INOD - Innodata: Transformative Deals? I Do Not Think So

2023-06-22 18:06:57 ET

Summary

• Innodata Inc. has experienced a significant increase in its share price following its earnings results, driven by the AI trend.
• However, doubts arise regarding the justification of this surge due to erratic revenue growth rates and concerns about the actual health of the company's balance sheet.
• The historical volatility of Innodata's revenue growth and its lack of customer stickiness raise questions about its long-term profitability.
• Furthermore, despite claims of a healthy balance sheet, the company's cash flow is weak, and its ability to generate substantial free cash flow is uncertain. As a result, a neutral stance is recommended for investing in the stock.

Investment Thesis

Innodata Inc. (INOD) seen its share price move significantly higher since its earnings results last month, as the business jumps on the AI-hype train.

However, I'm not sure that this move is entirely justified, and here I describe why.

Not only are its revenue growth rates erratic, but I question whether its balance sheet is in fact as healthy as we are made to believe.

Altogether, I am neutral on this stock.

Why Innodata? Why Now?

Innodata aims to empower organizations to unlock the value of their data and make informed decisions through their data engineering and digital transformation services.

Innodata uses AI to help companies extract insights from their data by employing advanced analytics techniques. As you can imagine, given its narrative, the business' share price is moving higher, fast.

However, if we rewind the clock, we can see that in the past couple of decades, at the helm of CEO Jack Abuhoff, the stock has been hyped up many times, only to subsequently retrace back down.

Readers that are long INOD stock will declare that this time it's different. And on this front, I ask that you bear with me.

Why is the stock has the stock jumped more than 50% since its results came out last month? Here's the quote that got investors excited.

While we are confident that agreements will be inked until this happens, there is always the chance that it does not. The deals are potentially large.

To illustrate, one of the new customers has indicated that it will cut an initial purchase order for $2.5 million to get us started, but it will be supplementing that as we move forward. They also shared with us their vision for where the initial scope of work might go, which if fully realized, we believe could result in approximately $12 million of new quarterly revenues at maturity.

Now, I ask that excuse my cynicism and allow me to provide some context to Innodata's operations.

Historically, Innodata's customer base has been highly concentrated. Furthermore, in the recent past, the customer that become a top 10% customer one year, doesn't necessarily continue to be a top 10% customer the following year.

Here's the quote from the 10-K SEC filing .

We have historically relied on a limited number of customers that have accounted for a significant portion of our revenues. One customer in the DDS segment generated approximately 11% of the Company’s total revenues in the fiscal year ended December 31, 2022. Another customer in the DDS segment generated approximately 11% of the Company’s total revenues in the fiscal year ended December 31, 2021.

Why do I bring this up? Because I wish to make the case that its business model is less sticky than one would be led to believe. Here's another worthwhile quote from the Q1 earnings call:

It is also worth knowing that there was no revenue in the quarter [Q1 2023] from the large social media company, which contributed $4.4 million in revenue in Q1 of last year, but dramatically pulled back spending in the second half of last year as it underwent a significant management change.

This is Not a SaaS-Like Revenue Growth Rate

Above, we see just how volatile Innodata's revenue growth rates are. This is not a fast-growing business.

Meanwhile, looking ahead to 2023, Innodata states that if we exclude the loss of its large social media contract from last year, the business would actually be growing at close to 20% CAGR in 2023. Isn't this a form of double counting?

What About Profitability?

Innodata declares that 2023 could see more than $15 million of EBITDA. This puts the stock priced at slightly over 20x forward EBITDA. This doesn't sound too shocking.

But when we consider that there's very little customer stickiness, I don't know if this valuation makes sense.

Moreover, consider another quote from the earnings call,

We ended the quarter with a healthy balance sheet, no appreciable debt and $10.8 million in cash and short-term investments on the balance sheet.

I'm not sure that Innodata holds a healthy balance sheet. After all, the business carries $11 million of cash and is barely breaking even on a free cash flow basis.

What's more, the main reason why its free cash flow wasn't worse in Q1, was because working capital was a positive source of funds. Without working capital providing funds, Q1 would have been free cash flow negative. And its $11 million of cash on its balance sheet would have been chipped away.

The Bottom Line

In my analysis, I note that I have reservations about the recent surge in Innodata Inc.'s share price following its earnings results.

While the company capitalizes on the AI trend and offers data engineering and digital transformation services, I question the sustainability of its revenue growth and the true strength of its balance sheet.

Innodata's historical revenue growth has been volatile, and its customer base has shown a lack of stickiness. This raises concerns about its ability to maintain long-term profitability. Additionally, the company's cash flow situation is not particularly robust. Given these factors, I adopt a neutral stance on Innodata Inc. stock.

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