mistakes in its acquisition strategy and acquire the “wrong” business or “overpay” for a business, it doesn’t create huge problems. In August 2020, Accenture also announced it will cut about 25,000 jobs worldwide. The reason might be the pandemic, but it also seems quite natural that after dozens of acquisitions, the company will restructure in several ways and as part of this process, some jobs are not necessary any more.
Great Balance Sheet
When a company is acquiring other businesses on a regular basis, there are different ways to finance the acquisitions. For example, by increasing the number of outstanding shares (Accenture is actually buying back shares on a regular basis – we get to that later) or by taking on debt. The company is using neither of those options and has only $54 million in long-term debt and about $8 billion in short-term debt on its balance sheet (and compared to $17.5 billion in shareholder’s equity these amounts are neglectable). In the recent past, Accenture usually paid for the acquisitions in cash and with about $8.4 billion in cash and cash equivalents on the balance sheet, the company can continue to grow by acquisitions. This amount is also providing enough liquidity for Accenture to whether storms that might come in the next few quarters. The biggest problem regarding the balance sheet might be $7.7 billion in goodwill, but this is also no reason to be worried.
Wide Economic Moat
Aside from the strong balance sheet, which gives Accenture enough margin for maneuver to make further acquisitions in the years to come, the company is also protected by a wide economic moat. This moat is based on several aspects. A first important aspect and source of wide economic moat would be the intangible assets for Accenture. This includes the intellectual property portfolio the company has established over the years and which now includes more than 7,400 patents and pending patent applications in areas like artificial intelligence, blockchain, cybersecurity, extended reality, and the Internet of Things. But aside from the patents, the brand name (reputation might even be a better term) seems to be the most valuable intangible asset the company has. When considering the differentiation between outsourcing and consulting business, the brand name is especially important for the consulting business as it can be very helpful to attract new customers. The brand name is especially important when many competitors enter an industry and try to attack and gain market shares by offering cheaper prices.
The fact, that Accenture is currently working or has been working with so many big, respected international companies is leading to a reputation that will attract new customers. If respected international corporations hire Accenture to consult them, other companies will tend to hire Accenture themselves. By working with so many leading corporations all over the world, Accenture has also gained a huge knowledge base and information about new trends as well as typical problems companies all around the world might have.
Aside from the intangible assets (patents and brand name), the high switching costs are also adding to the wide economic moat around the business. While the brand name is important for attracting new customers, the outsourcing business relies on switching costs, which will keep the customers from leaving. 99 of the company’s top 100 clients have been with the firm for more than five years and 95 have been with the firm for more than 10 years. Accenture also ended FY 2020 with 216 Diamond clients, which is the company’s category for the largest clients. This number has increased steadily in the past – in fiscal 2020, Accenture added 15 new Diamond clients and in 2014, the number of Diamond clients was only 140. On the one side, we might see personal relationship costs as the customers are forming a bond of trust with Accenture and especially if the customers are dealing with the same employees from Accenture again and again this relationship can be very strong. But the switching costs are rather resulting from learning costs, which are high as it takes quite some time for Accenture and its employees to understand the business and get the necessary knowledge in order to provide valuable consulting services. And especially after relationships have lasted for several years, Accenture has gained a lot of knowledge about the customers and often has a good understanding of the business. When switching to another consulting firm, this (steep) learning curve has to be duplicated, which is leading to high costs for the customer.
The switching costs are especially high when the consulting services are embedded in a complex structure and the consulting service is interconnected with many processes in the company and important for many different departments and business units of the company. It is also increasing the switching costs if the consulting service is mission-critical for the company as the market environment often doesn’t allow to take a lot of time for instructing a new consulting firm.
(Source: Author’s own work based on numbers from Morningstar)
The wide economic moat is also visible in different numbers. In the chart above, we see the gross margin and operating margin, which were very stable during the past decade. This is indicating pricing power for the business and resilience against price pressures and low-price competitors. Accenture also has an extremely impressive return on invested capital, which was as high as 71.5% during the last decade (the lowest reported number was 38.1%). The average RoIC was 55% during the past decade and these numbers clearly show a wide economic moat.
