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Abstract
After my protection on Thoughtworks (NASDAQ: TWKS) on March 24, which I beneficial impartial as a result of administration carried out poorly and progress is anticipated to underperform friends, this put up offers an replace on my enterprise ideas and actions. I nonetheless maintain TWKS as near-term outcomes stay unsure because of the aggressive atmosphere and the CEO change. From a valuation perspective, I do not assume the expansion potential could be very engaging both.
Funding thesis
On 07/05/2024 TWKS launched its 1Q24 earnings.My primary takeaway was that the corporate reported income of $249 million, beating estimates of $244 million and administration’s steerage vary of $241-246 million. Regardless of the 19% drop in income, administration famous that the corporate as a complete is doing higher. Whereas some necessary prospects and geographic cohorts nonetheless see double-digit declines Sequential progress traits have improved year-on-year in all areas besides the monetary companies vertical.
For the primary time in seven quarters, TWKS raised its income forecast, now anticipating sequential progress of 1-3% in 2Q24. Issues appear to be going effectively, in keeping with the newest demand replace introduced on the JPMorgan TMT convention. TWKS is witnessing a steady funds amongst purchasers and the pipeline continues to be in fine condition, with the acquisition of great new logos among the many highlights. Whereas actually optimistic on the floor, I consider the outlook stays dangerous and unsure, and I define my reasoning in favor of my conviction beneath.
For starters, the better-than-expected income progress in 1Q24 is not fully natural. The primary purpose for the rise was the worth discount of TWKS to stay aggressive. This means that underlying demand has not recovered to regular ranges in any respect. Sturdy proof for this view is that the associated fee atmosphere remained the identical with lengthy gross sales cycles and weak small offers in 1Q24. In keeping with the JP Morgan TMT convention, time to shut offers stays about 20% longer than 2-3 years in the past. TWKS is just not alone on this; different gamers within the business are additionally going through the identical drawback. Take Cognizant Know-how Options (CTSH), for instance. They lowered their FY24 earnings expectations in 1Q24 after revising their forecasts for greater earnings in 4Q23.
Including to the business’s weak point, TWKS’s enterprise mannequin—utilizing low-cost abroad staff (equivalent to India)—which was as soon as a aggressive benefit, is now turning into short-term pricing points. In good occasions (the economic system was doing effectively) this mannequin was considered positively as worker prices had been the biggest value of doing enterprise. Decrease workers prices will imply that TWKS can earn greater margins as prospects will not be very worth delicate in good occasions. Nonetheless, in an unsure or poor macro local weather (equivalent to the place we’re in the present day), I anticipate that purchasers might be extra cautious about their spending (as evident from the prolonged gross sales cycle) and can doubtless negotiate decrease charges accounts, realizing that the companies supplied by TWKS are carried out by staff in areas with decrease prices. That is evident from two information factors: (1) TWKS needed to decrease costs to stay aggressive; and (2) common income per worker was ~$118K in 1Q22, with staff from low-cost areas making up 73% of the entire workforce, and has since declined to ~$92.2K in 1Q22. 1Q24.
The combination of offshore and onshore actually places strain on what we name common billing charges world wide. After which the impression is the impression on our common costs. 1Q24 earnings name
Lastly, the CEO transition provides a complete new layer of uncertainty to the enterprise. I will be trustworthy instantly and say that I’ve lots of respect for Mike Sutcliffe (the brand new CEO) as he is held a number of management positions at Accenture (together with NA Monetary Providers and Accenture Digital) and has over 30 years of business expertise. Nonetheless, so far as the CEO transition is anxious, it casts a cloud over the enterprise technique going ahead. Since Mike will not truly take workplace till June seventeenth, we cannot know what his intentions are or how he plans to exit the present macro atmosphere. I’ve two necessary questions in thoughts:
- Will or not it’s aggressive in pricing to seize extra quantity whereas sacrificing income progress? (This places extra strain on the close to time period progress outlook)
- Will the present worker base have the ability to work effectively with the brand new CEO? That is the primary change of CEO since 2013.
Evaluation / Danger
I discover that the vary of outcomes is extraordinarily extensive at this level, and modeling how issues play out is like flipping a coin.
- Huge case (upside threat): the upside is that the economic system is recovering; TWKS sees extra deal stream resulting in greater income and earnings; and the transition of the brand new CEO goes effectively with none main disruptions. On this case, TWKS may attain the very best degree of earnings per share in FY24 ($0.08). TWKS valuation (ahead PE) rose after 1Q24 outcomes to 33x ahead PE. Utilizing this as a yardstick to gauge how a lot the market is prepared to place up within the occasion of a rebound, the bullish worth goal is $2.64.
- Bearish (draw back threat): The aggressive atmosphere will proceed for the foreseeable future, resulting in low demand and, mixed with a low worth contribution, very low income progress. The brand new CEO may not match into TWKS, leading to poor technique planning and execution. It isn’t laborious to think about TWKS hitting the low finish of the FY24 steerage ($0.02). Assuming TWKS trades at 17x (which was the latest low), this means a bearish $0.34 share worth (large draw back).
I am not assured sufficient to say with certainty how issues will play out within the close to time period given all of the uncertainties. However what I’m positive of is that the expansion potential doesn’t look engaging in any respect. I might be improper concerning the optimum worth, however I might moderately anticipate extra proof that TWKS will see a restoration than make investments in the present day.
Conclusion
In conclusion, my ranking for TWKS stays a Maintain ranking resulting from an unsure near-term outlook. Whereas the corporate beat expectations for Q1 2024 income, that progress wasn’t fully natural, and the business stays aggressive. Additionally, the enterprise mannequin of bringing in low-cost international staff is turning into a drawback as prospects grow to be extra worth delicate. The upcoming CEO transition provides one other layer of uncertainty. Lastly, I consider that the upside potential for TWKS is restricted, so I might anticipate indicators of a transparent progress trajectory earlier than going bullish.
