INOD - Innodata: Riding AI Wave At 70x FCF? Not Me

2023-08-23 10:45:42 ET

Summary

• Innodata is a company that focuses on providing digital services and solutions to various industries.
• The company has a strong investment thesis due to its expertise in data management and analytics.
• Innodata has been experiencing steady revenue growth rates, making it an attractive investment option.

Investment Thesis

Innodata ( INOD ), a data engineering company, has seen its share price soar numerous times over the past two decades, only to subsequently and unexpectedly drop once again.

Presently, it's again jumping to all-time highs. That being said, recently the company has made tremendous progress, and in the past couple of quarters, Innodata has succeeded in signing up a large Big Five customer. Needless to say, for a company with a sub $1 billion market cap to sign up such a large customer is undoubtedly a very positive development.

But as I dig into the financials, I remain skeptical that this investment is such a bargain valuation. Consequently, I remain neutral on this stock.

Why Innodata?

Innodata helps companies harness the power of AI by preparing high-quality data, deploying AI models effectively, and offering AI-enabled industry platforms. They serve a wide range of industries and are well-positioned to capitalize on the growing AI market.

Furthermore, Innodata used its Q2 earnings call to announce that it secured another major deal with one of the world's largest tech giants. This achievement marks their successful entry into the cutting-edge world of generative AI and large language models, technologies that are poised to revolutionize computer technology.

Moreover, Innodata won all the potentially-transformative pipeline deals discussed in the previous quarter, solidifying its position as a key player in the AI landscape.

These deals, including the most recent announcement, have yet to reflect in the financial results, but are expected to have a substantial impact, the topic we turn to discuss now.

Revenue Growth Rates Set To Improve, But How Much?

Innodata doesn't provide clear guidance ahead. Rather, Innodata notes that on a normalized basis, the quarter just passed, Q2 2023, would have seen a 13% y/y increase.

Furthermore, looking ahead, Innodata asserts that Q3 will see a sequential increase and that Q4 will also see a sequential increase from Q3.

Given that management hasn't provided any tangible figures, I've come up with what I believe are fair and reasonable estimates to quantify management's commentary.

That being said, if we look back to Innodata's Q1 2023 results, at the time Innodata stated that

[...] we expect that, exiting this year, our revenue growth rate could potentially be high teens (or in the 20s, backing out from 2022 the large social media company [that didn't renew their contract])

The quote above clearly alludes to the high 10s% CAGR for Q4. Nevertheless, for my part, I believe that my Q4 revenue estimate of 10% is more reasonable. Furthermore, management hasn't provided much of a tangible framework to make me more bullish.

Even if it ends up being the case that Innodata's Q4 grows in the mid or even the high-teens, I would still struggle to view Innodata as a high-growth company. That's not even 20% CAGR. For a company this size, for them to reach 20% CAGR wouldn't be such a struggle if their tech was in strong demand.

Moving on, in my opinion, it appears that Innodata is too eager to double-count its revenues. By that I mean, when they gain a large customer, they book that revenue promptly, but when they subsequently lose that large customer, they note that if they hadn't had that customer in the prior period, its revenues now would be growing much faster . I believe that reasonably-minded readers would question this practice.

Cash Flow Profile Doesn't Inspire Much Hope

For the past 6 months, Innodata's free cash flow was $1 million. Although, that is a dramatic jump from the negative $7 million for the same period a year ago.

However, even if Innodata's free cash flow into the second half of 2023 were to double, this would still leave Innodata's free cash flow at less than $5 million on an annualized go-forward basis.

Investors are being asked to pay approximately 70x forward free cash flow. I believe this is an unreasonably high valuation. And that's if we could confidently assume that Innodata's free cash flow could increase by 100% from this point forward over the next year.

Meaning that, for Innodata to reach a multiple of 70x forward estimated free cash flow, there needs to be a dramatic improvement in its free cash flow profile.

I argue that hoping to see such a dramatic improvement leaves investors with no margin for error. That's not to say that there can't be such a large improvement; there certainly can, but it requires this jump in free cash flows to support Innodata's current valuation.

The Bottom Line

Innodata has recently achieved remarkable progress by securing a major deal with a top-tier tech giant, establishing its presence in the emerging field of generative AI and large language models.

This accomplishment, along with previous transformative deals, positions Innodata as a key player in the AI landscape. However, upon closer examination of the financials, I maintain a neutral stance on the stock due to concerns about its valuation.

While Innodata has the potential to benefit from the growing AI market and improving revenue growth rates, the current valuation, with a forward free cash flow multiple of around 70x, leaves little room for error in achieving the necessary dramatic improvement in free cash flows to support its valuation.

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