Accenture: Unattractive Risk/Reward At These Prices

Investment Thesis

I wanted to take a look at Accenture (NYSE:ACN) to see if the company is a good investment at the current prices for a person who has not initiated a position just yet and is looking to add a leader in the industry. With the slowing down revenue growth outlook, I don't think it is a good time to invest in the company right now and I will patiently wait for a pullback to start a new position. I will assign a hold rating to the company as I don't believe long-term investors should sell their position either.

Outlook

I was surprised that the stock price plummeted on the Q3 earnings results, where CEO Julie Sweet, did what other companies do, and talked about AI opportunities a lot. On top of that, the company beat consensus estimates also. Maybe investors are finally not as excited about gen AI as they were at the beginning of the year.

As Julie Sweet said in her remarks that we are still in the very early stages of AI, and it is hard to see what kind of potential it holds for customers. I am quite sure that AI will help reduce inefficiencies in some areas more than others, but where we currently are in the cycle of AI, I don't think it is going to be a lot of cost reductions for now until the AI has been trained for much longer and developed further. I've been using Microsoft's (MSFT) Bing AI chat for all my searches and asking some more advanced questions than I would in a Google search bar. It looks like it is working well, but when I check the information, it is still either incorrect or outdated. But the AI answers full of confidence that it is the right answer and only would double check it if I say it is incorrect, so there’s a lot of progress to be made there.

Nevertheless, the company wants to be ahead of the curve and will be investing $3B over three years in AI initiatives. The company saw very strong demand for AI with their new and current customers that look to improve efficiencies and reduce costs and make every aspect of their operations much more comfortable for their clients. This will provide some revenue potential for the company, but as I mentioned, it is hard to tell how big of a potential this will be in the long run. I would hope for massive potential, but I will stay pessimistic.

Acquisitions

I am sure the company will continue to acquire companies left and right to support its operations and keep the inorganic growth strong. With the investments in AI, the company is looking to increase its AI workforce from 40,000 to 80,000, which means that there are a lot of companies that it can acquire to reach that goal in the near future. The company has been acquiring companies very aggressively and according to Mergr, it has acquired 165 companies in the last 5 years alone! Most of them are small firms, but they do add up. The company boasts a massive 732,000 employee headcount as of Q3 ’23. I wouldn’t be surprised to see the company becoming 1 million strong in the next 3-5 years especially if it is going to keep hiring and acquiring companies at the same rate.

Margins

Speaking of employees, I think the headcount is too high, which keeps margins quite narrow in my opinion. I don’t think the 19,000 employees that the company is going to cut in the next 18 months since the announcement is going to be enough. The company went on a hiring spree just like many other tech firms have in 2022 and subsequently, they all had to announce layoffs. What I fear is going to happen again is more inefficiencies with the massive hiring boom in the AI space as I mentioned above. I don’t think the company is going to stop there and will most likely hire more than it has said, which I think is going to affect the company’s margins negatively for a couple of years until we start to see more substantial layoffs.

In summary, I think the company has a lot of opportunities in AI, but at the cost of probably lower margins and more inefficiencies in the short run because of the headcount. The company helps other firms to become more efficient and streamlined. It should hire itself to help with internal inefficiencies and fix those margins.

Financials

Just to note, the below graphs will be as of FY22 because that is the most recent full year available. I will mention some of the most recent quarter numbers for extra color if needed also.

As of Q3 23, the company had a very strong financial position, $8.5B in cash against $43m in long-term debt, which essentially means it has no debt and no insolvency risks. The large cash pile allows the company to continue its aggressive strategy of acquiring companies to aid its operations and hopefully reward shareholders in the long run.

The company’s historic current ratio has been at around my acceptable minimum of 1.5, however slightly below it. It is still a decent ratio because it means that the company is not being inefficient with its assets, and it can cover its short-term obligations without a problem. It has increased from 1.23 at the end of FY22 to 1.37 as of Q3 ’23, which is good.

In terms of efficiency and profitability, the company has been performing really well in these categories over the years. ROA and ROE have dipped slightly in 2020 but have been turning back up in recent years and are well above my minimum of 5% for ROA and 10% for ROE. This tells us that the management is using the company’s assets and shareholder capital very efficiently.

The same can be said about the company’s return on invested capital. It has been well above the minimum of 10%, even when it saw a dip in 2020. This tells me that the company has a competitive advantage and a strong moat. The company is able to achieve very good returns. A prime example is the $3B cloud investment in 2020, which coincides with the dip in ROIC and subsequent higher returns thereafter, meaning the investment was a massive success. It seems like a Deja Vu because the company is going to invest $3B in AI initiatives now, and if the past is anything to go by, the company will be able to achieve higher returns, but we will have to wait and see.

In terms of margins, I would like to see these improving over the long run and I think they will, however, I also think in the short run, say 2 years, margins may contract slightly due to the excitement in the AI space and the hiring spree.

Overall, I see a company that is very strong financially with a lot of gunpowder to continue its strategy of acquiring companies to build up its strong moat and maintain that competitive edge for years to come. Now what would I be willing to pay for such a company?

Valuation

I won’t be too optimistic about the growth prospects of the company. What I decided to do is to assume that the advancements of AI will not present higher levels of growth, instead, I assumed that AI opportunities will help the company grow at a similar pace it has in the last decade, to be on the conservative end. ACN grew at around 8% CAGR over the last decade, so for my base case, I went with 7.4% CAGR over the next decade. For the optimistic case, in which I assumed AI may be able to lift the company's growth levels a bit more, I went with 11.2% CAGR, while for the conservative case, I went with 5.4%.

In terms of margins, I decided to improve gross and operating margins only very slightly to be on the conservative side because I feel like, in the first couple of years, the hiring sprees are going to continue and will affect margins, while on the back end of the model, efficiencies will be more visible with advancement in tech and maybe a lot more layoffs. I decided to improve gross and operating margins by around 200bps over the next decade, which will bring net margins from around 11% in FY22 to around 14% by FY32.

I will also add a 25% margin of safety, which is the lowest I do for companies that have solid financials, just to be on the even safer side. With that said, Accenture's intrinsic value and what I would be willing to pay is $226.27 a share, which means the company is trading at a premium right now and doesn't have a good risk/reward profile for me.

Closing Comments

I might be a little too conservative here, but I would rather be safe than sorry and invest. The company is very strong and has a lot of potential to keep performing well, however, I would be more interested in starting a position at either a much lower share price or if the company can prove it can grow its EPS considerably in the next couple of years or at least guide in the next couple of quarters to much higher EPS growth.

The potential for AI to improve a company's operations and provide more wins is still very unknown and is hard to quantify. I do believe it is not going to hurt the company in the long-term, however, in the short-term I wouldn't be surprised if sometime in the next couple of quarters we will see margins declining slightly, coupled with further economic uncertainty, which may lead to a good entry point if we’re patient.

I will keep the company on my watchlist with a price alert and will come back once the company reports FY23 numbers at the end of September.