TWKS - Thoughtworks: Staying In The Sideline Until FY 2023 Is Over

2023-04-03 08:47:58 ET

Summary

• The weak near-term outlook and FY23 guidance have led me to revise my recommendation from a buy to a hold.
• FY23 revenue is expected to be flat from FY22, effectively wiping out 1 year of growth.
• Margins are also a concern due to wage inflation for specialized skillsets, but operating leverage could be a potential boon.

Overview

Thoughtworks ( TWKS ) is an international technology consulting firm that uses a multidisciplinary approach to help enterprises adopt modern technology. In my initiation post , I expected TWKS to see a slight dip in growth in FY23 (to $1.4 billion revenue), followed by an acceleration to $1.7 billion revenue in FY24. With that assumption, I had a buy rating. For this reason, I was prepared for a slow start to the year in anticipation of 4Q22 results; however, 1Q23 guidance came in significantly below both my and consensus expectations, ultimately leading to very weak FY23 guidance, with FY23 revenue expected to be flat from FY22, effectively wiping out 1 year of growth. Importantly, the FY23 forecast is based on sequential improvement throughout the year. It's possible, but if the macro environment gets worse, things could get a lot worse. This also implies that TWKS may fall short of their FY23 guidance. Many consensus analysts and investors, I believe, have lowered their expectations and holdings in response to these dynamics. In light of these developments, I am changing my recommendation from a buy to a hold. As things stand, I anticipate FY23 growth to be flat, and FY24 growth to be ~15%. While I do believe that macro headwinds and a higher mix of relatively more macro-sensitive onsite/project work are contributing factors to TWKS' growth issues, I continue to hold out hope that, with sharp execution and improving macro, TWKS will be able to return to delivering 20% growth over the medium term (FY25). I'm tempted to give this a buy rating once we get past this weak macro sentiment and TWKS outlook becomes clearer. Until then, this is a hold.

4Q22 overview

Overall sales of $311 million beat consensus estimates of $307 million by 2% and increased by 12% organically (fx-neutral). Management does not anticipate further weakening of the adjusted gross margin this year, which fell to 39.7% due to promotional pricing and lower utilization rates. Adjusted EBITDA margin came in at 18.7% due to better SG&A.

Weak macro impacts growth

As I mentioned above, the entire reason for my downgrade is because of the weak near-term outlook. Specifically, TWKS 1Q23 guidance implies mid-single digit sequential revenue decline on constant currency organic basis. What is important to note is 4Q22 was the first time TWKS revenue decline on a sequential basis, and the 1Q23 guidance implies another sequential decline. Given that the guide was given after 2 months in, the 1Q23 guidance is very credible, in my opinion. Management has blamed postponed annual budgets and the fact that customers are concentrating on cost-cutting projects for the slump in business. Now here is the issue, all of these factors are largely dependent on the macro environment and outlook, which are outside of management controls. While management expects to improve sequentially, I believe things might actually get worse as inflation is still running high and rates are not expected to come down anytime soon. If I were the management of TWKS underlying customers, I would very likely push out any large projects to shore up cash at least until 2H23, where I will have a better outlook to FY24. Apart from the broader effects, TWKS is also encountering internal challenges specific to the company, including a shift in the product mix towards offshore and the negative impact of the Covid-19 outbreak on its operations in China. On a positive note, I think these headwinds are only temporary and that this year's growth will be unaffected by them. Evidently, management has mentioned that new budgets, which are now largely finalized, are already resulting in new expenditures or project awards. In addition, as trade with China resumes, we can expect positive trends.

While there are both positive and negative drivers at play, I prefer to play safe and judge from the side lines before taking a strong view.

Margins

The effect on economic growth is only one of many concerns. Wage inflation, which is still high for very specialized skillsets, also impacted TWKS net margin due to the current macro situation. Although wages have moderated, I am concerned that wage inflation will surge again as long as inflation and interest rates remain high. Since TWKS employees need unique skill sets, their wages are more inelastic than the typical worker, which means take longer to come down. On the other hand, operating leverage is a potential boon to margin. A lower revenue base contributed to the margin decline in 4Q22, but this trend should reverse if TKWS growth continues as guided in FY23. Although I am optimistic about a future increase in profits, I do realize that positive revenue growth is also necessary for a full recovery.

Valuation

I have revised my estimates to reflect the new outlook. As per my model, FY23 is going to be a flattish year followed by improved rates moving forward. The key thing to note here is the 1Y upside (based on FY23 estimates) is near 0%, but upsides improve as we move past FY23. This is based on my assumption that the macro environment will turn for the better. As such, I shift my rating to hold in the near-term and would revise to buy if things turn for the better.

Conclusion

The weak FY23 guidance has led me to revise my recommendation from a buy to a hold. However, I remain optimistic that with sharp execution and improving macro conditions, TWKS will be able to return to delivering 20% growth (just not in the near-term). I have revised my estimates to reflect the new outlook and shifted my rating to a hold in the near-term, but would revise to a buy if things turn for the better. Overall, while there are both positive and negative drivers at play, I prefer to play it safe and judge from the sidelines before taking a strong view.

For further details see: