Description

Thesis

At current prices, there is an opportunity to buy the premier IT, operations and outsourcing company at 11.5x EPS, under 5x EV/EBITDA or 10x EV/FCF vs. a historical range of 12 to 18x EPS.  This is a very low price for a company with high returns on capital, expense adjustment flexibility and still-growing end markets.  Further, the partner stock overhang is almost finished though partners will still hold over 10% of the company.  Assuming the global economy begins to mend, FCF should recover to $2.7B to $2.9B range within a few years.  Layer in two years of FCF equivalent to $5B plus the $4B net cash (as of 08/31/09) on the balance sheet and a likely valuation for the company should be 50 to 75% higher than its current valuation.  [Note that by August 31, 2011, the company will have about $9B in cash (assuming no buybacks) or close to 40% of the current market cap.]  This is based on a 14x EPS of $3.00 by 2011 plus $9B in cash - or $51 versus the current price of $31.00.

Background

Accenture is a consulting firm focused on IT, operations and outsourcing.  It was structured as a partnership before its IPO 8 years ago; founders still own roughly 14% of the company.  The management team is mostly homegrown and has done a stellar job in growing the business profitably while also returning close to $15bn in the form of dividends and share buy backs to shareholders.  About 60% of the business is consulting (systems integration, technology, management consulting) and 40% is outsourcing (where they take over the back office operations of a company).  The company is diversified across geographies and vertical markets and has 96 of the fortune 100 as clients.  Historically, the business has grown 9-12% annually in a normal environment and during the last down turn it still grew top-line 1%.  Given its size and scale, few competitors can match ACN globally - save for IBM and HP.  One competitive advantage of note is their status as an independent broker that does not sell hardware and software as well.

What created the opportunity?

The company was thought of as a defensive name all throughout last year as their business held up nicely as revenues grew high single digits while margins continued to improve.  The company has a pristine balance sheet with no debt and close to $3B in cash and continues to use cash to buy back both founder shares and open market purchases.  At year end 2008, ACN reported strong quarterly results but gave slight downside guidance for the rest of the fiscal year which ends August 31, 2009.  

At the time, the company expected:

-          new bookings of $24-$27bn,

-          revenue growth of 6-10% in local currency,

-          operating margins in the 13.4% to 13.7% and

-          free cash flow in the $2.4-$2.6bn range.

Subsequently in March, the company revised downwards again:

-          new bookings of $23-$25bn,

-          revenue growth of 0-4%,

-          operating margins of 13.4-13.7% and

-          free cash flow of $2.25-$2.45bn.  

Note that utilization has remained flat at 83%.  On the recent earnings call on March 26, 2009, the CEO said that from December to January there was just a substantial falll-off in business activity that carried through March when he announced guidance for the year.  The issue at the time was that customers did not have their budgets for the year and the company did not receive the typical $400-$500MM in contract add-on revenues during the quarter.  The market is concerned that it is a late cycle business and business could deteriorate much further - primarily the consulting side of the business as outsourcing is actually growing nicely.  However, in the last quarter book to bill was 1.0 for consulting and 1.3 for outsourcing, which is in line with last year's numbers.

Our View

This is an extremely high quality business with returns on equity over 80% and returns on capital over 65% trading at under 10x EV/FCF and about 11x mkt/FCF.  As the addressable market size is over $700bn by 2012, there is still a lot of growth over almost any cycle.  [Note that the current market size is $638bn for a CAGR of 6-6.5% to 2012.  The company thus has only 3% market share]  At the time of its IPO, ACN had 17 clients that averaged $100MM in revenues and now it has 80.  The revenue base is highly recurring, especially on the outsourcing side.  On the consulting side, much of that is recurring as consultants are often engrained in their clients businesses.  Given:

-          the variable cost structure,

-          its ability to maintain pricing and margins,

-          high returns on capital,

-          the recurring nature of a large portion of their business,

-          the long term growth potential, and

-          the strong balance sheet,

this company should trade at 14x EPS or about 8x ebitda multiple when the company returns to growth.  Given the cash the company will generate over the next two years, the cash balance should be about $8.8bn.   This translates to a share price of $51-$52/share or 65% upside from here.

Risks

-          Normalized growth takes much longer to return and thus it becomes a value trap

-          The macro environment gets much worse and IT spending deteriorates much further

-          The dollar strengthens further against other currencies

Financials

Note: The assumption is that nothing gets any better or worse for FY2010 and begins to return to growth in FY2011

Catalyst

-          June 25 earnings announcement - where hopefully things are not as bad as they were from Jan-March and the market responds

-          Overhang lifted from final founder shares getting unlocked this summer (only 15MM shares left)

-          Continued share repurchase and potential dividend increase with the cash on the balance sheet and the cash management expects to generate

-          Continued consolidation in the sector (at least puts a floor on valuation)

-          Rebound in financial services clients IT spending

-          Wall street upgrades as they get comfortable that things aren't falling off a cliff

-          Currency has been a significant drag on earnings over the last six months and could be a nice tailwind in the next six months