Description

Thoughtworks (ticker TWKS) is a US-headquartered IT consulting company with a good reputation in the CIO market for being “expensive but worth it” and being better than competition at crafting solutions for the client's hardest technological problems.  That reputation stands in stark contrast to TWKS’s poor 2023 financial performance, the stock price chart, and current valuation of 1x TEV/ LTM Sales.  Thoughtworks plays in the shortest-cycle, lowest-visibility, most discretionary end of the IT services market.  Thoughtworks was hit the hardest by the 2023/2024 market slowdown.  I believe the 'first-in, first-out' principle will apply to this IT services market and when IT spend begins to grow (e.g. when the AI uncertainty begins to dissipate), TWKS will be among the earliest, disproportionate beneficiaries.   This is a low-float small-cap with some risks & hair on it, but I think the risk-reward is attractive. 

Thesis

Thoughtworks is a busted 2021-vintage IPO.  Its poor performance stands out even against a backdrop of the broader IT sector underperforming.  Today, Thoughtworks is valued at $2.76 per share and $1.2B TEV but at its peak, Thoughtworks generated $250M of EBITDA.

At the time of the TWKS IPO in 2021, TWKS was considered a best-in-class IT consulting business that could sustain 20% growth rates and with 50x+ forward P/E multiples that could rival the nosebleed levels of DAVA / EPAM / GLOBs of the world.  In 2023, the IT market weakened.  TWKS's clients scaled back existing projects and pushed out new business; the time to convert the pipeline into new sales extended.  In these more challenging conditions, peers with larger implementation and managed services practices have done considerably better than Thoughtworks.   TWKS’s adjusted EBITDA margins went from 18% at their peak to 3% today.   Revenue growth was 33% in 2021 and is -19% in the most recent quarter.   TWKS's TEV peaked at $10B (10x EV/sales) and is $1.1B (1x TEV/sales) today.  In response to these pressures, TWKS recruited a new CEO (Mike Sutcliff; starting in June/July) and launched a restructuring program designed to structurally take out c.$100M of costs out of the business.  Headcount declined 15% from its peak of 12,800 in December 2022 to 10,800 currently.  From a cyclical point-of-view, both Thoughtworks and its peers have indicated demand is troughing and revenues are likely to grow again towards the end of 2024 calendar year.  There is profound skepticism baked into the valuation.  Using TWKS’s “peak” year historicals (2022), the current valuation corresponds to 4.7x TEV / EBITDA and 6.6x P/E.  This suggests the market doesn’t really believe Thoughtworks is likely to get to that level of financial performance any time soon, even if IT consulting demand improves.  I am more optimistic, and think TWKS will financially benefit from the right-sizing actions that were recently taken as well as new focus brought by Mike Sutcliff, the incoming CEO.  2-3 years out, I think fair value is north of $5 per share, and I expect a 20%+ IRR.  

Sector overview

Share prices of IT services companies have been notable laggards recently.   Corporates are streamlining IT budgets and pushing back discretionary projects.  Some areas like cyber have been less-affected but everything else has been taking a back-seat while the corporates are figuring out what to do with AI.   Continued uncertainty on interest rates and inflation is not helping things, too.  This has been a decent-sized speed bump in the otherwise up-and-to-the-right charts of share prices and EBIT for the sector, and I believe it creates a good buying opportunity.  Note that some of this is partially mirrored in recent earnings blow-ups in large-cap software.

In IT, the de-rating has been even more pronounced in the smaller, faster-growing peer set.

 IT spend grows at faster-than-GDP speeds.  Over the long run, IT services companies have been good investments relative to the broad index. 

This LT outperformance is despite the IT services business model having several business model attributes that I generally try to avoid.  All of them feature as plot-points in Mad Men (one of my favorite old TV shows), one way or another:

• No barriers to entry

• It’s an HR business, with key variables being staff #s and utilization %

• It’s also a relationship business, and losing important VPs/SVPs means losing accounts

• Little competitive differentiation

• Often the easiest way to grow into a new geography or customer segment is via acquisition.  Price / DD quality / integration can be hit-or-miss

• Temptation to bid aggressively for contracts and assume that a return will be realized due to future ‘efficiencies’ (like junior staffing, greater % offshoring, etc)

So why bother? Technology spend secularly goes up over time, and in this sector, things truly go wrong only when significant financial leverage is involved (ie. Atos SA) or due to some sort of regulatory issue or infighting (like when Arthur Andersen gave birth to Accenture).  Broadly, the sector is exposed to the right-tail of LT outcomes.  The cyclical slowdown that the sector is currently experiencing will eventually pass, creating the opportunity to invest in the sector at valuations more attractive than they have been in a long time.  

Fundamentally, spend on IT consulting is about helping the corporation manage some sort of anxiety or insecurity about the future.  There is a trade-off: too little anxiety about the future means there is no need to commission new projects; too much anxiety prompts the corporate to postpone projects and wait until some of the anxiety goes away.  Today I believe we are to the right of the apex.  There is AI uncertainty and also interest rate uncertainty.  

