Notable Calls

Firm notes that over the last few weeks they reached out to a number of industry sources to update their thoughts on the systems integration and IT outsourcing market and on Accenture shares in particular. The feedback from CIOs and other industry sources was consistent with, if not somewhat more bearish than, the feedback they received in early December that led them to downgrade Accenture shares to a HOLD rating. In summary, cost reduction is dominating the IT agenda of most large enterprises in 2010 and while discretionary IT spending is improving modestly, they're hearing that sales cycles remain protracted, that larger enterprises are not yet embarking on large-scale software and services initiatives, that the focus remains on smaller incremental projects and that pricing terms on systems integration projects remains tough. Without exception, Kaufman's sources argued that the Indian firms were seeing a much stronger demand recovery.

Kaufman concludes that demand for project-based systems integration work in particular could remain sluggish throughout 2010 and that Accenture is likely to lower its fiscal 2010 top-line guidance to a range of perhaps negative 2%-5% (from positive 1% to negative 3%) on its next earnings call in late March. They also believe that a flat margin outlook is a best-case scenario given continued pricing pressure. Firm maintain their assumptions for a 4% constant currency decline and below-consensus EPS of $2.68 in fiscal 2010 while for fiscal 2011 they are lowering their growth rate assumption to 4% from 7% and our EPS estimate to $2.90 from $3.00, below Street consensus of $3.05.

In firm's view, the read-through for Accenture shares from the results out of HP on Wednesday and from Cap Gemini yesterday was negative. HP's services business was down approximately 4% in constant currency and was the weakest of its major segments, while the applications services unit (which comes closest to Accenture's mix) was down 8%. HP did not call out any demand recovery, it guided to similar demand trends going forward and revenues from the EMEA region (47% of Accenture's mix) were soft. Likewise, Cap Gemini's outlook for a sequential revenue improvement of just 1% in both 1H10 and 2H10 (basically flat revenues at the 2H09 run-rate), a material margin decline to 5% in 1H10 and "huge" pricing pressure were
not inspiring.

Kaufman notes they are cognizant of the fact that Street expectations are more muted than they were last quarter and that Accenture has already tilted the Street toward the lower end of its guidance range. However, the prospect of a downward guidance revision from a defensive name presumably on the cusp of a revenue recovery gives the firm reason to re-evaluate their rating on the stock. Kaufman believes that Accenture's P/E multiple could drift from 15x today to perhaps 12x-13x our fiscal 2011 EPS estimate of $2.90, implying a share price of approximately $35-$38. In their judgment, this downside risk is large enough to warrant a downgrade to a SELL rating. They are also lowering their price target from to $37 from $43 per share, based on an assumed P/E multiple of 12x-13x their fiscal 2011 EPS estimate of $2.90.

Yet, Street sentiment remains generally positive. Accenture shares have traded flat since its disappointing November quarter earnings call and have outperformed each of IBM, EMC, Dell, Cisco, HP and SAP over the last three months; 14 of the 21 sell-side analysts following Accenture shares rate the stock a Strong Buy or Buy; and the consensus sell-side constant currency growth estimate of approximately negative 2%-3% is still within Accenture's guidance range and the consensus is for an acceleration to 7% growth in fiscal 2011. This suggests that the majority of investors still believe that a near-term demand recovery is likely and that it is simply lagging the recovery in enterprise hardware (especially servers, chips, storage and network equipment) spend by a few quarters.

Accenture's P/E Multiple of 15x Looks Full
Accenture shares now trade at a calendar 2010 GAAP EPS multiple of 15x, at the lower end of the range of 15x-20x that investors were willing to pay during the 2005-2007 period. While a P/E multiple of 15x is not expensive, Kaufman would argue that further multiple expansion is likely to be tough if the Street needs to digest a more muted recovery trajectory. Accenture's P/E multiple gap relative to IBM (which tends to widen in good times, narrow in bad times and has peaked at about 4 multiple points on several occasions over the last seven years) has now opened up and has returned to peak levels.As illustrated in Exhibit 4, Accenture's P/E multiple is firmly in the bottom half of the range for its peer group of large-cap technology vendors, although Accenture shares have usually traded in this range. Kaufman concludes that the stock is hardly expensive but that it may be fully priced at 15x GAAP EPS given the sluggish demand environment.

Notablecalls: Kaufman's Karl Keirstead & Shateel Alam do it again - they are way ahead of the pack with their check and downgrade (see archives for their previous downgrade in the name).

With the analysts calling for a guide-down later in March, the call is bound to get attention. The market seems to be in a shoot-first-ask-questions-later mode so there will be some downside in the stock price today.

I'm guessing 1-1.5pts towards the $40 level.