We mentioned above that Accenture is growing by acquisitions and probably will continue to grow by acquisitions in the years to come. Additionally, Accenture is protected by a wide economic moat, which gives the company pricing power. But it is also important that the overall market in which a company is operating can grow in the years to come.
When looking at consulting services, the overall market is expected to grow with a CAGR of 3.8% in the years until 2025. Other studies are expecting growth rates between 4% and 5% – similar to the growth rates in the recent past. And not only consulting services will continue to grow, but outsourcing services are also expected to grow. When looking at IT outsourcing services – the main market of Accenture – we can expect a CAGR of 2.6% for this market segment in the next few years. Accenture is also present in the digital transformation market, which is expected to grow with a very high CAGR of 22.7% in the years until 2025. Digital transformation is the process of using digital technologies to change processes, models, businesses, and organizational activities to further improve the performance of businesses and this is certainly one of the core areas of Accenture’s services.
For Accenture, it will continue to pay off that the company has been focusing on digital services, cloud services, and security services. In 2020, these segments generated $30 billion in revenue (representing 70% of total revenue). Especially, with the COVID-19 pandemic, many companies need to accelerate their digital transformation and move to the cloud – and Accenture will profit from these trends in the years to come. The strong bookings in the fourth quarter (which were $14 billion and the second highest number on record reflecting 9% growth) are also a strong sign, that Accenture is profiting from this trend.
I don’t think many people are investing in Accenture for the dividend, but Accenture is paying a dividend nevertheless. Accenture started paying a dividend in 2005 and after starting with an annual dividend, then switching to a semi-annual dividend Accenture is now paying a quarterly dividend. After the most recent dividend raise, Accenture increased its dividend from $0.80 to $0.88 every quarter. This is resulting in a dividend yield of 1.5% and a payout ratio of 40% (when taking the fiscal 2020 earnings per share).
Aside from paying out part of its generated free cash as dividend, Accenture is also buying back shares. Very recently, the company approved $5 billion in additional share repurchase authority and with the remaining ~$1.3 billion in share repurchase program, this brings the total amount to $6.3 billion and Accenture will continue to buy back shares. Since the early 2000s, Accenture decreased the number of outstanding shares by 36%.
Intrinsic Value Calculation
I already mentioned above, that investors seemed to be disappointed by the results and the company’s guidance. But the guidance seems to be solid, considering we are in the middle of a severe recession. For the full year of 2021, management expects revenue to grow between 2% and 5% in local currency and GAAP diluted earnings per share to be in a range between $7.80 and $8.10.
For our intrinsic value calculation, we are rather pessimistic (or: cautious) and assume, that Accenture won’t be able to grow next year. For the years to come we are still conservative and assume 4% revenue growth in the years to come (combination of organic growth and acquisitions). Additionally, we can assume that Accenture might improve margins by cutting costs and by profiting from scale effects. We assume this will add another 1% to bottom line growth. And finally, Accenture will continue its share buyback program, which will add 1-2% growth to the bottom line. Overall, we can assume Accenture to grow between 6% and 7% in the years to come.
As basis for our calculation and free cash flow in 2021, we assume the same free cash flow as in 2019 ($6,028 million). In 2020, the free cash flow was a record of $7.6 billion, but I am once again rather cautious. When using these numbers and 5% growth for perpetuity, we get an intrinsic value of $199.54 for Accenture making the stock a little overvalued at this point.
I am always calculating rather cautious and try to make assumptions, that are realistic and consider also that things might go wrong or that we will face difficult times (recessions, pandemics, etc.). But when looking at the long-term performance since 2000, revenue could increase with a CAGR of 7.2% and net income increased even with a CAGR of 14.22% making our assumptions probably too pessimistic. Although growth slowed down a little bit in the past decade, revenue still grew 6.43% annually on average and net income increased 11.64% every year on average.
Although the overall market in which Accenture is operating is highly fragmented, marked by competition and expected to grow “only” in the low-to-mid single digits, Accenture is a great business. Protected by the wide economic moat, Accenture will outperform the overall market and grow organically as well as by acquisitions. And Accenture is especially dominant in market segments where we can expect higher growth rates – digitalization, cloud or security. But Accenture still seems to be overvalued at this point – although I have to admit, that my assumptions for the years to come are rather cautious.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.