Thoughtworks Holding, Inc. (NASDAQ:TWKS) Q3 2023 Earnings Call Transcript

Thoughtworks Holding, Inc. (NASDAQ:TWKS) Q3 2023 Earnings Call Transcript November 7, 2023

Thoughtworks Holding, Inc. beats earnings expectations. Reported EPS is $0.04, expectations were $0.03.

Robert Muller: Hello, everyone, and welcome to Thoughtworks Earnings Call for the Third Quarter of 2023. We will be recording today’s call, and during the presentation, all lines will be on listen only. Joining us today will be Thoughtworks President and CEO, Guo Xiao; and CFO, Erin Cummins. The earnings press release was issued earlier today and is also available on our Investor Relations page at thoughtworks.com. Some of the matters we’ll discuss on this call, including our expected business outlook and anticipated costs and benefits of our restructuring actions are forward-looking and as such, are subject to known and unknown risks and uncertainties. These include, but are not limited to, those factors described in today’s press release and discussed in the Risk Factors section of our annual report on Form 10-K, our quarterly reports on Form 10-Q and other reports we may file with the SEC from time to time.

These risks and uncertainties could cause actual results to differ materially from those expressed on this call. These forward-looking statements are made only as of the date when made. During our call today, we will reference certain non-GAAP financial measures. We will also provide growth rates in constant currency as a framework for assessing how our underlying business performed, excluding the effect of foreign currency rate fluctuations. We include non-GAAP to GAAP reconciliations in our press release furnished as an exhibit to our Form 8-K. The non-GAAP financial measures provided should not be considered as a substitute for or superior to the measures of financial performance prepared in accordance with GAAP. Thoughtworks assumes no obligation to update or revise the information presented on this conference call.

I will now hand over to Xiao.

Xiao Guo: Thank you, Rob. Hello, everyone, and welcome to our third quarter earnings call. I’d like to start with an overall update on our business before Erin takes you through our results in more detail. Erin will then share our guidance before we move to Q&A. The quarter progressed in line with expectations that we discussed during our last earnings call. We delivered revenue of $280 million, in line with our guidance and adjusted EBITDA margin of 12%, which exceeded our guidance. The restructuring program we shared with you in August is being executed to plan. The results are $17 million in quarterly cost takeout by the end of the quarter or $68 million on an annualized basis. Our global digital engineering center is operational and is driving innovation with our clients and improving our ability to innovate and respond to client demand.

Now let me share an update on the demand environment. We’re seeing stability in our sales pipeline compared with Q2 2023 with fewer client passes. Our new logo acquisition continues to be a strength with 34 new clients in the quarter, increased from 29 in Q2 2023. We are prioritizing our investments in sales and marketing. We’re seeing our efforts in outbound demand generation paying off, contributing 51% of the net new bookings in Q3. Though we’re still seeing longer average sales cycles and programs of work being broken up into smaller deals, we’re hearing from some of our clients that budget pressure is starting to ease. I personally met with over 70 clients in the third quarter. Based on my conversations, digital transformation remains a top priority for our clients despite the macro environment.

We are focusing on creating value for our clients through [Siri] expansion. For example, DAMO, innovation around Gen AI and core services, data platforms, data mesh, enterprise modernization, cloud and FinOps. We continue to see a lot of client interest in Gen AI, and we’re well positioned to meet this demand. We’re focusing on four main areas: AI-assisted software delivery, AI-powered digital products, AI and data platforms at scale and AI-assisted enterprise monetization. Alongside some vertical opportunities, for example, drug discovery, we have a Gen AI reskilling program underway at scale. We have trained over 2,300 Thought workers across 51 courses. We were excited by Thoughtworker engagement in our AI for software festival. The festival is a huge success.

We’re supported by Microsoft and GitHub who are helping with execution, contributing co-pilot licenses and are now working with us on joint opportunity development. We’re pleased with the innovation pipeline that is shaping up as our teams explore and experiment with new tools and technologies. Legacy Bridge is a good example of our innovation around Gen AI. Legacy Bridge is a Thoughtworks AI-assisted software delivery technology, which brings a differentiated approach to legacy code modernization. According to IDC’s August 2023 Worldwide CIO survey, Legacy monetization is a top priority for CIOs. In Q3, we’re working with a new client, a North America top five insurance company using Legacy Bridge to accelerate the monetization of their legacy applications.

