TWKS - Thoughtworks: Well-Positioned To Benefit From The Digital Transformation Services Growth

Summary

• The market for digital transformation services expected to reach $6.7 trillion by 2029, expected to grow at a CAGR of 20.9% from 2021.
• Thoughtworks has a strong reputation for delivering high-quality services to its enterprise clients, as demonstrated by its industry-leading revenue per employee of $116K.
• Thoughtworks stands out due to its diversified revenue streams across various client concentrations, client locations, vertical mix, and delivery mix.
• I keep a Buy rating on the company’s stock with a price target of $16.

Thesis

Thoughtworks (TWKS) has several key qualities that I consider essential for a successful IT Services growth stock, including a 20%+ revenue growth rate, high-quality relevant work, and delivery as evidenced by industry-leading revenue per employee and margins, a strong culture that attracts and retains top talent, and an experienced management team. The Digital Transformation Market is expected to grow at a double-digit rate through 2029, which I believe sets TWKS to benefit from the trend. I keep a Buy rating on the company’s stock with a price target of $16.

Post Q4 2022 Earnings Outlook

TWKS performed well in the fourth quarter, surpassing market estimates in terms of revenue and operating margins. However, the company provided cautious guidance for the first quarter and for 2023. Although I had expected a decline in TWKS's 2023 CC organic growth based on the results of its peers, the growth guidance of 0-2% was lower than anticipated. I believe that this lower guidance reflects macro-related uncertainty, which could have a significant impact on TWKS's consulting business. This may put pressure on the stock price in the near-term, however, TWKS is already trading at a considerable discount compared to peers which will limit the downside.

A large Digital Transformation Services TAM allows for Significant Growth Opportunity

The market for digital transformation services is significant and expected to reach $6.7 trillion by 2029, with a compound annual growth rate of 20.9% from 2021. Thoughtworks is positioned to take advantage of this opportunity and is expected to grow revenue at least at the market CAGR of around 20% in the short term due to its expertise in enterprise modernization, cloud, platforms, and digital transformation. The company is likely to benefit from the growth of cloud- and AI-based software providers, which are expected to grow at a rate of 20% or more in the coming years, driving similar levels of growth in IT services companies that implement those solutions and modernize business processes.

Thoughtworks has a strong reputation for delivering high-quality services to its enterprise clients, as demonstrated by its industry-leading revenue per employee of $116K . This is higher than any of its public peers, including Accenture. Thoughtworks also charges premium bill rates, which are typically higher than those of other software engineering companies, reflecting the company's strong brand and value proposition.

TWKS Business is Relatively Diversified which Mitigates Typical Risks

Compared to other IT companies of similar size, Thoughtworks stands out due to its diversified revenue streams across various client concentrations, client locations, vertical mix, and delivery mix. For instance, its top 10 clients account for 27% of revenue, which is lower than its peers, who have a range of 25% to 60%. North America contributes 37% of its revenue, which is lower than its peers, who have a range of 60% to 90%. The top delivery country, in terms of employee count, represents 25% of headcount, which is lower than its peers, who have a range of 50% to 70%. Lastly, its top vertical contributes 27% of its revenue, which is lower than its peers, who have a range of 35% to 40%. A diverse revenue mix reduces the risk of slowdowns in large clients, verticals, and regions, as well as minimizes the impact of supply and foreign exchange dynamics in any one country.

The company has a focus on long & strong client relationships

Thoughtworks has a diverse client base, with no single client accounting for more than 5% of its total revenues. This is in contrast to most peers who have one client contributing to more than 10% of their revenues. To maintain this, the company is very careful in choosing its clients, and once it secures one, it uses its domain and technology expertise to expand its presence within that account. By leading with a strategy consulting approach, Thoughtworks develops strong relationships with its clients, which is evidenced by an average tenure of about 11 years for its top five clients. These relationships also help the company enhance its end-to-end application development capabilities and increase its market share within client accounts. The top five clients generated an average revenue of $32 million for Thoughtworks, and the company has 23 clients generating more than $10 million in annual revenues. Additionally, the top 10 clients belong to five different verticals, indicating that the company is successful in replicating its success across different clients and industries.

Financial Outlook

I expect TWKS to continue to grow at revenues at around 20% beyond this year, which is consistent with its digital peers and significantly higher than the mid-single digits growth rate in the overall IT services industry. I believe that TWKS has an advantage due to its technical expertise and its focus on high-growth areas such as AI, data engineering, and cloud-native application development. This has contributed to the strong growth rates of similar pure-play companies like EPAM, DAVA, and GLOB, as well as the higher growth segments within Accenture. Additionally, the company should benefit from its established client relationships, which have been built through its focus on strategy consulting work and its thought leadership in emerging growth areas.

Valuation

My price target for December 2023 is $16, based on a multiple of 15 times the estimated EBITDA for CY23. This multiple is in line with the valuations given to digital pure-play peers. The target multiple is justified by Thoughtworks' slightly discounted revenue growth forecast, and high strategic value as a digital pure-play asset in the IT Services industry, especially with its strong culture and talent pool. Thoughtworks' diversified revenue mix and higher-end strategic advisory services justify an in-line multiple, even if its long-term revenue growth profile is slightly below that of its digital peers.

Risks to Rating

Scalability of Business

Thoughtworks operates in rapidly-evolving technology markets with high demand for digital talent. To maintain its position and continue to grow, the company must stay at the forefront of technological trends and maintain its reputation as a thought leader. This is necessary to retain existing enterprise clients and attract the most skilled technologists to the company. Maintaining the quality of talent is essential, and the company has a rigorous hiring process to ensure that it doesn't sacrifice its culture and talent pool. As the company scales up from its employees, it will become increasingly challenging to maintain this standard, especially with competition from companies like Accenture.

Cyclicality of Business

Thoughtworks provides premium consulting services that command high bill rates, resulting in a higher proportion of short-term project work. To maintain revenue growth, the company must actively pursue sales and execute contracts effectively. This type of work is highly valued but can be considered more cyclical or discretionary, and the company may suffer in times of economic downturn.

Final Thoughts

Thoughtworks' excellent reputation for high-quality consulting work and its talented workforce are expected to enable it to maintain long-term relationships with top-tier clients. This places the company at a higher level on clients' strategic vendor lists. As long as Thoughtworks maintains a sharp and innovative execution, it is likely to enjoy repeat business from clients, which is evident from the average tenure of seven years for its top ten clients. My price target for December 2023 is $16, based on a multiple of 15 times the estimated EBITDA for CY23.

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