Counseling the Chat Bots
Since the release of ChatGPT to the general public in November last year, the stock markets have been entranced by generative artificial intelligence (AI) technology. Money managers and individual investors alike have poured vast amounts of money into stocks of companies that have merely mentioned “AI” on their earnings calls, and even more into companies that are actually developing the technology or systems allowing it to run. Most of these stocks have already reached enormous valuations, posing risks of a snapback.
However, there is a group of companies that have so far flown under the radar of AI investors: technology consulting and services companies. According to JP Morgan (JPM) analysts, these companies will tremendously benefit from the technology, as it will support their cost savings, lift their productivity, and provide additional revenue opportunities. The IT consultants will be the ones who implement, update, and support AI systems within their customers’ businesses.
All these near-future benefits come on top of the ones already present. As digital transformation becomes a non-negotiable in our tech-driven world, businesses of all sizes require IT consulting and services to innovate, streamline operations, and secure their assets. This consistent demand signals reliable revenues for IT services firms. Additionally, the industry is characterized by its scalability potential and high-profit margins, offering an attractive return on investment for shareholders.
Global IT consulting firms, in particular, have the added advantage of geographic diversification, catering to a wider customer base and accessing varied markets. Their expertise across multiple domains enables them to adapt to region-specific trends and requirements. These firms are well positioned to leverage international business opportunities, mitigating risks associated with economic fluctuations in specific regions. This global footprint provides a robust platform for steady growth, making them an attractive investment choice.
Economy and Markets: Looking Forward
There are several very important reports scheduled to be published in the next few days:
- Later today, we’ll receive August’s NY Empire State Manufacturing Index, providing highly important data on the state of the manufacturing sector in New York State.
- Also later today, we’ll see published the Minutes of the Federal Open Market Committee (FOMC), providing clues to the future Federal Reserve’s policy outlook.
- On Friday, we’ll get a glimpse of the preliminary August’s S&P Global Manufacturing PMI, an important forward-looking indicator of the general conditions in the overall economy.
As for the stock calendar, the Q2 2023 earnings season for Smart Investor Portfolio companies is drawing to a close, with only Keysight Technologies (KEYS) and Applied Materials (AMAT) scheduled to report this week.
The ex-dividend date for Applied Materials (AMAT) is August 23rd.
Today, we’re letting go of a robust and profitable company whose outlook is more cloudy than usual due to the uncertainty faced by its sector, as its outlook is influenced by several conflicting factors. In its place, we’re adding an IT consulting and services industry leader with stellar financial metrics, high efficiency, great profitability, and an insatiable appetite for expansion.
New Deletion: Valero Energy (VLO)
Valero Energy Corp., the second-largest independent refiner in the U.S., manufactures and markets transportation fuels and other petrochemical products. The company also produces and sells ethanol, dry distiller grains, syrup, and inedible corn oil primarily to animal feed customers. In addition, it owns and operates crude oil and refined petroleum products pipelines, terminals, tanks, marine docks, truck rack bays, and other logistics assets; and owns and operates a plant that processes animal fats, used cooking oils, and inedible distillers corn oils.
Valero Energy Corporation was founded in 1980 and is headquartered in San Antonio, Texas. It was formerly known as Valero Refining and Marketing Company and changed its name to Valero Energy Corporation in August 1997. It is a mid-cap company belonging to the Energy sector (Industry: Oil & Gas).
Valero’s financials demonstrate robust health: it has a very moderate debt-to equity ratio; its short-term assets cover both its short- and long-term liabilities; its interest coverage is more than satisfactory. Its efficiency and profitability ratios are also quite spectacular, with much higher-than-average for the industry Return on Equity (ROE) and Return on Assets (ROA), as well as operating and net margins. It has a very solid cash position, supporting shareholder returns in terms of dividends and share repurchases.