At the end of Q3, we’re working with around 30 clients on Gen AI projects. For example, we’re working with a new client, MEGT, an Australian employment and training not-for-profit business. MEGT has been supporting employers, apprentices, trainees, job seekers, and students since 1982. MEGT has an ambitious strategy, underpinned by digital growth and innovation agenda. We partnered to deliver AI capability assessment to service high-value AI use cases across MEGT value chains. Our scope included baselining organizational, digital maturity and readiness. We provided an actionable road map to help MEGT plan execute on its high-value digital and AI-enabled strategic initiatives. Thoughtworks is also working with new client Rightmove. Rightmove is the U.K.’s number one property website.

We’re working with Rightmove to explore how AI and Gen AI capabilities could support their strategic goals. Using Gen AI tools and helping building AI skills in-house, we’re looking into ways to increase operational efficiency as well as bring deeper user value across a suite of Rightmove products from B2C property search to features for estate agents. Additional new Gen AI wins in the quarter include a Fortune 500 pharmaceutical, a top 10 semiconductor company and a $10 billion turnover European e-commerce company. At the core, our growth strategy is to deepen relationships with existing clients and win new logos. We then supplement this with focused strategies around M&A, geographic expansion and partners. First, starting with partners. In October, we announced that Thoughtworks has joined Stripe’s Partner Ecosystem to provide solutions that enable modern digital commerce and financial operations.

At our clients’ high pages Group, Australia’s number one online trade people marketplace, we have developed a new and improved payment system on Stripe’s payment processing platform. Thoughtworks financial monetization solution powered by Stripe, has made the payment experience even simpler and smoother for high pages trace people and their customers. I’m proud that in Q3, Thoughtworks was recognized as the Google Cloud Global Partner of the Year for diversity and inclusion, striving to be a company that truly reflects the diverse societies we’re working has been a priority of ours. We passionately believe that technology must be created by diverse teams that reflect society to better serve society. Now let me share some details of recent successes with existing clients, PEXA Group, one of Australia’s leading property tech organizations has been working with Thoughtworks since 2021.

In August 2023, PEXA signed a further three-year partnership with Thoughtworks, ensuring work continues on PEXA’s most important digital initiatives. At BMW, we have been working together on the BMW connected AI platform, which we have built on top of a micro services platform based on Kubernetes clusters in AWS cloud. The connected AI platform supports multi-region compliance regulations and provides a standardized, scalable way to support all current and future connected AI use cases to ensure cost-efficient AI deployments, multi-tenancy and portability between cloud providers were also key design considerations. BMW data scientists now don’t have to worry about infrastructure aspects like persistent storage, identity, access and infrastructure security, everything is built into the platform.

We’re now live with the first use case around proactive vehicle maintenance management. We’re facilitating many more AI use cases, including the BMW intelligent personal assistant. We’re pleased that in Q3, our client Falabella won the Forrester’s 2023 Technology Strategy Impact Award for the Americas. Falabella, the $14 billion retail and financial services company that operates across Latin America, has been a Thoughtworks client since 2018. Falabella partnered with Thoughtworks to define the Company’s business agility model and develop an e-commerce product blueprint that evolved into its cloud native digital retail backbone. This acts as the Company’s core technology platform across its channels, segments and countries. Google Cloud hosts the multi-tenant DRB.

It enables Falabella’s store modernization and digital point-of-sale system that unifies its digital search, catalog, card and checkout experiences. Falabella expects the DRB’s modern architecture to substantially reduce time to market for new features and increased resilience. Now let me share a couple of examples of our successes with new clients, with Air Canada, Canada’s largest airline. We’re partnering to consolidate their disparate design systems into one best-in-class and globally aligned design system iteratively demonstrate its use via rapid prototyping and create a road map for its development and evolution. In the U.K., we’re working with a manufacturing company, AkzoNobel, who delivers sustainable and innovative solutions to their customers, communities and the environment to protect future generations.

We’re partnering with AkzoNobel on their e-commerce platform to improve their scalability and maintainability in order to support future growth and strategy. Now in my discussions with clients, they often tell me that two of the things that really differentiates Thoughtworks are our brilliant technologies and our thought leadership. I’m proud to share that we issued volume 29 of the Thoughtworks Technology Radar in October, our biannual report informed by real Thoughtworker experience solving our clients’ most complex business challenges, the CTO of moneysupermarket.com posted what many of our clients tell me. He posted an ever-expanding technology landscape its resources like the Technology Radar that help guide us through the maze of options.

