Morgan Stanley Analyst Cuts Accenture To Equal Weight, But I Strongly Disagree

Dec. 5.13 | About: Accenture plc (ACN)

On Wednesday December 4, 2013, Seeking Alpha's "Market Current" reported this:

Morgan Stanley cuts Accenture and NetApp, ups Western Digital and Brocade

  • Citing the impact of faster-than-expected cloud computing adoption, Morgan Stanley's (NYSE:MS) Katy Huberty has downgraded Accenture (NYSE:ACN) and NetApp (NASDAQ:NTAP) to Equal Weight. Meanwhile, citing more favorable risk/reward, Huberty has upgraded Western Digital (NASDAQ:WDC) to Overweight and Brocade (BRCD ) to Equal Weight.
  • Concerns about the impact of cloud services on sales of IT outsourcing services such as Accenture's, and enterprise storage hardware such as NetApp's, have been around for some time. Recent numbers (I, II) provided by the companies, and by peers such as IBM and EMC, haven't done much to soothe those fears. Synergy Research recently estimated sales of cloud infrastructure (IaaS) and app platform (NASDAQ:PAAS) services rose 46% Y/Y in Q3.
  • Accenture now trades at 15x estimated FY14 (ends Aug. '14) EPS exc. net cash, and NetApp trades at just 10x estimated FY14 (ends April '14) EPS exc. net cash.

First of all, let me state that I am not an expert on cloud services, so I researched what others had to say about Accenture's Cloud services and I found the following that linked to an IDC Report that states:

"An IDC vendor assessment of the 2013 cloud professional-services sector has identified Accenture as a worldwide leader in the field."

The report also presented a graph showing Accenture's role in cloud professional services:

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Then Accenture backed that up by stating the following:

"Accenture has worked on more than 6,000 cloud computing projects for clients, including more than 60 percent of the Fortune Global 100, and has approximately 8,500 professionals trained in cloud computing."

Therefore it seems strange to me that this was in the SA Market Current:

"Citing the impact of faster-than-expected cloud computing adoption, Morgan Stanley's Katy Huberty has downgraded Accenture"

It is strange in that if there is faster than expected cloud computing adoption and Accenture is a world leader in cloud computing, then how can this be a negative for Accenture?

As far as Accenture's financials go and the analyst stating that Accenture trades at 15x estimated FY14 (ends Aug. '14) EPS exc. net cash, she is really missing out on what makes Accenture one the most profitable companies in the world and that is it's free cash flow, which I will demonstrate in the following analysis.

This analysis will use the following six free cash flow ratios:

  • CapFlow
  • FROIC
  • Price to Mycroft Free Cash Flow
  • Mycroft/Michaelis Growth Rate
  • Free Cash Flow Payout Ratio
  • Free Cash Flow Reinvestment Rate

Those new to this analysis can find an introduction by going here that will explain in detail how each of these ratios is calculated. When used together, these unique ratios will generate a quantitative picture of a company's underlying fundamentals, including strengths and weaknesses.

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The "2014 Mycroft Free Cash Flow Per Share" estimate, shown in the table above, is generated by taking the trailing twelve months (NYSE:TTM) free cash flow result for Accenture and then adding my Mycroft Michaelis Growth Rate into the equation in order to generate forward looking estimate for 2014. That growth rate is generated by using my FROIC ratio (Free Cash Flow Return on Invested Capital). Basically FROIC tells us how efficient operations are as it zeros in on how much free cash flow is generated for every $1 of total capital employed. Accenture has a FROIC of 63%, which means that for every $100 of invested capital, the company generates $63 in free cash flow. Now my Mycroft/Michaelis Ratio takes that 63% and multiplies it by the firm's free cash flow reinvestment rate. The reinvestment rate that I use is a free cash flow reinvestment rate instead of the standard one used by analysts that simply uses net income:

Free Cash Flow Reinvestment Rate = 100% - (Free Cash Flow Payout Ratio).

Or;

Free Cash Flow Reinvestment Rate = 100% - (Total Dividend/Total Free Cash Flow).

By replacing net income in the payout and reinvestment ratios with free cash flow, I am thus able to make my analysis more precise by incorporating capital spending (Cap Ex) into the equation.

