TWKS - Thoughtworks: Upgrading To Buy As Business Is Doing Better Than Expected

2023-06-22 10:39:15 ET

Summary

• Thoughtworks has adjusted its growth strategy to maintain profit margins despite slowing revenue growth, focusing on cost-cutting measures and outbound demand generation.
• The company has improved utilization rates and increased its offshore mix, which should drive improvements in near-term EBITDA.
• Valuation is attractive once we look past FY23.

Overview

Thoughtworks ( TWKS ) is an international technology consulting firm that uses a multidisciplinary approach to help enterprises adopt modern technology. While TWKS's first-quarter results were better than expected, the company did lower its growth guidance for FY23 due to softer demand, which has caused project delays and slow conversion of bookings into revenue, as has been the case for many of software/IT businesses. This macro, however, has shown how well management can adapt to changing conditions by adjusting its growth strategy to maintain profit margins despite slowing revenue growth. This is significant because it indicates that TWKS's cost structure is adaptable enough to prepare for and profit from a rapid uptick in demand. This also aids in pinpointing the "floor" relative to the TWKS margin. Overall, I am shifting my rating on TWKS stock to a buy as I see the business turning for the better.

Growth analysis

In my analysis of TWKS's growth trajectory, it is evident that the company's core customers are increasingly prioritizing cost-cutting measures. Given the current economic climate, TWKS's management has proactively adjusted the company's project mix to focus on expense reduction rather than solely generating revenue. This adaptability and ability to align its go-to-market strategy with customer demands are commendable, as it ensures TWKS's relevance across different economic cycles. Notably, TWKS has strategically restructured its delivery process by relocating the delivery team from Australia to India, enabling efficient cost management for clients by reducing delivery costs. This cost optimization aligns perfectly with customer needs.

Furthermore, TWKS has recognized the significance of outbound demand generation and has intensified its efforts in this area. While the company has historically relied heavily on inbound demand driven by its industry thought leadership, it now acknowledges the potential for growth and expansion through outbound initiatives. This strategic shift towards outbound demand generation is a positive development, as it provides TWKS with more control and scalability in driving demand.

Margins

Improving its utilization rate and increasing its offshore mix are, in my opinion, the two most important levers in its business to support near-term margin expansion. Increasing the number of projects or decreasing the number of employees are two ways to boost utilization. TWKS opted for the latter, which led to a 4% decrease in headcount and improved utilization rates With that, I expect expansion in its gross margins given improved unit economics, and similarly, I also expect TWKS to see some form of operating leverage given lower fixed cost now, which should drive near term to EBITDA into the 20%+ range in 2H. While it has successfully reduced the overall team to its target range so far, this suggests that it can go down further if the operating environment (steep and hard landing recession) forces management.

Another avenue where I see possible enhancement to margin is TWKS to leverage the potential of generative AI. Keep in mind that TWKS is an organization that thrives on the skills of its employees, and I'm confident that there are many routine programming tasks that can be automated. Engineers will be freed up to work on more intricate aspects of building design, which should increase productivity and efficiency. In addition to affecting margins, this change should boost top line by allowing each engineer to take on more projects. The demand for TWKS solutions would also increase if more businesses started using AI, since most of them need to do a lot of housekeeping on their data environments before implementing anything meaningful with generative AI.

Valuation

I recommend my buy rating for TWKS as the valuation is attractive once we look past FY23. As management's strategy shifts (to focus on helping customers save costs rather than drive revenue, which I expect the former to have lower revenue as it would be counter intuitive to be more expensive to the customer), I revised my model for FY23 performance to be slightly worse than what I expected in my previous model, but % growth remains in line with consensus estimates. Given the similar growth profile, but smaller scale and weaker margin profile, I believe TWKS will eventually trade at a minor discount to its peer EPAM Systems ( EPAM ) who is trading at 20.5x forward earnings today. Comparing the relative valuation (EPAM / TWKS) historically, EPAM trades at around 1.1 to 1.3x premium to TWKS if we remove the outliers. As such, I applied ~3.5x discount to the current 20.5x.

Risks

Wage inflation

At the very fundamental level, TWKS' growth driver is a matter of how many talents it employs (i.e., the more talents it has, the more jobs it is able to process). As such, in the face of rising inflation and a strong labor market, I would not be surprised to see TWKS getting squeezed by rising wages. And if TWKS is unable to pay well, these talents can easily move on to the next consulting firm.

Global operations expose TWKS to operational and economic risk

A significant part of TKWS's revenues (63%) comes from international sales. TWKS’s growth strategy includes certain markets, the developing nature of which presents several risks, in particular labor, which could result in difficulties in staffing and managing foreign operations. A clear example is the use or availability of certain work visas, which could limit TWKS' global delivery model.

Conclusion

TWKS has demonstrated its ability to adapt and thrive in a challenging economic climate. Despite softer demand and project delays affecting revenue conversion, TWKS's management has successfully adjusted its growth strategy to maintain profit margins. TWKS has also recognized the importance of outbound demand generation, and has allocated resource to build it up, which I expect will lead to greater control and scalability in driving growth. With improvements in utilization rates and increased offshore operations, TWKS is also poised for near-term margin expansion.

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