One of my favorite ways to invest in technology is with the leading digital IT service firms. Companies like Accenture (ACN -0.90%), EPAM Systems (EPAM -1.78%), and CDW (CDW -0.66%) are all extremely high-quality, growing businesses run by excellent management teams, and they serve a crucial need by helping clients adapt and thrive in this period of accelerating digital change.
These three companies are perfectly positioned to benefit from long-term tech tailwinds and disruptive innovations such as cloud computing, artificial intelligence (AI), machine learning (ML), distributed working/learning, network security, and more. A bonus point is that they are mostly technology-agnostic, meaning that they are not overly exposed to disruption risk. Rather, innovation and disruption drive their business!
Each company reported earnings recently and provided fresh insight into their operations. Let's see how they performed in their most recent quarter (spoiler alert: they all crushed it) and what it could mean for you as an investor.
Accenture's fiscal 2021 Q3 earnings
IT services giant Accenture's third-quarter fiscal 2021 revenue increased 21% (16% in constant currency) year over year, operating income increased 24%, and EPS grew 26% as it continues to take what it calls "significant market share."
This operating leverage was driven by an increase in both gross and operating margins compared to the same period last year. Accenture had a record 20 clients in the quarter, each delivering bookings greater than $100 million. The company generated a return on invested capital (ROIC) of 31%, and its net cash (cash net of debt, including leases) grew to $6.5 billion. Net cash now accounts for 16% of total assets.
It's important to note that I don't think Accenture's normalized constant-currency growth rate will stay at that elevated 16% level. Some of this growth is driven by an easy comp. But some is definitely the result of increased demand and market share gains coming out of the pandemic, and I do think Accenture can be a structurally higher-growth company in the post-COVID-19 world.
This was obviously an incredible quarter, so management once again raised its full-year guidance across the board. It now expects constant-currency revenue growth of 10% to 11% (up from 6.5% to 8.5%); free cash flow (FCF) of $8 billion to $8.5 billion (up from $7 billion to $7.5 billion); and adjusted EPS of $8.71 to $8.80 (up from $8.32 to $8.50), implying growth of 17% to 18% over adjusted 2020 EPS of $7.46.
Accenture expects its full-year fiscal 2021 ratio of FCF to net income to be a whopping 1.4 to 1.5. What sparked this impressive increase in guidance? CFO KC McClure explained on the earnings call, "Importantly, organic revenue is the driver of the increase to our updated guidance."
Accenture continues to use some of its FCF to make digital acquisitions. It made 39 acquisitions (all over the globe) through the first three quarters of its fiscal year, and it expects to spend a total of $4 billion on acquisitions for the full year. Two of the ones it made this quarter were purchased for more than $1 billion.
This is still small relative to Accenture's size and financial capacity, but I think it indicates that CEO Julie Sweet is getting more comfortable with slightly larger acquisitions, and she could be testing the company's capability to make even larger acquisitions down the road.
This is something I'll be keeping an eye on. Accenture is an underappreciated acquisition machine as it has successfully acquired and integrated roughly 200 companies since 2013. Its acquisitions have historically added roughly 2% to top-line growth each year, but it pays for its acquisitions from internally generated cash flow (not from debt) and its acquisitions do not overly dilute ROICs. Using calculations from investment-research site New Constructs, Accenture's trailing-12-month ROIC is 33%, compared to its five-year average ROIC of 34%. Given the larger spend on acquisitions in fiscal 2021, the company estimates that acquisitions will add 4% to top-line growth in fiscal 2022.
Another place where Accenture continues to invest is its 569,000 employees. It hired a net 32,000 in the quarter, and through the first three quarters of the year, it promoted a record 117,000 employees, including nearly 1,200 to the level of managing director.
Accenture also continues to invest in the communities in which it operates, and recently committed to contributing $100 for each of its 540,000 employees (at the time of the announcement) for a total of $54 million going toward those communities. This is something, but Accenture could do more!
The key takeaway for long-term investors is that Accenture's business was extremely resilient during the pandemic and subsequent lockdowns. While the pandemic isn't over, it is entering the "new normal" with accelerating growth and market share gains.
This is because the pandemic made companies realize that they need to immediately digitize their businesses or risk losing relevance in an increasingly digital world. Accenture benefited from that because it's the biggest brand with the most experience in enterprise-wide digital transformations.
It has compounded digital knowledge and uses its playbook (a record of successful digital projects) from one company or industry and applies it to similar projects at other companies in other industries. Its client list includes three-quarters of the Fortune 500 and 92 of the Fortune 100. Equally impressive, 97 of its top 100 clients have been customers for more than 10 years.
Accenture invested ahead of the digital curve and now has the widest service offering in the industry at a time when digital projects/budgets are getting bigger (just look at the record 20 clients that committed to bookings of at least $100 million in the quarter). The company is perfectly positioned to benefit from the digital revolution in various ways, including digital marketing, cloud, automation, the internet of things, data analytics, AI, cybersecurity, quantum computing, neuromorphic computing, and even blockchain.
It has leading partnerships with Amazon Web Services, Alphabet's Google, Microsoft, Oracle, Salesforce, SAP, Workday, and Apple. It is the No. 1 software-as-a-service (SaaS) IT service provider.
Accenture is also the leader in digital marketing with Accenture Interactive, which the company claims is "the world's largest provider of digital marketing services." The company is currently working on building Industry X (its supply chain and manufacturing business) into the next big line of business on par with its Accenture Interactive segment.
The pandemic will force major companies around the world to rework their supply chains to be more agile and more resilient to future disruptions. There is probably no company better suited to lead them through this massive digital transition and supply chain/operations optimization than Accenture. As Sweet said in the conference call, "We believe that product development, design engineering, manufacturing, and the supply chain make up the next big digital transformation frontier."
Competition for the top tech talent needed to meet the growing demand for enterprise-wide digital transformations will be a hurdle, but not necessarily a systemic risk. Employee attrition (churn) is elevated at Accenture and across the industry, and it's something to keep an eye on.
EPAM Systems' fiscal 2021 Q2 earnings
Following EPAM's first-quarter 2020 earnings (when the pandemic was breaking out across the world), I posted this note into FoolIQ, our internal research management system at The Motley Fool:
The most important consideration for long-term Foolish investors is that EPAM is a founder-led, best-in-class digital engineering firm that went into this crisis with NET CASH and strong profitability, real free cash flow (above and beyond SBC [stock-based compensation], which is not FCF), and rising returns on invested capital (ROIC). EPAM's business model that stresses profitable growth and a cash-rich balance sheet will enable it to remain resilient throughout the crisis and come out ever stronger on the other side.
Remaining resilient throughout the crisis and coming out even stronger on the other side is exactly what EPAM did. Its second-quarter 2021 revenue increased 39% (36% in constant currency) year over year, and its adjusted EPS grew 40%. Three percentage points of its revenue growth came from acquisitions, which is noteworthy because acquisitions are contributing to growth at the same time that the company's ROIC is rising. This is a rare phenomenon because acquisitions at other companies often dilute ROIC.
According to stocks analyst New Constructs, ROIC for EPAM has increased every year since 2016, and its trailing-12-month ROIC is a whopping 32%, topping its five-year average ROIC of 25%. The increase in ROIC has been driven by a consistent increase in both net operating profit after tax (NOPAT) margins and invested capital turnover, which means EPAM is firing on all cylinders. Its combination of 20% organic long-term revenue growth combined with high and rising ROICs (driven by both consistently higher margins and consistently better balance-sheet efficiency) is the definition of investing nirvana, and its market cap and stock price have responded with market-crushing returns.
EPAM's growth was strong across all verticals and geographies, and it continues to improve its client diversification to rely less on a few large customers; revenue growth among EPAM's top 20 clients was 19% year over year, but growth outside of its top 20 was 55% in the quarter. To give an idea of the urgent demand for EPAM's services, CFO Jason Peterson told investors that several customers have gone from doing no business with the company to being one of its top 20 customers in a year or less. This level of demand acceleration is pretty incredible.
On the second-quarter earnings call, CEO Arkadiy Dobkin explained that demand for EPAM's digital engineering and consulting services is being driven by app development, cloud integration, and massive ongoing digital transformations from both new and existing clients. These transformations are driving larger and longer contracts for EPAM.
To support what Dobkin calls a surge in demand, EPAM is hiring new talent, both organically and through acquisitions, at an accelerated rate. Through the first half of 2021, it has already hired more employees than it ever has in a full year. And the company is having great success growing its talent base in Eastern Europe (where it has traditionally recruited the best and brightest) as well as in India and Latin America.
There is intense competition for top tech talent, which means management will be raising wages, but the company is carefully offsetting that by exercising pricing power on larger digital transformation projects. On the call, Peterson said "the dynamics on the pricing side are certainly improving."
He added, "One of the things that we're beginning to see even in the middle of this year, which I think is different than certainly last year and probably different even than prior years, 2019 and 2018, is we are getting midyear rate increases." Peterson also said the company expects to see greater-than-usual rate increases in 2022.
Following the strong first half of the year, management is raising its full-year guidance for the second quarter in a row. In the fourth quarter of 2020, management originally guided for full-year 2021 constant-currency revenue growth of at least 22% and adjusted EPS of $7.20 to $7.41. Then, in the first quarter of 2021, EPAM raised its full-year guidance to constant-currency revenue growth of at least 28% and adjusted EPS of $7.54 to $7.76.
And now, with the release of its second-quarter earnings, management is guiding for full-year constant-currency revenue growth of at least 35% and adjusted EPS of $8.25 to $8.44 (30% to 33% higher than EPAM's 2020 adjusted EPS of $6.34).
On the call, Dobkin stressed that EPAM's long-term goal is to "grow profitably with 20% organic year-over-year [revenue] growth." Keep in mind that through the first quarter of 2020 (up until COVID really broke out), it had grown organic revenue by at least 20% for 37 consecutive quarters. As the pandemic eases, the company has returned to at least that level of growth. As a quality-growth investor, I appreciate its choice to balance its long-term goal (for organic revenue growth of at least 20% per year) with attractive margins and ROIC.
The long-term investment thesis for EPAM should account for the fact that this is a founder-led, digitally native IT services and consulting firm known for its best-in-class engineering and software services at a time when there is urgent demand for enterprise-wide digital transformation projects.
This increased demand results in larger and longer-term contracts that carry higher margins for EPAM. Because of the ongoing nature of these transformations, the company is a crucial partner to its clients (becoming embedded into their workflow), leading to 90% recurring revenue from existing clients. Also, its very close relationship with its customers creates a constant feedback loop, and enables the business to iterate and innovate at a rapid pace.
EPAM's brand name and leading recruiting apparatus give it an advantage in hiring the best and brightest digital engineers in Eastern Europe, and now it's trying to build a scaled presence in India and Latin America. Its balance sheet is rock solid with $1 billion in net cash, which equates to 36% of total assets. It's a 20%-plus organic top-line grower, and all of the important drivers of value (including NOPAT margins, invested capital turns, ROIC, and FCF) are moving up and to the right.
CDW's fiscal 2021 Q2 earnings
Before I get into the quarterly results, I'd like to point out three big differences between CDW and Accenture and EPAM:
- CDW primarily serves small and medium-size businesses (typically with less than 5,000 employees), whereas Accenture and EPAM are implementing digital transformations at larger enterprises, in many cases Fortune 500 and/or Forbes Global 2000 companies.
- CDW is a value-added reseller that carries inventory on its balance sheet and has distribution facilities to ease fulfillment (more on that below).
- Accenture and EPAM have large net cash positions, but CDW has manageable net debt. It has dramatically reduced leverage since being taken private in a leveraged buyout in 2007, and its prudent use of debt allows it to generate sky-high returns on equity (ROE). According to S&P Global, CDW's five-year average ROE is 61% and its trailing-12-month ROE is a whopping 89%. Largely because of its use of debt, the company's ROE is significantly higher than the ROE at Accenture or EPAM (more on CDW's balance sheet and returns below).
