Description

Background

We like shorting big-cap names with increasing storm clouds on the horizon, where you don’t have to worry about catastrophic squeezes, M+A take-outs or fighting with Elon Musk’s PR machine. Accenture fits the bill of the former type of name to a tee. $53bn market cap and short interest is a mere 3% of the float. It is trading at 16.2x consensus CY ’15 for what should be low single digit top line growth with competitive intensity and margin pressure increasing.

Accenture suffers from some of the malaise that impacts other enterprise IT names like IBM (but with less financial chicanery).  We started toying with the idea since Stan Druckenmiller got on CNBC post Robin Hood saying that “being long IBM is like being short innovation”. As many may know, Accenture specializes in IT outsourcing and related consulting projects. There was a decent bull case espoused by skca74 on 6/12/2009 that is worth reading to get some additional context of what the firm looked like several years ago.

I note that it has generally been a good business: not very capital intensive, decent margins, and with shareholder friendly management. Recent weakness in revenue growth has been perceived as cyclical given EMEA is 40% of sales but I think has been masking true secular pressure from cloud. In essence, a customer paid Accenture millions of dollars to help them integrate ERP, HR, E-commerce website or whatever else your business was doing. As companies adopt more cloud solutions (be they SaaS, PaaS or IaaS, choose your favorite acronym) there is “less work to do” b/c the cloud system does a lot of what needs to be done out of the box, given they are often turn-key solutions.  How much less work? From what we’ve seen anywhere from a 15-25% reduction in spend to the IT consultant/integrator. 

When you couple a shrinking pie with aggressive Indian firms like CTSH, INFY etc, you have a recipe for a market share fight and margin compression.

So why now?

This issue has been building up for years, but I think there are some signs that we are seeing a tipping point.

First, ORCL and SAP haven’t had great results this year once you adjust for all their SAAS M+A. I’d argue that that is a leading indicator for these systems projects that are Accenture’s life blood b/c they take longer to implement than the software license recognition at the tech companies.  

Second, Accenture themselves has been investing in building out their cloud practices (they aren’t putting their head in the sand) despite the fact that they will admit that the average cloud deal they do is about 20% smaller than the legacy IT deal it would replace.  

Third, the Indian Rupee has fallen massively over the past 2 years (from 45 to 60) which helps their competitors Infosys, Satyam etc. Now, this isn’t 100% a disaster given Accenture has some off-shore workers but means the competitors can give some price to take share given the translation effects.

Finally and most importantly, you are seeing chinks in the financials on several metrics, which I will enumerate:

A)     Earnings have been choppy – starting with Q4 ’12 (they are on an Aug FY) they’ve missed 5 of the last 8 quarters, for a business that should have decent visibility.

B)      They took down their FCF guidance for this year (from $3.2-3.5bn down to $2.9-$3.2bn) as well as their margin expansion targets (10 bp expansion to 14.3% versus pervious 10-30 bp expansion).

C)      On their Q2 earnings call, they even fessed up to some pricing pressure issues:

“Before moving down the income statement, let me provide some overall context on the factors impacting our profitability this quarter. Specifically, our operating results for the quarter reflect lower contract profitability, primarily driven by pricing pressures and our challenge in absorbing higher payroll costs, and to a lesser extent, lower margins in the early stages of a few large contracts. At the same time, our results also reflect a higher level of investment in the quarter to build new capabilities including strategic acquisitions aimed at enhancing our capabilities in key growth areas.”

“I would say that dial is probably turned up a little bit since last quarter in terms of the pricing environment. There's a couple of factors that are worth noting. One is that the ongoing trend in vendor consolidation is influencing the pricing environment. And then secondly, we have seen more pricing pressure, if you will, in certain areas and in particular in the application services area where the environment, competitive characteristics are such that prices becoming very prominent in the bidding process. So that's kind of what we see on the pricing front. We also have seen some pricing pressures on our existing book of business and what that means specifically, as you alluded to, is we are a little further behind where we had expected to be in terms of being able to pass cost rates through on our existing contracts. And so those are the two dynamics that we saw on our second quarter results”

 You can see this pricing pressure starting to impact gross margins which were down 110 bps YoY in the most recent quarter.

Interestingly enough, Morgan Stanley recently initiated on the space and did a survey where they looked at the firms most willing to discount. Of all 13 named vendors, Accenture led the pack at 44%, by contrast CTSH was at 14% and Infosys at 12%. The metric was defined as % of respondents seeing more discounting net of % seeing less discounting. So this leads me to believe this isn’t a one off quarter but something systemic that we will continue to see impact the income statement as less attractive revenue is recognized out of their backlog.

D)     If you go through the #s carefully, it looks like for FY-14, non-organic growth will contribute 150-200 bps which means that organic growth is something like 250-300 bps.. It is a bit tricky to get this precise given f/x rates, but this shows the core growth is now low single digits and that is with them being willing to discount to take share.

E)      They also saw an uptick in attrition to 14% in the latest quarter, from 12% in the previous quarter. I think this is due to the fact that they are keeping SGA in check to offset ongoing gross margin pressure. If talented employees don’t get the bonuses or promotions they expect they will leave.

I think there will be ongoing pressure on both consensus estimates and the multiple will de-rate to less than a market multiple making this a laggard and hence better than simply shorting the SPX as a hedge.  While hard to be precise, I can see earnings struggle to grow next year (ex buyback) and at 14-15x the stock could fall to $65.

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