In the past three years, the company’s revenues grew by 11% a year on average, while earnings growth was 35% per annum. In the second quarter of 2023, the company beat analysts’ estimates on earnings, as it did in all previous quarters, but missed on revenues, which fell by 33% year-on-year. Despite the beat on earnings, EPS came in more than 50% lower than in Q2 2023.
All in all, Valero is a robust and profitable company. Our decision to sell the stock lies not within Valero’s fundamentals, but within its industry’s current and forecasted conditions.
The decline in profits this year was to be expected since all U.S. refiners now find themselves in similar situations. Last year’s profits surged to a record on the back of rising energy prices and stronger-than-average demand following Russia’s invasion of Ukraine and the subsequent sanctions on Russian crude and gas exports.
This year, with energy prices receding and demand slowing as manufacturing sectors in most countries cool, while global refining capacity rises, profit margins are coming back to earth. The manufacturing and freight slowdown is expected to continue in the second half of the year, as economies around the world, particularly in Europe and Asia, are weakening. At the same time, additional refining capacity in Asia and the Middle East is expected to continue depressing margins.
Longer-term, the outlook is even more uncertain. The prognosis for demand, which will rely on the extent of any global economic slump and the speed at which it recovers over the next years, is the main source of uncertainty for refiners. To add to it, there are several uncertainties regarding supply. On the one hand, many companies in the U.S., Europe, and other rich countries, are converting old refining capacity to biofuels, or shutting refining facilities altogether. On the other hand, there are new refining capacities coming online in Africa, Asia, and the Middle East, likely raising net capacity by 2025, according to research by McKinsey. Even longer term, the energy transition process is expected to increasingly weigh on demand and margins.
Returning to a shorter term, we should also take into account that all these conflicting influences come on top of the regular ones. Oil & gas prices are notoriously difficult to predict, given that they are impacted by weather, geopolitical events, and many other factors. Given this unpredictability, we believe it’s time to cut our exposure to the energy sector. Smart Investor is definitely not disposing of the blue-chip Dividend Aristocrat Enterprise Products Partners (EPD), and keeping, for now at least, Occidental Petroleum (OXY), Warren Buffett’s favorite stock. However, we find it’s time to sell VLO, with its extra-high volatility, while it has recouped its year-to-date losses.
We’d like to reiterate that Valero is a great and profitable company, and we may reevaluate it if and when the energy sector outlook becomes clearer.
VLO’s removal from the portfolio will make room for the company we are adding this week, ACN.
New Addition: Accenture (ACN)
Accenture PLC is a multinational professional services company, which provides management consulting, technology, and outsourcing services. Most of its services span the IT sphere, offering application services, including agile transformation, DevOps, application modernization, enterprise architecture, software and quality engineering, data management, intelligent automation comprising robotic process automation, natural language processing, and virtual agents, and application management services, as well as software engineering services. The company also offers strategy and consulting services; data and analytics strategy, data discovery and augmentation, data management and beyond, data democratization, and industrialized solutions comprises turnkey analytics and artificial intelligence (AI) solutions; metaverse; and sustainability services. Accenture also provides management, HR, strategy, infrastructure, customer experience, finance consulting, mergers and acquisitions, and other services.
With its market capitalization of $209.6 billion, 740,000 employees worldwide, 9,000 clients in over 120 countries, and 2022 revenues of $61.6 billion, Accenture is a mega-cap Fortune Global 500 company. It belongs to the Information Technology sector (Industry: Professional Services).
Accenture is heavily investing in research and development. It has a network of around 400 performance and innovation centers, developing innovative solutions for the company’s clients. ACN has over 8,300 patents and patents pending worldwide. The company has numerous cooperation agreements, such as a collaboration with Amazon’s (AMZN) Web Services to develop cross-industry solutions. It is also cooperating with ServiceNow (NOW) and NVIDIA (NVDA) to fast-track the development and adoption of enterprise generative AI capabilities.