Second-quarter 2021 sales increased 17.9% (16.3% in constant currency) year over year, and adjusted EPS grew 29.3%. This was CDW's first quarter with over $5 billion in sales.
Because 2020 was such as strange year, sometimes it's helpful to look at sales on a two-year stack basis. CDW's sales grew 11.2% over the second quarter of 2019. Impressively, this strong top-line growth is accompanied by rising ROIC. According to New Constructs, the company's ROIC has increased for five consecutive years, and its trailing-12-month ROIC is now 20% compared to its five-year average of 15.4%. CDW is one of the rare companies whose rising ROIC is being driven by a consistent increase in both net operating profit after tax margins and invested capital returns. In other words, CDW is firing on all cylinders right now.
The company's FCF declined in the quarter, but that is to be expected because inventory is a use of cash (a cash outflow) and the company is carrying higher inventory levels to better serve clients and win market share in a supply-constrained environment. I discussed CDW's inventory and working capital dynamics in-depth in my deep dive on CDW. So an investment in its clients' success is exactly what you want to see.
CDW's balances sheet is healthy, with a leverage ratio that is below its long-term target and an interest coverage ratio (EBIT/interest expense) of 9, which is its highest level going back to its IPO in 2013.
Its strong growth is being powered by clients prioritizing digital transformations across the full tech stack, with a focus on cloud (and hybrid cloud) migrations and network security. To further strengthen its cybersecurity practice, CDW acquired the firm Focal Point Data Risk. It does seem that acquisitions will be more of a capital allocation priority under CEO Christine Leahy.
For the full year 2021, CDW expects the U.S. IT industry to grow 5% and it expects to win significant market share because its industry-leading scale allows it to better procure the inventory that its customers need in a supply-constrained environment.
On the second-quarter earnings call, Leahy said, "Because we can create a solution and deliver to customers, we generally get our greater-than-fair share [of inventory from original equipment manufacturers]." CDW is guiding for its constant-currency revenue to exceed U.S. IT industry growth by 4.25 to 5 percentage points. In other words, CDW is guiding for 2021 sales growth of 9.25% to 10%, and also expects to generate adjusted EPS growth of around 16% to 16.5%. This rate is very strong and even better than the long-term expectations I set out in my deep-dive report on CDW.
But importantly, on the second-quarter earnings call, CFO Collin Kebo said that demand is strong, and that growth is possibly being held back somewhat by supply constraints for hardware. Even though CDW has the best chance of getting inventory to customers when they need it, it is still being affected by supply challenges out of its control (just less so than the rest of the industry). Kebo said:
On the demand side, we continue to see strong activity and momentum, particularly with U.S. commercial customers and in CDW Canada. On the supply side, visibility remains a challenge. Notebooks, displays, docking stations, certain infrastructure hardware, including networking and servers, are constrained, resulting in longer lead times and a higher backlog. With the exception of Chromebooks, the supply environment has not improved since our last earnings call, and most vendor partners do not expect the situation to improve in the second half.
Our updated outlook for the balance of the year assumes modest growth in the backlog. If supply turns out to be more resilient, enabling us to work down the backlog or keep pace with even stronger demand, that would be upside to the outlook. We feel good about the health of the business and believe supply uncertainty is a question of timing across the second half and into 2022.
In other words, the company is doing great and could be doing even better if the supply of devices can keep up with demand.
If you want to invest in the cloud, AI/ML, cybersecurity, or distributed/hybrid work, but you don't know which company will win, then you might consider buying a basket of stocks in one or more of these categories. It's a fine strategy, and I would recommend it.
Another choice would be to just invest in the IT services companies that help clients plan, implement, and monitor their cloud, AI/ML, cyber, and distributed work strategies. These three stocks, in their own ways, do just that and could form the basis of an IT services basket of shares.
Similarly, if you're an investor who wants to invest in tech, but who also insists on profitable self-funding business models, high ROIC, and growing free cash flow, you would do well to take a look at Accenture, EPAM, and CDW individually.