Endava Stock: Downgrade To Hold As Outlook And Execution Became Very Uncertain (NYSE:DAVA)

Summary

Readers may find my previous coverage via this link. My previous rating was a buy, as I believed Endava Plc (NYSE:DAVA) would see its valuation rerate upwards to the historical average as the business continues to grow. My underlying belief was that IT spending should recover as the macro environment returns to normalcy. It is pretty clear from the share price drop that I have overextended myself in this stock due to my overconfidence that a return in IT spending would come true. I am revising my rating from buy to hold as I lost confidence in the growth outlook of the business after the massive guide down and poor performance.

Financials / Valuation

DAVA reported 2Q24 revenue of GBP183.6 million, down 10.6% vs. 2Q23. Growth would have been worse without the contribution from M&A, which boosted growth by 530 bps. This performance was below consensus expectations for GBP 184.5 million. Gross margin also saw a major decline from 40.6% to 33.2%, as did EBIT margin, which came in ~870bps lower vs. 2Q23 at 11.9%. This led to a very disappointing EPS growth performance of -~50%.

I have become a lot more conservative about modeling the business. Instead of modeling 3 years out, I am just focusing on the next year because of all the execution uncertainties today. Also, management’s creditability is no longer as creditworthy after the massive guidedown.

My new model assumptions are -8.3% growth in FY24 and 9.8% in FY25, and 15%/18% EBITDA margin in FY24/25. My FY24 assumptions are based on management guidance, which I gave the benefit of doubt that FY24 goes according to guidance. As for FY25, my assumptions are based on consensus estimates (to be fair, consensus has been pretty accurate all the while for the past ~20 quarters), and DAVA remains trading at the current multiple, the upside is not attractive for the risk profile.

The upside seems to be largely dependent on the market rerating the stock valuation upwards (the current 12x EBITDA is near an all-time low), but I argue that because of the weak guide and execution hurdles, the market is unlikely to rerate this up in the near term. It is more likely that after showing a couple of quarters of a positive turnaround, the market will gradually rerate upwards. As such, I am now downgrading to hold.

Comments

It was a horrible quarter that really impacted my outlook for the business in the near term. Management’s revised guidance was also an arrow through my bullish view, effectively saying that demand is going to stay weak and any reversion to normalcy is in sight. To be specific, they guided for FY24 revenue of GBP722 to GBP735 million, which is a massive downgrade from the prior guidance of GBP791 to GBP805 million. On a y/y basis, this implies growth is going to slow from -4 to -2% to -11 to -13%. The implication is insanely huge because the former makes it easier to convince the investor community that there is growth inflection here (because it is nearer to 0%). For the latter, it basically meant that we are nowhere near a position inflection, and investors likely took their hands off the stock until there were signs of a positive turnaround.

The weak revenue outlook also has major implications for margins and earnings. Cycling back to the guidance, management now expects FY24 adj EPS of GBP1.09 to GBP1.22, a bigger than revenue downgrade of 900bps (EPS downgrade by 2900bps at the midpoint), because of the lower utilization rate. This is really bad for the business and stock narrative. Although DAVA announced restructuring actions to improve its utilization, it is unlikely that it will result in an immediate boost in margins given that restructuring typically takes some time to work (suppose it does work). In the meantime, the narrative is basically weak growth and margin outlook, which basically means no investors will be interested in the near term.

The other reason I believe this restructuring effort will take longer than expected to materialize is because resources are going to be stretched between restructuring and integrating the GalaxE acquisition. While this acquisition looks positive in theory—diversifying business into the healthcare vertical and also enabling DAVA to penetrate the Indian market—integrating the business and making sure that work culture and business model require a lot of focus. A great standalone business does not mean that it will continue to be great under another company. Remember that GalaxE extends DAVA’s reach into verticals that management does not have extensive knowledge of (for example, healthcare, which is going to be one of the largest revenue contributors, accounting for 14% of total revenue), so it is likely that it will take more time to integrate.

Overall, I just think the execution hurdle is high and management creditability is really bad at the moment. Any misexecution here, even if it is just a minor issue, could spark further selldowns by investors as they lose further confidence in the management team. I am still sure that growth can recover because of the digital transformation tailwind and DAVA’s expertise in payments, which enables them to penetrate other verticals easily (since all industries need payment solutions), but the near-term outlook is just poor.

Conclusion

I am downgrading DAVA to hold following a disappointing 2Q24 performance and revised guidance. 2Q24 performance was really poor with revenue and EPS significantly missing expectations, where gross and EBIT margins contracted sharply. The huge downwards revision in guidance sent a really negative signal to the market, which I believe has impacted management credibility. Although there are plans to improve utilization, I think execution uncertainties are very high given the need to integrate GalaxE.