The research, insights and recommendations truly stand out. And in Q3, Thoughtworks was ranked by Forbes as one of the world’s best management consulting firms. This recognition was based on feedback from clients, and we’re delighted to be ranked for the first time in 2023. Now let me share an update on our people, as we have restructured our business during the quarter, taking care of Thoughtworkers has been a top priority. We’re pleased that voluntary attrition remains low at 12.2% on a TTM basis in Q3 compared with 12.6% on a TTM basis in Q2. Our head count at the end of Q3 was around 11,000. We continue to selectively higher with a focus on specific skill sets, such as data, infrastructure, in addition to expanding our sales force. Our Glassdoor rating is 3.93 in Q3.

We exceeded industry benchmarks in five of the workplace attributes categories, including career opportunity, culture and values, and senior management. In Q3, we continued to lead the industry in responsible and ethical technology practices. For example, with our work alongside the United Nations, we’re providing guidance on ensuring awareness of buyers, transparency and the mitigation of negative unintended consequences in examining emerging technologies. Thoughtworks and the UN team have developed a framework and set of approaches for the responsible creation and management of technology systems and products. I would like to acknowledge the continued support of our Thoughtworkers and thank them for the extraordinary impact they deliver every day.

Now let me hand over to Erin.

Erin Cummins: Thank you, Xiao, and thanks to everyone for joining us on today’s call. Earlier this morning, we announced our results for the third quarter of 2023. The quarter progressed in line with the expectations we provided in August. Our teams are working closely with our clients on their most strategic initiatives and our overall pipeline remains robust. Our outbound engine is delivering well, contributing 51% of net new contracts in the quarter. New client acquisition continues to be a strength with 34 new clients in the quarter. Our restructuring program is progressing according to plan. I’m pleased to report that our fast execution has resulted in $68 million of cost savings on an annualized basis. Our global digital engineering center is operational and is optimizing our delivery capabilities.

DEC is driving efficiencies and improving utilization, which in Q3 was within our target range. Now let’s move on to our results in more detail. Revenues in Q3 were $280 million, representing a year-over-year decline of 16%; in constant currency, revenue declined 17%. Acquisitions contributed 1 percentage point to the revenue growth rate in Q3. For the quarter, we saw year-over-year declines of 10% in APAC, 17% in Europe, 18% in North America and 25% in LATAM. Moving to our industry verticals. Automotive travel and transportation remains our fastest-growing vertical, rising 12% year-over-year. We saw year-over-year declines of 14% within Energy, Public & Health Services, 16% in Financial Services, 23% in Retail and Consumer and 25% in Technology and Business Services.

For the third quarter on a TTM basis, around 93% of our business came from existing clients. We currently have 34 clients with revenues greater than $10 million on a TTM basis. In the third quarter, as a percentage of total revenue, our top 5, top 10 and top 50 clients generated 19%, 29% and 67%, respectively. In the third quarter, our annualized average revenue per employee was $99,000, which is above the industry average and is reflective of the highly strategic work that we provide to our clients. On a trailing 12-month basis, we ended Q3 with bookings of $1.4 billion. This is a 6.7% decline versus Q3 2022. As we have discussed previously, this is primarily due to smaller contract sizes and shorter contract terms. Adjusted gross margin was 37.4% for Q3 compared to 40.7% during the prior year period.

Q3 2023 adjusted gross margin included some temporary headwinds related to onshore offshore mix shift as well as mid-single-digit pricing declines on a like-for-like basis. In the third quarter, our adjusted SG&A as a percentage of revenue was 26% compared to 21.2% in the prior year period and 26.5% in Q2 2023. Adjusted EBITDA was $34 million for the third quarter, and adjusted EBITDA margin was 12%. Q3 GAAP diluted loss per share was $0.08 compared to a loss of $0.12 in the prior year period. Our adjusted diluted EPS was $0.04 compared to $0.08 for the third quarter of 2022. We had free cash flow of $4 million during Q3 compared to free cash flow of $28 million in the prior year period. This figure is inclusive of $11 million in restructuring-related cash payments.

