Beyond the coronavirus-induced short-term uncertainties, Accenture (NYSE:ACN) is poised to profit from the modernization and digitization of enterprises in many industries, thanks to its shift to growth technologies. In addition, with its strong free cash flow and large cash balance, the company won't face any financial difficulty even if a prolonged recession materializes. Yet prudent investors should remain cautious, as the stock price doesn't offer any margin of safety.
Shift to growth technologies
Over the last several years, the consulting and outsourcing specialist has been growing its business thanks to its focus on growth technologies, such as cloud and cybersecurity, under an initiative it calls "The New." As a result, revenue grew from $32.9 billion in fiscal 2016 to $43.2 billion in fiscal 2019, with "The New" representing 65% of total revenue in 2019, up from 40% in 2016.
Granted, with its operations in 51 countries and in many industries, the company is exposed to the global economy. But despite the coronavirus pandemic, management expects revenue to grow by 3% to 6% during this fiscal year.
The coronavirus situation boosted some of the company's businesses as many enterprises rushed to deploy remote working capabilities. And Cisco's CEO Chuck Robbins said last week during the tech giant's latest earnings call that many enterprises realized their computing infrastructures needed an update to adapt to this new way of working, which bodes well for Accenture's consultancy business in the medium term.
However, the company's shift to growth technologies doesn't come for free. Consistent with the last several years, management spent $1.2 billion across 33 acquisitions in fiscal 2019, and it expects to spend up to $1.6 billion this fiscal year.
|Acquisitions||$1.6 billion||$596 million||$1.2 billion|
Limited margins upside potential
Accenture's consultancy and outsourcing services depend on human resources, which limits the company's capacity to improve its margins despite its growing scale.
Over the last several years, the gross margin stayed close to 30%. In contrast, Software-as-a-Service (SaaS) companies usually generate gross margins largely above 60%, and their business scale is better as limited extra resources are required to serve extra customers.
Thus, despite Accenture's low sales and marketing expenses as a percentage of revenue thanks to its long-term activities with some large customers, the potential for higher operating margins remains limited: Management forecasted full-year operating margin to land in the range of 14.7% to 14.8%.
Besides, investors should consider the company's free cash flow with a grain of salt. During the last quarter, free cash flow reached $1.37 billion, up from $1.22 billion one year ago, and management anticipates free cash flow to reach $5.5 billion to $6.0 billion this year. Based on the midpoint of full-year guidance, that would correspond to an attractive free-cash-flow margin of 12.7%.
However, free cash flow excludes share-based compensation (SBC), which amounted to $372.3 million, or 3.3% of revenue, during the last quarter. SBC is not a cash expense, but it represents a real cost to shareholders as it increases the number of shares (dilution). In addition, the company's acquisitions are not taken into account in the calculation of free cash flow.
Assuming $1.6 billion of acquisitions this year and $1.4 billion of share repurchases to hold the number of shares flat, free cash flow would actually not exceed $3 billion during fiscal 2020.
No margin of safety
Based on the midpoint of full-year guidance, the market values the company at an enterprise value-to-sales ratio of 2.5, and at a price-to-earnings (P/E) ratio of 24.2.
Given Accenture's strong operating performance and solid balance sheet ($5.44 billion of cash and short-term investments, and only $19.9 million of total debt at the end of last quarter), that valuation doesn't seem exaggerated.
However, you should keep in mind that the company's revenue growth depends on acquisitions that are not taken into account in free cash flow and earnings calculations.
As an illustration, the market cap corresponds to 20 times the midpoint of management's forecasted free cash flow this year. But if you consider $3 billion of acquisitions and SBC in fiscal 2020, that multiple would become much less attractive at 42 times.
In any case, with its successful focus on growth technologies, Accenture remains a solid tech stock. Yet its valuation doesn't provide any margin of safety; prudent investors should stay on the sidelines.