DAVA - Endava: Expect Valuation To Revert To Historical Average

2023-12-20 19:49:30 ET

Summary

• I reiterate my buy rating for DAVA as signs of macroeconomic recovery suggest positive growth prospects in FY24.
• DAVA's financials for 1H24 show a decline in revenue but better-than-expected profitability, with strong performance in Rest of the World and Europe.
• I expect DAVA's growth will recover to historical levels as the macro environment stabilizes and IT spending recovers, leading to a potential re-rating in valuation.

Summary

Readers may find my previous coverage via this link . My previous rating was a buy as I believed Endava's ( DAVA ) long-term growth tailwind remains intact, but I also recommended not to size up any existing position because of the near-term uncertainties. Given that, as of the time of writing, DAVA has almost touched my target price of $75 (the current price is $74), I think it is appropriate to provide an update on my recommendation. I am reiterating my buy rating as there are growing signs that the macro environment might be reaching normalcy in FY24, which is very positive for DAVA as IT spending should recover. As this happens, I expect the market to start re-rating DAVA’s multiple to its historical average as the near-term growth uncertainty is removed.

Financials / Valuation

As expected, 1H24 is going to be an uncertain period. The business reported 1Q24 revenue of £188.4 million, representing a y/y decline of 3.9%. On a constant currency basis, revenue declined 0.6% Y/Y. While growth was weak, it was encouraging to see DAVA perform better than expected on profitability. Gross margins came in at 36%, beating consensus by 100 bps, albeit still down y/y and sequentially. The same was true for profit before tax margin, which fell by ~430 bps y/y and 440 bps sequentially.

Based on my view of the business, DAVA should be on track to see growth recovery in FY25 as the macro conditions turn for the better in FY24, along with all the micro-level drivers (listed below) that the business has. I continue to expect DAVA to achieve 15% growth in FY25 and 20% growth in FY26. The underlying assumption is that DAVA growth will recover to historical levels. The same logic applies to my EBITDA margin assumption: as growth recovers, so should EBITDA margins. The variant here vs. my previous model is that stock returns from here onwards are going to be largely driven by valuation multiples reverting to mean. I believe a big reason for DAVA valuation de-rating to mid-teens was that the growth outlook is uncertain in the near term. Now that there are signs for IT spending to return, I expect the market to start pricing in this. Historically, DAVA has traded at 23x forward EBITDA; hence, I am using that as my assumption.

Comments

I think there was no surprise to DAVA's weak 1Q24 performance when compared to 4Q23 and 1Q23, as the market is already aware of the tough macro environment impacting the business. However, digging deeper into the operating results, I think the weakest period might be over for DAVA, and as the business environment improves over the coming quarters, DAVA could see growth accelerating back to historical levels.

While overall growth was down 3.9% on a reported basis, DAVA saw continued strong performance in Rest of World, which grew ~180% Y/Y and now represents ~10% of company revenue. This is a huge achievement, as Rest of World was only 3% of the group’s business in 1Q23. At the rate at which it is growing, it is going to represent a larger piece of growth moving forward. Another region that performed well was Europe, which grew ~9% Y/Y and now represents ~25% of company revenue. Collectively, the growth contribution from Rest of World and Europe in the current revenue mix is around 20%. The region that is pulling down is the UK and North America, which I believe have a good chance to return to growth in the coming quarters (more on this below). Regional performance aside, I would like to follow up on the number of customers with >GBP1 million in revenue that DAVA had. This metric has remained steady at 145 customers (vs. 4Q23 of 146), representing y/y growth of an additional 5 customers. Unlike what the tough macro headline suggests, DAVA continues to see positive traction in the going-up market.

A lot has happened over the past 2 months, especially with the Fed mentioning that the period of rate tightening might be over, which is an indication that the economy is heading towards normalcy soon. This is huge, as the sharp increase in rates has heavily increased the operating costs of many businesses, resulting in many businesses either slashing technology-related budgets or delaying the implementation of projects. Both of which had a huge impact on DAVA growth. Looking forward, as the macro environment stabilizes and short-term discretionary spending recovers, DAVA should see growth recover. The weak performance over the past few quarters would also serve as easy comps for DAVA on a sequential basis, making the headline growth rate look a lot more positive (likely triggering positive stock momentum). If we look at DAVA’s comp, Cognizant Tech Solution (CTSH), CTSH went through a similar phase during subprime. Growth slowed dramatically from 40+% to mid-teens in 2009, but recovered very strongly to 40+% once the economy recovered. I believe DAVA will see a similar growth trajectory.

Elsewhere, as seen from the growing spend per customer and number of clients with >GBP1 million in revenue, DAVA clearly has strong expertise in expanding relationships with existing clients. For better reference, clients contributing more than GBP5 million have increased by >6x from 5 in FY16 to 33 in 1Q24.

Additionally, we had 33 clients each paying us in excess of GBP5 million per year in the quarter just ended compared to GBP25 in the same period last year, representing a 32% year-on-year increase. Source: 1Q24 earnings

Altogether, there are three growth drivers here that should propel DAVA growth back to historical levels easily.

1. Macro level: The upcoming recovery in North America and the UK region will cause a sharp acceleration in growth as businesses increase their budgets for IT-related spending.
2. Micro level: DAVA continues to deliver strong growth in Rest of World and Europe, both of which are already contributing 20% of consolidated growth, assuming the same growth rate and current mix of revenue.
3. Micro level: DAVA continues to increase spend per customer, driving growth.

Risk & conclusion

It is impossible for me to say with certainty how next year's IT budget will pan out. The situation may deteriorate and persist for an extended period of time. While DAVA has been so successful in increasing spend per customer (or going upmarket), it might result in net-negative impact if DAVA pushes too aggressively, causing the customer to churn.

In conclusion, I reiterate my buy recommendation for DAVA as the business is poised for a potential re-rating in valuation. As the NA and UK economy return to normalcy in FY24, which should lead to a recovery in IT spending, I foresee DAVA's market multiple reverting to historical averages as uncertainties diminish. Elsewhere, Rest of World and Europe have shown robust growth, contributing significantly to the company's revenue mix.

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