Grid Dynamics: Pure-Play Exposure In Digital Transformation

Summary

I recommend going long Grid Dynamics (NASDAQ:GDYN) stock. The market for digital transformation is growing rapidly as businesses aim to compete digitally and require technological transformations to stay ahead of nimbler, more technologically advanced competitors. GDYN is well-positioned to benefit as it provides highly technical software development services, which are in high demand due to a shortage of skilled programmers and a shift towards creating innovative digital products and user experiences.

Company overview

GDYN provides consulting on digital transformation strategy, legacy replatforming solutions, technology engineering, and cloud services.

Digital transformation

Although it’s still in its infancy, the market for digital transformation is expanding rapidly. Businesses now aim to compete digitally, which requires them to undergo transformations to fend off attacks from newcomers who are more nimble and technologically advanced. When faced with the imperative to innovate technologically, the standard method of IT management-a combination of vendor solutions and outsourced services-often falls short.

In the eyes of C-suite executives, technology is no longer a cost-cutting measure, but rather a competitive advantage. There has been a shift in focus from process automation to decision automation thanks to the development of AI. Instead of buying off-the-shelf software, businesses are putting their money into creating innovative digital products and user experiences. I think this is what fuels the need for highly technical software development, which in turn creates opportunities for a dedicated software shop like GDYN.

Although there is an increasing need for skilled programmers, there is currently a shortage of this talent pool. In addition, businesses are turning to third-party providers like Grid Dynamics to meet demand because they cannot compete with technology companies in attracting and retaining such talent.

Exposure to a large and growing TAM

Grid Dynamics is a top provider of next-gen IT services, and they make all their money from digital transformations. In my opinion, this gives investors a great chance to get in on the action in a market that’s set to more than double over the next 10 years, going from $588 billion in 2010 to over $3 trillion by 2020. As far as digital transformation goes, Grid Dynamics excels in areas like cloud-native app development, AI, and enhancing customer experiences with their in-depth technical skills.

Presence in multiple verticals

As opposed to its rivals, GDYN prioritizes maintaining a small but loyal customer base. This is likely why GDYN had only 50 customers before it bought Daxx and Tacit. My estimates are that GDYN’s top five clients have each contributed roughly $28 million in annualized revenue in 3Q22. In addition, the fact that they come from different industries shows that it can scale to meet the needs of a wide range of businesses, which is a major selling point.

As a result, I believe that the next five largest clients, who account for about half of total revenue, as well as the other 23 clients who each generate over a million dollars annually, all have room for expansion. GDYN appears to not only value long-term partnerships with its customers, but it has also shown the flexibility to diversify its portfolio by expanding into new markets and service areas after major losses at some of its biggest clients in 2020.

CEE workforce is more proficient

About 85% of GDYN’s total workforce is based in Central and Eastern Europe (CEE), where the company’s primary delivery locations are situated.

Even though the region might not provide the same or more scalability in terms of labor pool and cost efficiency as India, I think GDYN European workforce could be more tech and programming savvy on average. Additionally, the industry talent shortage should be somewhat mitigated by the company’s delivery strategy. While nobody is completely safe from problems like these, Grid Dynamics has chosen to focus its operations in non-major metropolitan areas that are home to a large number of highly educated people.

Truth is, India is significantly more scalable than many CEE nations in terms of the total labor pool and the number of new engineers graduating each year. Additionally, the country’s cost structure makes it a prime location for inexpensive shipping.

However, while India’s large scale and low prices are attractive, I find that the service quality and proximity of the workforce in Central and Eastern Europe to be preferable. It’s not uncommon to find people with a bachelor’s degree or higher in the area who are studying IT. Because of this, most people working at GDYN have graduate degrees. To demonstrate competence, HackerRank conducted a ranking of developers and programmers from different countries. Poland placed third, Hungary was fifth, and the Czech Republic was among the lowest-performing countries. On the other hand, India only ranked 31st. While India’s scalability is unrivaled and its best programmers are on par with their counterparts anywhere, I believe the data shows that, in some Central and Eastern European countries, tech labor is more skilled on average.

Profit margin

Given that GDYN has already achieved its 40% gross margin target, I anticipate that its EBITDA margins will increase over time, eventually reaching its long-term target of 20% (reiterated in 3Q22 earnings). I expect GDYN’s gross margins will remain stable throughout its growth, while its high SG&A expenses will provide leverage on a rapidly expanding revenue base. With respect to SG&A, I anticipate that S&M costs will remain stable, while the G&A mix may continue to decline, resulting in increased EBITDA margins.

3Q results were encouraging

While GDYN’s third-quarter results were well above expectations, the company’s outlook for the fourth quarter suggested a more severe macro slowdown. Although I find encouragement in 4Q guidance because it establishes a realistic goal, a disappointing 4Q would reduce the baseline for growth in the coming year. The fact that the company is consistently fulfilling larger contracts is also encouraging for its future development. Even if growth slows down slightly in 2019, it’s likely to pick up again after a year or two.

The growth in GDYN’s top five customers was 48%, and the growth in the next five customers was 45%, both of which were encouraging figures to see beyond the headline metrics. In addition, quarterly revenue from the biggest client was over $10 million. This exemplifies the firm’s capacity to handle complex client relationships and grow its market share within existing accounts. Finally, the company secured a number of deals with new customers, which should propel its rapid expansion in the coming year.

Valuation

Investors can expect a 39% return based on my model.

My model assumption is based on my belief that GDYN will continue to grow, albeit with a slight slowdown in FY23. As previously stated, EBITDA margins should grow over time as GDYN grows its top line and gross profit over its operating cost base (i.e., G&A as a percentage of revenue declines). I expect GDYN to achieve 15% EBITDA margin in FY24, which is lower than the long-term target because I believe GDYN will continue to invest in S&M to penetrate each vertical.

As GDYN grows and expands its margins, I believe the valuation gap between it and its peers (DAVA, EPAM, GLOB) will narrow. However, because GDYN has yet to reach its long-term margin, I believe it should continue to trade at a slight discount to peers.

Risks

Customer concentration

Grid Dynamics’ top five customers account for a sizable portion of the company’s total revenue, indicating that the company relies heavily on a small number of clients. Still, GDYN boasts a sizable clientele comprised of similarly sized businesses from a wide range of sectors. Thus, I think any headwind should be far more manageable compared to the past.

Political risk

To a large extent, Eastern European countries are where GDYN is most well-known and most actively promoted. The delivery of services to customers could be interrupted if political unrest in the area continues.

Conclusion

Businesses that want to compete in today’s economy need to make technological changes in order to keep up with their more nimble and technologically advanced rivals, driving rapid growth in the digital transformation market. A shortage of qualified programmers and a shift toward developing novel digital products and user experiences put GDYN in a prime position to profit from the rising demand for its highly technical software development services.