We continue to have good liquidity. Our cash balance stood at $87 million as of September 30, 2023, alongside an undrawn revolving credit facility. Our outstanding term loan balance was $297 million as of September 30, 2023. Now let’s turn to our business outlook for Q4. For the fourth quarter of 2023, we expect revenues to be in the range of $265 million to $270 million, reflecting a year-over-year decline of negative 15% to negative 13% or negative 16% to negative 14% in constant currency. Our Q4 guidance is informed by sales cycles remaining elongated and programs of work being broken up into smaller deals. However, we are seeing stability in the pipeline compared to earlier quarters, especially among our larger clients. We expect utilization adjusted for seasonality to continue to trend upwards and billable hours adjusted for seasonality to be consistent into Q4.

For the full year, we now expect revenues in the range of $1.139 billion to $1.144 billion (sic) [$1.139 million to $1.144 million], reflecting a year-over-year decline of negative 12% — or negative 12% to negative 11% in constant currency. This includes an incremental $4 million of FX headwinds compared to the guidance we provided last quarter. We expect acquisitions will contribute approximately 1 percentage point to the revenue growth rate in Q4 and 2 percentage points to the revenue growth rate for the full year. We expect adjusted EBITDA margin for the fourth quarter to be in the range of 10.5% to 12.5%. For the full year, we now expect adjusted EBITDA margin of 11% to 11.5%. With respect to our restructuring program, we continue to expect total pretax charges of $20 million to $25 million, of which we have already recorded $16 million through the end of Q3.

We continue to expect annualized cost savings of $75 million to $85 million, resulting from our restructuring actions. For the fourth quarter, we expect adjusted diluted EPS to be in the range of $0.02 to $0.04, assuming a weighted average share count of approximately 328 million diluted shares outstanding. For the full year, we now expect adjusted diluted EPS of $0.12 to $0.14, assuming a weighted average share count of approximately 331 million diluted shares outstanding. Our Q4 guidance incorporates share-based compensation of $17 million. For the full year, we expect share-based compensation will total $65 million. By the end of 2023, we will have fully recognized all share-based compensation related to our IPO. As mentioned earlier, we are seeing signs of stability across our client base.

We intend to provide our guidance for 2024 during our Q4 earnings call next year. But our early expectation is that we will see revenue stability from Q4 into Q1 of 2024, followed by modest sequential growth throughout the remainder of 2024. In closing, we remain focused on driving digital transformation with our clients. These are long-term strategic initiatives for our clients, and we continue to foster multiyear relationships. With that, I’ll turn the call back over to Rob.

Robert Muller: Thanks, Erin. You can find our investor presentation on the Thoughtworks Investor Relations website. We will now move on to Q&A. I ask that you each to keep one question and one follow-up to allow as many participants as possible to ask a question. Operator, would you please provide instructions for those on the call? [Operator Instructions]

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Q&A Session

Operator: [Operator Instructions] Our first question comes from Maggie Nolan with William Blair.

Maggie Nolan: Erin, I wanted to dig into the last comment that you just made there on 2024. Can you elaborate a little on what maybe some of the drivers would be that would get you to that stability in the first quarter and then sequential growth from there?

Erin Cummins: Thanks for the question, Maggie. Yes, definitely. First of all, I will comment on stability generally. We have talked a bit in our prepared remarks already about stability. And on a relative basis, we have seen a more stable pipeline in the last few months, and we’re seeing this as a good sign. The other thing I would highlight that specific to fourth quarter is that there is seasonality. And so if we — and that’s because of more public holidays, more vacation time that we typically see and expect in the fourth quarter compared to Q3. So if we adjust for that moving from Q3 to Q4, we are expecting to see similar — and then we’re not being specific yet. Of course, we’ll be more specific in three months. These are critical two months or so as we close out the year.

But the way things are looking right now, we are seeing signs of stability moving into Q1. And so that’s our best view. We have been investing in demand and marketing overall, and we continue to increase our sales force, as Xiao mentioned earlier. So all of these things are helping build out that picture in 2024. But again, we’re not guiding now, we will be more specific in three months’ time.

Maggie Nolan: That’s still helpful context, and we’ll wait for the formal guidance next quarter. My other question was on the margin profile. I’m hoping you can elaborate a little on what some of the temporary headwinds are that you’re seeing with respect to the mix? And maybe just kind of help us understand where offshore and onshore mix is currently given all of the kind of changes that you’ve put through in the business structurally and operationally?

Erin Cummins: Thanks, Maggie. So just in terms of overall margin, there are temporary headwinds that we’re seeing right now. So from a structural perspective, I’ll start with what is impacting gross margin. While we have seen utilization improve, particularly from where we were at the start of the year, moving at a higher position from Q1 to Q2 than Q2 to Q3. So we’re definitely on the right path. We’ve moved more into our target range, but we’re not yet at where we want to be, I would say we’re at the lower end of that target range. And so that is an area of focus. Both Xiao and I touched on the restructuring and the digital engineering center. And so we’re feeling positive about the benefits on utilization, and we believe there is more to come.

