CA - TELUS International: Navigating Challenges And Seizing Digital Opportunities

2023-12-18 12:31:24 ET

Summary

• TELUS International has experienced a downturn in the customer experience and digital services sector due to the tech sector's decline.
• The company has a foothold in the AI market and is well-positioned to benefit from the growth of generative AI.
• TELUS International has implemented cost rationalization strategies and is focused on margin recovery to sustain profitability.
• We see 90% upside from today's price.

Investment Thesis

TELUS International (TIXT), a notable player in the realm of customer experience ((CX)) and digital IT services, has traversed a turbulent macroeconomic landscape since November 2022. Since our previous coverage of TIXT, the entire CX and digital services sector has experienced a severe downturn which we exhibit further in this article. TIXT has historically been known for its robust growth trajectory and leading profit margins compared to its peers. Similar to its peers, it has recently experienced a deceleration, primarily due to the downturn in the tech sector which represents its largest customer vertical. While the recent rise of generative AI may pose a threat to the traditional CX business, it also presents the CX industry a potential growth catalyst that can greatly improve profit margins. TIXT already has a foothold in the AI market through its data annotation and content moderation capabilities which will become increasingly critical as the push to commercialize AI and the overall regulatory scrutiny around it increases. TIXT's long-term potential remains solid, driven by its foundational strengths and strategic advancements into transforming itself from a traditional CX player to an end-to-end digital partner for its clients. This creates an opportune moment for investors with a long-term horizon to engage with a business grounded in sound fundamentals, enhanced by its experienced management team’s focus on digital transformation and AI capabilities.

Company Overview

Originating as a spin-off from the Canadian telecom behemoth TELUS Corp, TELUS International has established a formidable global presence in 28 countries, employing approximately 70,000 individuals, supplemented by a substantial community of AI gig workers. The company’s service offerings are categorized into three primary segments: Design, Build, and Deliver. This trio effectively encapsulates the complete spectrum of B2B services, ranging from identifying root causes of customer dissatisfaction and designing tailored solutions to constructing and maintaining digital platforms and infrastructure. The acquisition of WillowTree marks a strategic enhancement to TELUS International’s service portfolio, particularly augmenting its capabilities in the realm of front-end development, which complements the existing focus on digital transformation.

Recent Performance

The period following our previous article has been marked by deteriorating performance for TELUS International, influenced heavily by the wider economic context, especially in the technology sector. Notwithstanding these headwinds, the company has maintained robust free cash flow and has actively engaged in efforts to bolster its margins. We believe the overall performance actually highlights a resilient response to the market fluctuations, with strategic initiatives like cost rationalization and the integration of WillowTree being focal points to ensure the company is set up to take advantage of the market recovery. Nonetheless, the impact of reduced client expenditure, particularly from major tech entities, has been a significant factor influencing the company’s revenue streams.

As the chart above shows, recent years have marked a growth slowdown from the hypergrowth period the company experienced previously. While 2024 may still be impacted by the current recessionary environment, recent macro news has potentially signaled a return to normal activity levels faster than previously thought.

Market Overview

The digital transformation and customer experience services market, where TELUS International operates, is a rapidly evolving space, influenced heavily by technological advancements and economic shifts. Companies like Teleperformance, Concentrix, EPAM, Endava, Globant, and Accenture (ACN) are significant players in this domain, each offering a range of services from IT consulting to specialized digital solutions.

Competitive Performance

TELUS International, in comparison to its competitors, has faced unique challenges and opportunities. While companies like Accenture and EPAM have capitalized on broader digital transformation initiatives, TELUS International's focus has been more concentrated on CX innovation and digital IT services. The recessionary environment has had varying impacts on these companies. For instance, firms with a broader service portfolio, like Accenture, may have had more resilience in facing economic headwinds due to their diversified client base and service offerings.

Impact of the Recessionary Environment

The recessionary environment has led to budget constraints and project delays across the sector. This has particularly impacted companies like TELUS International, which have a significant reliance on tech sector clients. However, firms with a more diversified client base across different industries, such as Teleperformance and Concentrix, might have experienced a more cushioned impact due to their varied exposure.

