Intellectual Business: Uncertain Outlook Due to Competitive Environment and CEO Change (NASDAQ:TWKS)

summary

Following my coverage of Thoughtworks (Nasdaq: TOX) on March 24, which I recommended a Neutral rating given that management execution is weak and growth performance is expected to underperform peers. This post is intended to provide an update on Ideas about business and stocks. I still maintain a TWKS rating as near-term performance remains uncertain due to the competitive environment and this is a change in CEO. From a valuation perspective, I think the potential upside is not very attractive either.

Investment thesis

On 5/7/2024, TWKS released its earnings for the first quarter of 2024. My key takeaway was that the company saw revenue of $249 million, which beat the Street estimate of $244 million and management’s guidance range of $241-$246 million dollar. Despite a 19% decline in revenue, management noted that things are improving for the company overall. While some important clients and geographic groups are still seeing double-digit declines Compared to last year, sequential growth trends improved in all areas except the financial services sector.

For the first time in seven quarters, TWKS raised its revenue forecast, now anticipating 1-3% sequential growth in the second quarter of 2024. All appears to be going well, according to the latest order update presented at the JPMorgan TMT conference. TWKS is seeing budget stability among clients, and its pipeline remains in good shape, with big new logo acquisitions among its highlights. While these things are certainly positive on the surface, I believe the outlook is still risky and uncertain, and below I provide the reasons for my belief.

Initially, better-than-expected revenue growth in Q1 2024 was not entirely organic driven. The main reason for the growth was that TWKS reduced its price to remain competitive. This tells us that underlying demand has not recovered to a normal level at all. The strong evidence to support this view is that the spending environment remained unchanged with long sales cycles and weak small deals in the first quarter of 2024. The time needed to close deals is still about 20% longer than it was two or three years ago, according to the GB Conference Morgan TMT. 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 lowered their FY24 revenue forecast in 1Q24 after revising upward guidance in their 4Q23 earnings call.

On top of the weak industry, TWKS’s business model – which leverages low-cost employees abroad (such as in India) – which was once a competitive advantage, is now turning into a near-term pricing headwind. In good times (when the economy was doing well), this model was viewed favorably, as employee costs were the largest cost of doing business. The lower cost of headcount means that TWKS can enjoy higher margins because customers are not so price sensitive in good times. However, in an uncertain or poor macro climate (such as we are in today), I would expect customers to scrutinize their spending more (which is very evident from the lengthy sales cycle), and will be more likely to negotiate for lower invoice rates knowing that Services provided by TWKS are performed by employees in low-cost areas. This is evident from two data points: (1) TWKS had to cut prices to remain competitive; (2) Average revenue per employee was approximately $118K in Q1 2022 when employees from low-cost regions represented 73% of total headcount, and has since declined to approximately $92.2K in Q1 2022 2024 when low cost headcount will reach 75% of total mix in 1Q24.

The mix of offshore and onshore certainly creates pressure on what we call average billing rates around the world. And then it’s an impact – it’s an impact on our average prices. Q1 24 earnings call

Finally, a CEO transition adds a whole new layer of uncertainty to the business. I’ll be honest up front and say that I have great respect for Mike Sutcliffe (the incoming CEO), as he has held numerous leadership roles at Accenture (including NA Financial Services and Accenture Digital) and has over 30 years of industry experience. However, as far as the CEO transition is concerned, it casts a shadow over the business strategy moving forward. Since Mike will not actually take office until June 17, we will not know what his intentions are or how he plans to maneuver his way out of this current macro environment. There are two important questions on my mind:

1. Will he be aggressive with pricing to gain more volume, sacrificing overall growth? (This puts further pressure on near-term growth prospects)
2. Will the current employee base be able to work well with the new CEO? This is the first CEO change since 2013.

Assessment/Risk

I think the range of outcomes is too broad right now, and modeling how things will play out is like flipping a coin.

1. Bull Condition (Upside Risk): The upside is that the economy is recovering; TWKS sees more deal flows, resulting in revenue and profit growth; The transition of the new CEO is going well without any major interruptions. In this case, TWKS could achieve the maximum EPS guideline for FY2024 ($0.08). The TWKS valuation (forward PE) moved higher after 1Q24 results to reach 33x forward PE. Using this as a measure of how willing the market is to price in a growth rebound, this means the bull case target price is $2.64.
2. Bear Case (Downside Risk): The competitive operating environment will continue to do so for the foreseeable future, resulting in weak demand, weak pricing contributions, and very weak earnings growth. The new CEO may not fit well with TWKS, leading to poor strategic planning and execution. It’s not hard to imagine that TWKS will achieve the lower end of FY24 guidance ($0.02). Assuming TWKS trades down to 17x (which was the recent low), this means the stock price is on a downside of $0.34 (a huge downside).

I’m not confident enough to say with certainty how things will play out in the near term, given all the uncertainties. But what I am sure of is that the potential upside does not look attractive at all. I could be wrong about the bull case price, but I would rather wait for more evidence that TWKS will see a rebound in growth rather than invest today.

Conclusion

In conclusion, my rating for TWKS remains a Hold rating due to the uncertain near-term outlook. Although the company beat revenue expectations in the first quarter of 2024, this growth was not entirely organic and the industry remains competitive. In addition, the business model of utilizing low-cost foreign employees has become a disadvantage as customers have become more price sensitive. The upcoming CEO transition adds another layer of uncertainty. Finally, I believe that the potential upside for TWKS is limited, and therefore I would prefer to wait for signs of a clear growth path before turning to the upside.