The company was founded in 1951 in Dublin, Ireland. Accenture began as the business and technology consulting division of accounting firm Arthur Andersen, which was one of the “Big Five” global accounting firms until the 2000s. The firm split from AA in 1989 and adopted its current name, Accenture PLC, in 2001, under which it became a publicly traded company in the same year. Despite the fact that the company’s global headquarters are located in Dublin, Accenture’s stock is only traded on the NYSE. The company’s NYC office serves as its North America headquarters.
The company has been logging in fast business and geographic expansion since its establishment as an independent company, achieving its goals through organic growth as well as numerous acquisitions. It has acquired more than 275 companies globally since 2001. In the first seven months of 2023 alone, Accenture has bought 13 companies: Strongbow Consulting, Nextira, Bionest, Inspirage, and Anser Advisory in the U.S., Optimind in France, Flutura in India, Green Domus and Morphus in Brazil, Bourne Digital in Australia, Einr AS in Norway, Objectivity in the U.K., and SKS Group in Germany.
ACN checks all the boxes on financial health, capital efficiency, and profitability metrics. Despite financing numerous acquisitions, the company has zero debt; it has cash and equivalents of $8.5 billion. The company takes pride in an outstanding Return on Equity (ROE) of 31% and Return on Assets (ROA) of 14%, leaving its industry far behind on these metrics. Accenture’s operating margin of 14.5% and net profit margin of 11.3% are also considerably higher than average for its peers, indicating outstanding operational efficiency.
The company’s revenues have been growing at an average annual rate of 12.9% in the past three years, while earnings have increased by 13.2% annually. In fiscal Q3 2023 (ending May 31st) ACN exceeded analysts’ earnings estimates, as it did in all quarters in its public-company history, with just two exceptions over the years. Earnings per share grew 14% year-on-year, with the operating margin expanding to 16.3%. In addition, the company’s outstanding cash-generating ability came into light as its free cash flow increased 10% year-on-year.
Year-to-date and in the past three years, Accenture’s stock has risen in line with the performance of the S&P 500 Index (SPX); in the past five years, ACN’s investors took home a profit of almost 100%, versus SPX’s 62%. Due to the 30% increase in its stock price since its latest trough in March 2023, the company is trading with a 7% to 10% premium versus the IT sector’s average price-to-earnings ratios. However, it is much cheaper than many of its competitors, such as SAP AG (SAP) or Gartner (IT); it’s currently trading close to its own long-term average.
In addition to the share price appreciation, Accenture’s shareholders are rewarded with dividend payments and buybacks. Although Accenture’s dividend yield of 1.4% seems to be moderate at first sight, it’s higher than the IT sector average and is poised to grow further, as per company policy. In fiscal Q1 2023, ACN raised its quarterly dividend by 15%, the same increase as in fiscal Q1 2022; in fiscal Q1 2021 it was increased by 10%. The company has also been active in purchasing its shares: in fiscal Q3 2023 alone, the company repurchased its stock for the amount of $789 million, bringing the total buyback account for the first three quarters of fiscal 2023 to a total of $3.33 billion. Accenture’s remaining capacity withing the current share repurchase program stood at $3.5 billion at the end of the quarter.
Accenture has been drawing significant attention from hedge funds and individual investors, who have been increasing their exposure to the stock in recent months. Analysts pencil in an average upside of 10.2% for the stock in the next 12 months; coupled with dividends and buybacks, this presents an outlook for a solid total return, with a potential of further strong increase when the company’s efforts at integrating generative AI capabilities in its service suite begin to pay off.
ACN carries a 9/10 (“Outperform”) Smart Score rating on TipRanks with a “Moderate Buy” recommendation:
In conclusion, we are convinced that this IT services giant with stellar financial metrics, fast expansion, prudent management, and high total investor returns, will be a valuable addition to the Smart Investor portfolio.
What’s Next?
Our next commentary will come out on Wednesday, August 23, before the market opens.
Until then – we wish you a world of investment success!
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