DAVA - Endava: Long-Term Growth Trajectory Remains The Same Despite Recent Slowdown

2023-07-07 08:12:14 ET

Summary

• Endava's valuation has dropped to an all-time low due to a slowdown in growth, but this is believed to be a cyclical issue, not a structural one.
• The company is well-positioned for future growth due to its strong vertical and domain capabilities, including in ML and AI technologies, and its high client retention rate.
• Despite the current challenges, there is a positive outlook for Endava's future prospects with significant upside potential, particularly as macro conditions improve and IT budgets increase.

Summary

Endava ( DAVA ) valuation has derated to an all-time year low of 11x forward EBITDA, the key reason for the underperformance relative to my price target previously . I continue to believe DAVA is poised for sustainable high growth with increasing demand for its services from existing clients and the expansion of their businesses. With its Distributed Enterprise Agile approach, DAVA integrates with its clients' teams and provides its own Agile scaling framework, TEAS, to scale its services effectively. In addition, the company has a high client retention rate, and its revenue is primarily generated from fast-growing industries such as banking and IT. That aside, with a nearshore delivery model, DAVA is also able to better communicate with clients, strengthening relationships and meeting their needs. DAVA reported performance so far has not been great due to the macro environment, but I believe it is a cyclical issue that would resolve itself and not a structural one. Hence, with the lower valuation, I remain positive on DAVA given my view that the company remains well positioned in a high-growth area that I believe has long-term healthy end-demand due to positive secular tailwinds driving growth in digital transformation.

Slowdown is Not Structural

I think the obvious slowdown in growth from 30% to 20% this quarter is what has set off a series of selldown. The demand slowdown DAVA is experiencing, however, is cyclical and not structural, in my opinion. I feel it is important to point out that the recent instability in the US regional banking sector has had a chilling effect on demand for banking and financial services. A big part of DAVA's income comes from this market segment. Hence, that is an outlier period that should recover eventually. In general, I do not expect DAVA end markets to deviate from their long-term course, which is steadily progressing toward digital transformation. When the macro conditions improve and customers increase their IT budget, I believe DAVA will be well-positioned to continue growing at a fast organic pace thanks to its strong vertical and domain capabilities, including in ML and AI technologies. Companies will have to pay the price, either now or in the future, as the secular force of digital transformation grows stronger. Another growth driver that I believe will hasten the pace of digital transformation is the increasing interest in using AI to boost productivity. My forecast for FY24 is that demand will begin to improve as inflation is reined in and the economy feels the sting of potential further rate hikes to near 6% in FY23.

Margin Improvement

One silver lining is that DAVA was able to reduce headcount and launch transformation initiatives in response to the economic slowdown. I believe these actions have a long-term impact as DAVA margin is now structurally higher than in the past, but we are unable to see the fruits of this strategy due to wage inflation.

Valuation

I believe there is a 74% upside for DAVA. Based on my estimates, I expect DAVA to generate ~$1.1 billion in revenue and ~$300 million EBITDA in FY25. The reason for the step-down in revenue and EBITDA vs my previous model is due to the weaker-than-expected FY23 (using consensus figures). I still believe revenue growth will be driven by growing revenue per existing customer and also adding new logos. Likewise, for margins, the high incremental margins from upselling customers should aid in boosting margins. I also revised my multiples assumption downwards, despite believing the stock is still worth 17x EBITDA, because I expect investors to continue staying cautious for the near-term, and would not be in a rush to size up on the stock. Also, when comps against peers, I expect DAVA to at least be worth 13x given its expected EBITDA growth (consensus estimates).

Using the current forward EBITDA multiple of 13x, it implies that DAVA is worth ~$4 billion in enterprise value, which translates to GBP51 per share.

Risks

The success of DAVA's expansion depends on the company's ability to attract and keep a large number of highly talented and skilled IT professionals. Failure to hire, train, and retain enough competent IT workers could have disastrous effects on the business.

Conclusion

Despite the recent challenges faced by DAVA, I maintain a positive outlook on the company's future prospects. The current low valuation, combined with its strong positioning in the high-growth digital transformation sector, presents an opportunity for significant upside potential. While the temporary slowdown in growth may be concerning, I believe it is a cyclical issue rather than a structural one. As macro conditions improve and IT budgets increase, DAVA's strong vertical and domain capabilities, including ML and AI technologies, will enable it to resume fast organic growth. I remain optimistic about DAVA's future and believe it is undervalued relative to its growth potential.

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