Therefore from this we can determine that Accenture has a reinvestment rate of 67% and went on to use 33% of its free cash flow to pay out its dividend. Thus by taking 63% (FROIC) x 67% = 42.21%(rounded off at 42%). From there we add the dividend yield of 2.4%(rounded off at 2%) and we have a Mycroft/Michaelis growth rate of 42% + 2% = 44% .

Accenture's Mycroft Free Cash Flow per share of $7.17 was generated by taking its TTM free cash flow per share and multiplying it by (100% + 44% or 1.44). Once we have our result, we then take its current market price of $76.03 and divide it by $7.17 and get a Price to Mycroft Free Cash Flow result of 10.60. I consider a Price to Mycroft Free Cash Flow per share result of less than 15 to be good for purchase, and anything under 7.5 to be excellent.

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The higher you go above 15, the more overvalued a company becomes. I use a Price to Mycroft Free Cash Flow per share result of 22.5 as my sell price, and 45 as my short price.

An appropriately priced stock should trade around a Price to Mycroft Free Cash Flow per share result of 15. This benchmark result was determined by backtesting.

Buy (opinion) = A Price to Mycroft Free Cash Flow per share result of less than 7.5 is considered excellent (50% below the initial Hold level), and anything under 15 is attractive.

The result I give as my Buy opinion in the table above uses a Price to Mycroft Free Cash Flow per share result of 7.5.

Hold (opinion) = 15 to 22.5 (I use 15 in the table).

Sell (opinion) = 22.5 or higher (50% above the initial Hold level). (I use 22.5 in the table).

Short (opinion) = 45 or greater. The Price to Mycroft Free Cash Flow per share result of 45 was determined by going back to the peak of the market (in the year 2000) and averaging the Price to Free Cash Flow per share results for the key players at that time. (I use 45 in the table).

The CapFlow ratio result that you see in the first table above is an original ratio I created in order to tell me how much Capital Spending is used as a percentage of Cash Flow. A result of less than 33% is considered ideal and with Accenture coming in at just 10%, means that 90% of the company's cash flow is actually free cash flow and can be used for such things as buying back stock. From that you get great news like this showing up:

"In addition to its dividend boost, the company also added an additional $5 billion to it share buyback plan, which brings the total amount of planned repurchases to $7 billion."

In conclusion, it seems that Morgan Stanley's analyst, by simply using 15x estimated FY14 (ends Aug. '14) EPS exc. net cash (quantitative reason) in her downgrade, she really missed the big picture of Accenture's amazing free cash flow numbers. When a company has a CapFlow of just 10% and a FROIC of 63%, this means that Management is doing an excellent job in running the company and more importantly, controlling costs. From a qualitative point of view it is one of the few companies that my research identifies as having a perfect score on the "15 Points," outlined by Philip A. Fisher (the idol of Warren Buffett and father of qualitative analysis) in his book "Common Stocks and Uncommon Profits." Here are those points:

  1. Does the company have products or services with sufficient market potential to make possible a sizeable increase in sales for at least several years?
  2. Does the management have a determination to continue to develop products or processes that will still further increase total sales potential when the growth potential of currently attractive product lines have largely been exploited?
  3. How effective are the company's research and development efforts in relation to its size?
  4. Does the company have an above-average sales organization?
  5. Does the company have a worthwhile profit margin?
  6. What is the company doing to maintain or improve profit margins?
  7. Does the company have outstanding labor and personnel relations?
  8. Does the company have outstanding executive relations?
  9. Does the company have depth to its management?
  10. How good are the company's cost analysis and accounting controls?
  11. Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company will be in relation to its competition?
  12. Does the company have a short-range or long-range outlook in regard to profits?
  13. In the foreseeable future, will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders' benefit from this anticipated growth?
  14. Does the management talk freely to investors about its affairs when things are going well but clam up when troubles or disappointments occur?
  15. Does the company have a management of unquestionable integrity?

As for the subject of cloud computing I would imagine that any growth in the sector would benefit Accenture greatly as they have 60% of the Fortune 100 as clients. Finally, Accenture is much more than just a cloud computing firm. It also provides 100s of services for clients.

Accenture is one of the largest holdings in my client portfolios and is one of the best run companies I've seen. Like Boeing (NYSE:BA) and Apple (NASDAQ:AAPL) it is one of the few companies that you can "Buy and Hold" and sleep well at night.

Disclosure: I am long ACN, AAPL, BA, IBM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.