The bearish perspective on AI is that it is broadly deflationary and will eliminate lots of engineering man-hours, thus depressing the corporate need for IT services spend.  The bullish perspective is that AI is similar to past technological breakthroughs that made certain professions / businesses more productive.  Neither perspective is 100% provable.  I think it’s possible to reconcile elements of both.  For instance, I believe the low-end, BPO-oriented segment of IT like contact centers is at greater risk.   And on the flipside, I think AI is more likely to benefit the high-end of IT services that contain more creative / strategic / value-added work setting the direction for the rest, i.e. exactly where TWKS is positioned.  Even though companies like TWKS and Accenture pitch themselves as futurists & pioneers that determine where things will go, in reality they are just fast followers.  They identify the next big wave and once it is solid enough, they fast-follow to reap the benefits.  One industry figure recently likened AI to HTML, i.e. it will take time but there will be a tipping point after which everyone will invest in it.  This is even though currently the real $$ business benefits are dubious (e.g. I take the Klarna announcements with some skepticism) and companies that spend on AI do not yet want to go beyond pilot / POC projects.  The IT industry will have cycles like it has in the past but the need for advice will remain.  I believe the industry remains investable, despite the recent price action suggesting otherwise.   

Thoughtworks overview

Thoughtworks is an IT consulting business that was started by Roy Singham in Chicago in 1993.  Starting from the early 2000s, Thoughtworks gained a reputation for cutting-edge software development/implementation work.  Thoughtworks either pioneered or leveraged trends like agile development, open-source, cloud, web 3.0, and continuous integration.  Over time, TWKS moved further and further towards the top-end of the IT services market, with a predominant focus on consulting, almost completely ceding management/maintenance to others and shifting lots of implementation work to partners as well.   

TWKS’s business model differs from the broader sector in some important respects:

• ‘Premium’ positioning.  TWKS tends to charge more, and is relatively picky in choosing projects.  This is reflected in TWKS commanding higher average revenues per employee

• Dogmatic in their commitment to the cutting edge, to the point of being perceived as arrogant or inflexible by clients or others in the sector

• The above two factors combine to result in TWKS enjoying less repeat-business compared to most of the competition, and relying on more ‘one-off’ work

• Seen as thought leaders (i.e. a Gartner or Forrester of sorts), with Thoughtworks staff publishing various books on programming and thought-pieces / white-papers; however, this resulted in a less-intense focus on maximizing utilization and minimizing ‘beach’ (aka bench) rates

• Liberal leaning. TWKS was inspired by Ben & Jerry’s to adopt social impact and social justice as a core consideration for the business and its culture

• TWKS reported lower rates of employee attrition than the sector, which the company pointed to as a result of thought leadership, nurturing culture, and higher-quality staff

• Bigger China exposure vs peers

• Mainly organic growth.  TWKS did not do any acquisitions until 2021, and only spent $130M so far, in total

In 2017, Apax acquired Thoughtworks for $785M; at the time, TWKS had c.4,500 staff.   In early 2021, received a $720M investment at a $4.6B TEV from GIC, Siemens, Fidelity and Mubadala; staff count had risen to 7,000. In September 2021, TWKS went public, pricing its IPO at $21 per share.  Share price peaked around $34 per share ($11B TEV).  

The table below outlines market expectations at the time of 2021 IPO and TWKS actual performance.  2023 was a disaster. 

If we use 2019 (pre-covid) as the starting point, TWKS is underperforming all applicable peers on gross profit per share.   Note the rapid growth of DAVA and GLOB.  

IT services companies began missing or guiding down in 2023.  TWKS was hit particularly hard.   Compared to peers who can have 1-3 year projects that are heavy on implementation or managing / outsourcing, TWKS’s business has less visibility, with most projects concluding within a few months.  TWKS’s RPOs extending beyond 1 year are immaterial.  Compare this to industry leader Accenture; Accenture’s consulting segment declined in 2023 but overall Accenture RPO grew slightly to $27B as of Feb 2024, and a third of that amount (or 15% of LTM revenue) is expected to be recognized further than 1 year out.   

TWKS’s slowdown is broad-based.   The company is very well-diversified by customers, sectors, customer geographies, and staff geographies.  No 1 customer accounts for more than 5% of revenue and top 10 customers are 28% of revenue.  No 1 industry vertical accounts for more than 26% of revenue, and no 1 region accounts for more than 30% of headcount. 

Thoughtworks is taking a number of steps in response to the slowdown:

• Cut headcount; now at 10,760 FTEs vs a peak of 12,671 in 2022 (down 15%)

• Adjust delivery bases.  TWKS is trying to increase the staff utilization rate and increase the % of staff base in lower-cost jurisdictions.  FTEs declined the most in LatAm and Australia.  India FTEs were relatively stable and Southeast Asia FTEs grew (while China FTEs declined)  

• Pivot towards AI.  In 2023, c.30% of staff underwent ‘comprehensive AI-training’

• Grow managed services.  TWKS calls this AI-powered DAMO (digital applications management and operations) service.  Within 18 months of launch, the % of top 50 clients on DAMO grew from 5% to 30% and TWKS needs to grow this further

• Bring in a new CEO - Mike Sutcliff, expected to start in June / July 2024 while Guo Xiao transitions out.

