GDYN - Grid Dynamics: A Pure-Play IT Services Provider Driving Digital Transformation

2023-05-31 02:08:42 ET

Summary

• Grid Dynamics Holdings is down 19% YTD due to a weak macro environment and exposure to affected industries but continues to onboard new clients for medium-term growth.
• The company focuses on digital transformation services, with strong technical capabilities in areas like AI, data engineering, and cloud-native application development.
• My end-of-year price target of $13 applies a 25x multiple to the consensus CY24E EPS of $0.53.

Investment Thesis

Grid Dynamics Holdings, Inc. ( GDYN ) is down 19% YTD as investors remain concerned about Grid Dynamics' vulnerability to the weak macro environment that has been present for the past six months. The company's guidance for the second quarter fell well below estimates, indicating a mid-single-digit sequential decline in revenue. However, it is worth noting that Grid Dynamics continues to onboard new clients at a healthy pace, which sets the stage for promising medium-term growth and a more diversified revenue base. The addition of new clients is encouraging, and it will be important to closely monitor disclosures related to client penetration metrics in the near term. Overall, I remain bullish on the company's long-term growth trajectory and keep an end-of-year price target of $13 derived from a 25x multiple applied to the consensus CY24E EPS of $0.53.

Q1 2023: Weak Macro Reflecting in Results

The company's Q1 revenue and adjusted EBITDA came modestly ahead of market estimates, although the Q1 represents the smallest revenue beat to guidance and street estimates, indicative of a weak demand environment. The demand for IT services in project-based work is currently at its weakest since 2008/09, which poses challenges for GDYN. The company has high exposure to heavily affected industries like Tech, Retail, and Consumer Packaged Goods, which make up more than 80% of its revenue.

I expect a mid-single-digit sequential decline in 2Q (the third consecutive quarterly decline) and flattish growth in 3Q to represent stability before the growth trend potentially resumes. I expect the company to continue investing in its tech capabilities (such as in Generative AI) as well as in delivery diversification.

However, there are signs of medium-term optimism. GDYN acquired nine new enterprise clients in the quarter, adding to the 13 obtained in the previous quarter, bringing the total to approximately 100 such clients. Although these client accounts may currently have a limited impact on overall growth rates, this trend indicates significant growth potential in the coming years. It also presents an opportunity to diversify revenue streams beyond the core verticals of Tech, Retail, and CPG. The company is increasingly successful in securing new deals in the healthcare and financial services sectors, and I expect this trend to continue in the near term.

Pure play in the Fastest Growth areas within IT Services

Grid Dynamics is an IT services provider that focuses entirely on digital transformation services. According to Markets & Markets , the market for digital services, including cloud, AI, and consumer experience, is projected to more than double from $594 billion in 2022 to $1,548 billion by the end of 2027, growing at a CAGR of 21.1%, during the period.

Grid Dynamics positions itself as a provider of advanced technical capabilities in rapidly expanding areas like cloud-native application development, AI/data engineering, and consumer experience. The company differentiates itself through its extensive technical expertise, with all its engineering staff holding at least a master's degree in computer science. Additionally, the company has domain-specific knowledge and has made investments in industry-specific tools and platforms. Based on these factors, I expect Grid Dynamics to continue to grow at a 20%+ rate comparable to other specialized companies in the industry, such as EPAM, GLOB, and DAVA, which focus solely on digital transformation services.

Financial Outlook & Valuation

I anticipate that Grid Dynamics will experience solid revenue growth of 20% or more in the coming years, aligning with its digital peers and surpassing the mid-single-digit growth rates of the overall IT services industry. This growth is attributed to GDYN's strong technical capabilities and focuses on fast-growing areas like AI, data engineering, and cloud-native application development, which have also driven high growth rates for similar specialized companies such as EPAM, DAVA, and GLOB. GDYN's strategy of working with fewer clients has fostered deep client relationships, further contributing to its growth potential.

My principal valuation metric for GDYN is relative P/E, which is the most commonly used metric across the industry, and most peers typically trade on respective P/E multiples. My GDYN price target of $13 applies a 25x multiple to the consensus CY24E EPS of $0.53. GDYN is currently trading at 24x forward PE, while digital peers are trading at ~25-27x. I believe the company deserves an inline multiple to these peers as higher volatility in results should be balanced with higher long-term growth.

Risks

Grid Dynamics has a relatively high level of customer concentration, with its top five clients contributing to over 50% of its total revenues and the top 10 clients accounting for around 67%. While this high customer concentration can introduce volatility in revenue trends, I believe Grid Dynamics is better positioned to manage any potential challenges compared to the past. This is because the company has multiple large clients that are roughly equal in size and come from different industry verticals. Moreover, in terms of stock compensation expense, Grid Dynamics incurs a higher percentage relative to most peers, with it being in double digits as a percentage of revenue. In contrast, peers typically have stock compensation expenses ranging from 3% to 5% of revenue. As Grid Dynamics continues to grow its revenue base, I expect the stock compensation expense to normalize. However, until that happens, it will result in significant annual share-count dilution.

Conclusion

Grid Dynamics is a pure-play IT services provider focused on digital transformation. The company specializes in fast-growing areas such as cloud-native application development, AI/data engineering, and consumer experience. Grid Dynamics's deep technical expertise and specialization in high-growth areas contribute to their projected top-line growth in line with industry peers. GDYN's emphasis on building strong client relationships provides solid penetration potential and growth opportunities. My end-of-year price target of $13 applies a 25x multiple to the consensus CY24E EPS of $0.53.

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