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Summary
Following my coverage on Thoughtworks (NASDAQ:TWKS) in Mar’24, which I recommended a neutral rating as management executed poorly and growth is expected to underperform peers, this post is to provide an update on my thoughts on the business and stock. I remain hold-rated for TWKS as the near-term performance remains uncertain due to the competitive environment, and that is a change in CEO. From a valuation perspective, I believe the potential upside is not very attractive either.
Investment thesis
On 7/5/2024, TWKS released its 1Q24 earnings. My key takeaway was that the business saw revenue of $249 million, which beat the street estimate of $244 million and management’s guided range of $241-246 million. Despite a 19% drop in revenue, management noted that things are looking up for the company overall. While some important client and geographic cohorts are still seeing double-digit declines compared to last year, sequential growth trends have improved across the board except in the financial services vertical.
For the first time in seven quarters, TWKS has raised their revenue outlook, now expecting sequential growth of 1-3% in 2Q24. Everything seems to be going well, according to the most recent demand update given at the JPMorgan TMT conference. TWKS is witnessing budget stability among clients, and the pipeline is still in good shape, with substantial new logo acquisitions among its highlights. While these are certainly positive on the surface, I believe the outlook remains risky and uncertain, and below I lay out my reasoning for my belief.
To start, the better-than-expected revenue growth in 1Q24 is not entirely organic-driven. The main cause of the growth was TWKS lowering its price to stay competitive. This tells us that underlying demand has not recovered to a normalized level at all. A strong piece of proof that supports this view is that the spending environment remained the same with long sales cycles and weak small deals in 1Q24. The time to close deals remains about 20% longer than it was 2-3 years ago, as per the JP Morgan TMT conference. TWKS is not alone in this; other players in the industry are also facing the same problem. Take Cognizant Technology Solutions (CTSH), for example. They have lowered FY24 revenue expectations in 1Q24 after revising guidance upwards in the 4Q23 earnings call.
On top of a weak industry, the TWKS business model—leveraging lower-cost employees overseas (like in India)—that was once a competitive advantage is now turning into near-term pricing headwinds. In good times (economy doing well), this model was seen positively, as employee costs were the largest cost of doing business. Lower headcount cost would mean that TWKS can enjoy higher margins as clients are not super price-sensitive in good times. However, in an uncertain or bad macroclimate (like where we are at today), I expect clients to scrutinize their spending more (pretty evident from the elongated sales cycle), and they will likely negotiate for lower bill rates knowing that the services provided by TWKS are implemented by employees in lower-cost regions. This is evident from two data points: (1) TWKS had to cut pricing to stay competitive; and (2) average revenue per employee was ~$118k in 1Q22 when employees from low-cost regions represent 73% of total headcount, and has since dropped to ~$92.2k in 1Q24 when low-cost headcount is 75% of total mix in 1Q24.
The offshore-onshore mix definitely creates a pressure on what we call the average bill rates across the world. And then it is an impact — it is impact to our average pricing. 1Q24 earnings call
Lastly, the transition in CEO adds a whole new layer of uncertainty to the business. I will be frank upfront and say that I have a lot of respect for Mike Sutcliff (the incoming CEO), as he has held several leadership roles at Accenture (including NA Financial Services and Accenture Digital) and has more than 30 years of experience in the industry. However, as to the CEO transition, it casts a cloud on the business strategy moving forward. Since Mike will only take over effectively on June 17, we will not know what his intentions are or how he plans to maneuver out of this current macro environment. Two important questions I have in mind are:
- Would he be aggressive on pricing to capture more volume, sacrificing topline growth? (This puts more pressure on near-term growth outlook)
- Would the existing base of employees be able to work well with the new CEO? This is the first change in CEO since 2013.
Valuation / risk
I believe the range of outcomes is extremely wide at the moment, and modeling how things play out is akin to flipping a coin toss.
- Bull case (upside risk): The upside is that the economy recovers; TWKS sees more deal flows, which lead to revenue and earnings growth; and the new CEO transition goes well with no major disruption. In this case, TWKS could achieve the high end of its FY24 EPS guide ($0.08). TWKS valuation (forward PE) spiked upwards post the 1Q24 results to 33x forward PE. Using that as a yardstick to estimate how much the market is willing to price in growth recovery, this implies a bull case target price of $2.64.
- Bear case (downside risk): The competitive operating environment continues to do so for the foreseeable future, leading to poor demand and, coupled with poor pricing contributions, very poor earnings growth. The new CEO might also not fit well in TWKS, which results in poor strategy planning and execution. It is not hard to imagine that TWKS will achieve the low end of the FY24 guide ($0.02). Assuming TWKS trades down to 17x (which was the recent low), this implies a bear case share price of $0.34 (huge downside).
I am not confident enough to say for sure how things will play out in the near term, given all the uncertainties. But what I am sure of is that the potential upside doesn’t seem attractive at all. I could be wrong about the bull case price, but I would rather wait for more evidence that TWKS is going to see a growth recovery than invest today.
Conclusion
In conclusion, my rating for TWKS remains as a hold rating due to the uncertain near-term outlook. While the company beat revenue expectations in 1Q2024, this growth was not entirely organic and the industry remains competitive. Additionally, the business model of leveraging lower-cost overseas employees is becoming a disadvantage as clients become more price-sensitive. The upcoming CEO transition adds another layer of uncertainty. Lastly, I believe the potential upside for TWKS is limited, hence, I would rather wait for signs of a clear growth trajectory before turning bullish.
