The following segment was excerpted from this fund letter.
Endava plc (NYSE:DAVA)
Going back to at least 2017 with research on Syntel that ultimately led to Syntel’s acquisition by Atos, I have spent a lot of time understanding and investing in IT services. IT services generally earn extremely high returns on capital, and historically have augmented organic growth with acquisitions that build capabilities in other technical or geographical areas. Over time, IT services have evolved from relatively low-skilled IT infrastructure monitoring and troubleshooting, and now some companies are more focused on customer-facing activities.
This new generation of IT services businesses is involved in custom application development, generating next generation experiences for customers. Admittedly, the buzzwords in this industry are annoying and it can be sometimes difficult to understand the scope of services companies offer, and how much overlap there is with the older generation of IT services businesses. The main differentiator is that most of their work is on a time-and-materials basis, whereas legacy providers were replacing a previously insourced cost and needed to offer fixed price contracts to win business by guaranteeing customers superior cost to insourcing.
Finally, one of the main characteristics of Endava’s business model is that its engagements are project-based and have single deliverables for completion. This makes the business more sensitive to the economic cycle relative to legacy IT providers who are, again, generally replacing an ongoing function previously performed by a company’s internal team, i.e. is recurring in nature.
Right now is an interesting time to add to our investment in DAVA because the company has experienced a hangover from the COVID pandemic surge in spending. The pandemic caused significant IT investments to accommodate work-from-home policies and an expectation of permanent changes to how business was conducted, from remote sales calls to social distancing in manufacturing operations and more. From fiscal 2019 through fiscal 2023, sales grew at a 28.9% compound growth rate (‘CAGR’). This is a small decline from the 31.0% CAGR from 2017 to 2019, when the business was much smaller. To frame this more succinctly, in the last six years, the business has increased revenue by 5x.
Unsurprisingly, at least to me, the business is going through a post-COVID hangover, and needs to lap some strong comparables before resuming double-digit growth.
On top of the need to lap strong comps, the business over-invested in people, believing that the boom times would persist. The slowdown caught management by surprise and their worker utilization has fallen significantly. Fortunately, this can be fixed relatively quickly and margins should rebound towards 2019 levels.
In addition to all of this, the advent of artificial intelligence (‘AI’) has caused some people to question the value that Endava can provide if companies adopt AI. Who is going to help these companies adopt AI? Sure, Google (GOOG,GOOGL) and Amazon (AMZN) will have their own internal resources, but there are so many more companies who don’t have a need for full-time software engineering talent who will need a company like Endava to help them adopt AI. AI seems like more of an opportunity than a threat for Endava.
The business currently trades for 15x next year’s still-depressed earnings, a multiple we believe is far too low for a business that should grow at double digits for at least the next five years. There is certainly a realistic scenario where DAVA can trade for a price approaching $80 in 2-3 years.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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