Endava Stock: Risk-Reward Looks Unfavorable (NYSE: DAVA)
Endava (NYSE: DAVA) grew through mergers and acquisitions and strong demand for digital board pieces. However, the company’s large workforce relative to revenue and exposure to Central Europe potentially make the stock a risky bet. Furthermore, although market sentiment has led at elevated valuations, the ongoing war is likely to drive a stock price correction.
Endava is a UK-based IT services company primarily focused on payments, financial services and the TMT space. While the UK is the company’s largest revenue contributor, Endava generates substantial revenue in the US and Europe.
According to management, the company’s total addressable market is reasonably large, with an expected annualized growth of 15.5% between 2020 and 2023 to reach $6.8 trillion.
In addition to the diversity of geographies where Endava derives its revenue, the company’s operating delivery base is well diversified across the United States, Europe and Latin America, with plans to explore further in Asia.
Given the demand environment, the company expects a sustained level of hiring, closer to its 30% target.
I think, like we said, we tend to think of the upper limit as being around 30% for us in terms of bringing quality candidates into the business.
We’re saying that this 30% growth in the number of employees should translate into slightly higher growth in terms of revenue growth, just because of the price increases that we’re also able to add here.
Source: Endava Q3 2022 Earnings Call
In addition to strong hiring, Endava’s growth has also been driven by mergers and acquisitions. As a result, the company’s revenue grew at a CAGR of 29% between 2017 and 2021.
A major contributor to this growth has been customer growth, both organically and through acquisitions.
Additionally, the company has no significant debt and has generated positive FCF.
Readers should remember that Endava reports in GBP, so an exchange rate conversion factor of 1.2 should be applied. So, for fiscal year 2021, the company generated $99 million in FCF. Similarly, for 9M2021, the company made $60 million and for 9M2022, $75.6 million.
We believe Endava is a relatively solid revenue growth game, with expectations of revenue growth of over 30% in the future. However, we see some challenges with the story:
- Headcount and revenue per employee are lower than many competitors
- Europe’s focus on revenue generation could hamper growth if the eurozone experiences deeper than expected weakness
- Business Continuity Challenges in Light of the Russian-Ukrainian Conflict
- High valuations leave no room for error
Headcount and revenue per employee are lower than many peers
Endava has perhaps one of the lowest revenues per employee. While it’s not the only measure of an IT services company’s health, it says a lot about the average price Endava can command. Let’s not forget that the company has no deferred revenue and is therefore a pure service game. Part of the reason could be the geographical distribution of income, almost 60% of which comes from the eurozone. With the company’s operating philosophy of charging customers a bit more to achieve revenue growth faster than the number of employees, we don’t take much comfort in Endava’s assertion that 88 to 89% of customer revenue was generated in the previous year.
The focus on Europe to generate revenue could hamper growth if the eurozone experiences greater than expected weakness
Endava is a bet on Europe, with some exposure to the United States. The ECB and the IMF have been worried for some time about the euro zone.
the Board of Governors has decided to end net asset purchases under its Asset Purchase Program (APP) as of July 1, 2022. The Board of Governors intends to continue to fully reinvest principal payments of maturing securities purchased under the APP for an extended period beyond the date on which it begins to raise the key ECB rates and, in any event, for as long as necessary to maintain ample liquidity conditions and an appropriate monetary policy stance.
Compared to the United States, Europe remains fragile, as evidenced by the difference in attitude of central banks. While the US Fed has publicly stated that the economy is resilient and has become hawkish to contain demand-driven inflation, the ECB still has a somewhat dovish stance. We note that the Russian-Ukrainian conflict has further heightened fears of an impending recession in Europe, the resolution of which may take longer than expected.
The moot point is, why invest in a market that is likely to experience economic uncertainty for an extended period? Endava’s exposure to the United States may not be enough to help it weather the challenges of the European downturn, given that is where Endava’s focus remains.
Business Continuity Challenges in Light of the Russian-Ukrainian Conflict
Most of the company’s workforce is spread across Central Europe.
Endava has also drawn up a business continuity plan, or BCP, should war spread to any of the countries where the company has delivery centers. For example, the company generates about 9% of its turnover in Moldova.
We have our task force on the situation in Ukraine, which therefore monitors this twice a day, morning and evening, and we have plans in place which include the possibility of relocating our teams to Moldova.
So, for example, in Moldova, 96% of our employees work for customers, but we also deliver from another location. Which means that if we need to relocate them, we can relocate them to agents and infrastructure that already exist for those clients in other countries. Now, in terms of relocation, one of the things we wanted to highlight is most of our staff in Moldova, have an electronic passport, either a Romanian and/or Bulgarian passport
Source: Endava Q3 2022 Earnings Call
Despite the BCP, we believe, Endava is at considerable risk. NATO has expressed the possibility that the Ukraine-Russia conflict will drag on for years. In this context, today, it could be Moldova, and anyone can guess as well as we do as to where the war will go next.
Although it is not possible to find many companies without this risk, we would rather put our money where this geopolitical risk is minimal.
High ratings leave no room for error
SSIIs are considered relatively stable, especially in digital transformation. We therefore value the company in FCF.
While our revenue estimates for the business are solid, we don’t see how current pricing can be sustained.
Also on a 1-year forward basis, the company’s FCF yield is lower than the US 10-year – so do investors think Endava is more stable than the US government? The answer is an obvious no. Endava’s strategy for solid revenue growth put aside concerns about profitability. While strong revenue growth deserves a premium, we find current levels unduly high.
Another valuation discount should come from the inherent risk of the business model, which is focused on Europe. Without wanting to discount the company’s strong growth, we don’t think a 2023e FCF yield of less than 5% is what the stock should be trading at. This would imply that the stock price is half of current levels.
Risks for our thesis
We have a negative view of Endava, and the risks to our thesis or some potential positive factors could be:
- Structural strength in the euro: The euro has long been touted as an alternative reserve currency to the US dollar. Should the Euro become more substantial, the European region could prosper and see an acceleration in demand for digitization and payments. However, we view this as an unlikely scenario due to strained relations between major states due to various issues ranging from support for weaker states to immigration reforms.
- Mergers & Acquisitions: Endava has grown through an aggressive inorganic strategy. A significant acquisition to diversify its revenue and costs out of Europe could provide a significant boost to the company’s share price. While management remains opportunistic, we see no visible signs of planned transformational mergers and acquisitions in the foreseeable future. Endava must continue its mergers and acquisitions to maintain the high growth rates seen in the past. As the business grows, integration issues can arise leading to margin issues.
- Endava is bought out by a larger player: Companies like Accenture, Infosys and others have been on the prowl to buy up good quality assets in the current environment. Therefore, such a proposal for Endava could provide an advantage over current levels. However, given the company’s low revenue per employee, we don’t think many larger players would want to take on additional funds to buy Endava.
Endava is a play on payments and large-scale digital transformation in Europe. The company has a proven track record of growth, leading to valuations above fundamentals. Moreover, the market neglected the geopolitical risk of operations in Europe. As a result, we believe the company’s share price could see a significant correction.