Prior to retiring from Accenture in 2020, Mike Sutcliff was head of Accenture Digital, which then encompassed Industry X, AI, and the advertising / creative division (now Accenture Song). He had a successful 20+ year career at Accenture.  His core strengths are vision, sales, M&A and motivating staff.  Similar to Ravi Kumar’s first couple of quarters at the helm of CTSH, I expect Sutcliff to go on a ‘listening tour’ meeting with clients and employees and not to make drastic departures from TWKS’s existing strategy.  Below are my speculations for some of the things that I think Sutcliff may do:

• more aggressively hire experienced staff from places like Accenture to help strengthen C-suite relationships.  Gradually shift the culture towards a greater performance-orientation and client-centricity, while still maintaining a very high bar for talent

• speed up the increase in offshoring to lower-cost locations, prioritize North America and India, and de-emphasize China.  China accounts for 10% of TWKS revenue and 20% of staff base and is potentially a legacy of prior CEO Guo Xiao rising up through the ranks of TWKS as head of China

• set an ambitious goal to dramatically increase revenue and cross-sell from existing top 100 accounts.  E.g. TWKS’s top 5 customers average only $40M of revenue and the largest client is <$60M of revenue.  Compare this to say GLOB whose largest client (I believe Disney) is a $180M account and the next 4 clients generate $74M of revenue each, on average.  And industry leader Accenture has more than 100 clients that each generate annualized bookings of $400M or more

• target multi-year bookings (e.g. by cross-selling more DAMO).  This will be hard, given TWKS's lack of historical credibility and previous tendency to hand off management or even implementation to larger partners with more resources

• if departing too heavily from the 'premium' price points is too risky, consider adjusting the pricing strategy to increase outcome-based / value-sharing / success-based share of revenues, which is consistent with a more client-centric orientation

• to achieve the above goals, TWKS might need to increase its use of M&A.  Until 2021 TWKS did not do acquisitions and grew to 8,000 FTEs organically.  Since then TWKS did <5 acquisitions spending a total of $130M.  Such a small use of M&A is somewhat unusual in the industry.  ACN (where Sutcliff comes from) is an acquisition-machine that created significant per-share value despite constantly doing >20 acquisitions each year.  When Sutcliff joined Andersen Consulting in the late 80s it had 22,000 consultants in >40 countries, and by the time he retired from Accenture in 2020, Accenture employed 500,000 people across 120 countries.  Even today with c.$65B revenue, ACN is only 5% of the global IT services market (per Gartner), which remains fragmented

Some combination of actions listed above and an improvement from cyclical trough IT consulting demand conditions should be enough to return TWKS to growth and mid-teens EBITDA margins.  Exiting in 2027 at a 16x P/E is sufficient for a 21% IRR.  

Litany of risks, but well-discounted

Despite its history and potential, Thoughtworks is modestly valued at $900M market cap and $1.1B TEV (1x LTM sales), and this is because of a plethora of concerns:

• The expected 2H IT demand recovery may not materialize due to the economy

• GenAI creating structural deflation in IT services and reducing demand

• Loss of Thoughtworks's unique culture as Guo Xiao leaves and Sutcliff arrives, likely bringing with him some more ex-colleagues from ACN to infuse new blood into TWKS.  I grant that this may be a real concern but I counter that something has to drastically change for the business to become less precipitously cyclical, more competitive across multiple market environments, and better able to serve its clients

• After founder Roy Singham transitioned out of the business a few years ago, there were media articles accusing him of being a CCP influence agent.  This might have damaged TWKS's reputation, by association.  I think a credible, well-known ex-ACN outsider like Mike Sutcliff coming in as CEO can help make a cleaner break from this past (if at all relevant)

• Competition from the Indian outsourcers (TCS, Infosys, HCL) and CTSH who historically are seen as controlling the low-end but are becoming more credible across the spectrum

• Competition against the pure-digital players DAVA, EPAM and GLOB

• As always, competition against Accenture, Deloitte, BCG, Capgemini

• Accounting is messy due to the ongoing restructuring.  Cash conversion will remain patchy until the business gets back to it 2022 level of revenues and profitability

• 60%+ of shares are still held by existing financial investors (mainly Apax), creating an overhang of future secondaries.  Takeunder risk can never be ruled out

I believe the valuation addresses these concerns.  The company’s IPO priced at $7B TEV; the pre-IPO round by GIC / Siemens was at $4.6B.  The current $1.2B TEV is not a millions miles away from the $0.8B Apax buyout in 2017.  The company has $70M cash, $300M revolver (undrawn) and a similarly sized TLB facility (8% interest rate) maturing in 2027.  Lease liabilities are limited.  If Mike Sutcliff’s turnaround does not work, I think Thoughtworks may find a buyer not far below $1B TEV.  The brand is strong and TWKS attracted strategic interest in 2017 before Apax emerged as the winning buyer. 

N.B. Despite the $1B marketcap, free float is less than 30% and stock is relatively illiquid (ADV $4M), meaning the idea may not be suitable for large funds.  

Catalyst

Quarterly results

New management

Consulting demand recovery