I did also touch on pricing. Given the macro environment, we have seen some pressures related to pricing. We are working with our clients where we are seeing more sensitivity due to constrained budgets on the whole. So pricing for us has been a headwind. It’s something that as we look forward, we do think that is likely to continue to be a headwind into 2024. We do believe that normalized supply-demand dynamics will return at some point. But we think that as we move into 2024, that will be a situation that’s likely to remain. And then, again, just to mention on SG&A. Obviously, the restructuring we’ve touched on, it’s going well. We have worked on executing quickly on that. So we are seeing that benefit to the cost base. Part of that is making the adjustment to where the moves have been from onshore to offshore in terms of work.

And we have adjusted for most of that, but there is still friction that we’re seeing in gross margin from a headwind perspective that just really relates to transition and handover as these things really take a couple of quarters to fully move through. And then again, we are seeing efficiencies from our operations where we’ve reduced particularly back-office operations. We’re still doing more work on that. We’ll continue to do that into the next year. But again, in the positive, we are seeing good signs from a pipeline perspective, and we’re committed to continuing to invest in our demand and our sales and marketing.

Operator: Our next question comes from Ashwin Shirvaikar with Citi.

Ashwin Shirvaikar: And good quarter relative to expectations. It’s good to see that. I wanted to ask sort of try to draw a fine line between things not getting worse versus things getting better. If you could sort of walk through either by geography or vertical or project type, just sort of what sorts of things are in the mode of not getting worse stabilizing versus actually seeing green shoots and getting better versus neither if you could kind of provide granularity on that would be grade?

Xiao Guo: Sure. Thanks, Ashwin. So I’ll start with where things are not getting worse, which means they’re similar to what we described last quarter from a client buying behavior perspective. Sales cycle is still long, and we’re still seeing additional layers of approval required. The deal size is still compressed, especially initial statement work with ramp-up continue to be incremental. And also, the pipeline conversion is still slower than we used to see similar to what we have seen last quarter because the client sentiment is still cautious, budget is tight. So those are the things that are similar and it’s not getting worse. Where we’re seeing more stabilization is, for example, in areas where we have large programs’ work going on especially with the large client.

We used to see — when I say used to see in Q2 — early Q3, especially in Q2, we called out a few unexpected ramp-downs. This has been much less frequent in Q3. In fact, after the one we called out just at the beginning of July, we haven’t seen anything that scale since then. There’s still a bit of a rundown here in their scope reductions, but much less frequent and a much smaller scale. The other thing we’re seeing improving a little is that we are hearing from some client that budget is opening up in some aspects of the market, not all market for sure, but some of the market, for example, health care, energy, automotive. And then from a geo perspective, APAC is hearing more positive sentiment from a client, and we’re seeing some new projects starting there as well, a few $30 million-plus deals across the line recently.

And the other one I want to point out is our overall volume in Q3 is actually consistent with Q2 from ours build perspective, that’s enough a sign of stabilization. Now of course, as Erin mentioned, some of this work is moving towards offshore. So that’s putting a little bit of short-term revenue pressure on us. But overall, we’re seeing positive momentum in India and Europe, Asia and is offset by some of the similar behaviors in North America, U.K. and Australia.

Operator: Our next question comes from Puneet Jain with JPMorgan.

Puneet Jain: So, can you talk about like what you are seeing or what you expect from client budgets early next year, like in terms of magnitude and timing? And are there any differences like in demand environment that you’re seeing across verticals, it seems like TMT, Retail, the verticals that were weak early on are stabilizing, but energy utilities and financial services are deteriorating.

Xiao Guo: Sure. Thank you, Puneet. First of all, the 2024 budget cycle with our clients, we are having a lot of conversations with our clients about this. Just the overall tone is still very cautious in 2024. I don’t think it’s as cautious as last year, but it’s not significantly better. It’s not back to normal. So the time line is still little bit delayed. There’s still a lot of last-minute decision, where we’re expecting budget discussions probably continue late into December, even early January. And the other thing to call out, many business, as we have in this discussion are still prioritizing cost reduction programs over growth initiatives in the near future. So we expect any IT budget increases for 2024 to be limited and incremental.