Outlook for 2024

As we move into 2024, there is cautious optimism in the market. With economic recovery on the horizon, client budgets are expected to increase, potentially leading to the restart of projects that were previously put on hold. This recovery could benefit companies like TELUS International, which have been proactive in aligning their cost structures and refining their service offerings in anticipation of market recovery.

Potential Catalysts

• Digital Progression : The strategic integration of WillowTree significantly bolsters TIXT's portfolio, presenting substantial growth prospects in the digital transformation arena. This move positions the company to capitalize on emerging trends and client demands in the digital landscape. While TIXT already had digital capabilities prior to this acquisition (primarily focused on back-office work), the capabilities added via WillowTree allows the company to offer its client more end-to-end capabilities as it focuses on front-end development. Based on company disclosures from the time of acquisition, WillowTree was growing at 40-50% YoY which is significantly higher than TIXT's overall growth rate suggesting a new growth engine for the company.
• Content Moderation and AI Data Annotation demand particularly in Generative AI : Given the escalating demands for content moderation and AI data annotation services, TELUS International is well-poised to expand its market share in these growing sectors. Based on our estimates, TIXT is now the largest provider of AI data annotation services at scale and is likely a key service provider for all the large tech companies. One of the key issues with the commercialization of Generative AI is the absence of niche/specialized data and trust/safety related to the responses which the algorithm provides. These are serious issues which can greatly hinder the adoption of Generative AI into the mainstream. TIXT's services are aimed perfectly to help clients solve these problems and we believe this is a massive opportunity for the company.
• Cost Rationalization and Margin Recovery : In response to the challenging economic conditions, TIXT has implemented a stringent cost management strategy. This focus is pivotal in sustaining profitability amidst fluctuating market conditions and is a testament to the company's operational efficiency and strategic foresight. We believe this cost optimization will help TIXT become more agile and position it well as the overall market recovers.

Valuation

As discussed in our previous article, the market continues to compare TIXT with other legacy BPO players (TaskUs, Teleperformance, Concentrix etc). However, TIXT has made meaningful progression towards including more digital services in its revenue mix. The chart below shows that less than 50% of TIXT's revenue is now what would be considered legacy CX work.

The stock is currently trading at 6x NTM EBITDA. While this is in-line with other CX providers, we can clearly see from the chart below that the more integrated digital IT peers are trading around mid to high teens which is where we believe TIXT can move to as some of the catalysts mentioned previously materialize.

Using a conservative 9x multiple, we set our target price at $15 (currently trading around $8) which implies ~90% upside from current levels.

Key Risks

• Customer Concentration : TELUS International’s revenue is significantly reliant on a limited number of large clients. This concentration, especially in the volatile tech sector, heightens the risk of revenue instability due to client-specific changes or budgetary constraints.
• Macro-Economic Sensitivity : The company's financial performance is intricately linked to the broader economic conditions. Given its substantial engagement with the tech and e-commerce sectors, TELUS International is susceptible to economic downturns that could lead to reduced client spending and prolonged sales cycles.
• Integration of Acquisitions : The successful integration of acquisitions, particularly WillowTree, is critical in realizing synergies and driving growth. Challenges in this area could potentially impact the company's growth trajectory and profitability margins.
• Technological Advancements and Competition : In the rapidly evolving digital services market, staying abreast of technological advancements and maintaining a competitive edge is crucial. Failure to adapt to new technologies (such as Generative AI) or meet evolving customer needs could result in a loss of market share.
• Global Operations and Regulatory Compliance : The company's extensive international operations expose it to a myriad of geopolitical risks, regulatory changes, and currency fluctuations, adding complexity and potential costs to its operations.

Conclusion

TELUS International, in the wake of economic uncertainties and client spending shifts, demonstrates resilience and strategic agility. While the near-term outlook presents challenges, the company's commitment to digital transformation, strong operational foundation, and effective cost management strategies position it well for future growth which should be beneficial for investors with long term investment horizons. Investors should closely monitor the evolving landscape in this space and TIXT's responses to these key challenges and opportunities. We believe the stock has ~90% upside from current levels.

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