TaskUs: A Return To Growth But Margins Are Under Pressure

seekingalpha08-28

Shares are down nearly 10% since Q2 earnings, which saw the company return to organic growth.Margins however are expected to decline due to increased investments and a more competitive environment....

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Management's guidance points to a continued improvement in growth for the next two quarters. However margins are expected to decline as a consequence of rising competition and increased investments. While I recognize the rationale behind the higher near-term investments to drive future growth, and have factored this into my valuation model, I do not find the current valuation to be attractive at a Price/FCF of 9.4. Given the elevated levels of stock-based compensation (SBC) as well as the numerous risks which I have identified with this investment, I maintain a Neutral rating towards TASK shares. Financial highlights and my expectations looking ahead TaskUs generated revenue of $238 million in Q2, which represented a year over year growth of nearly 4%. Despite headwinds in its Digital Customer Experience and AI services segments which saw muted revenue declines, this was offset by strong year over year growth of 30% in the Trust and Safety segment. The impact of AI on TaskUs's business is something I grapple with, as I see GenAI automating basic customer interactions but also needing human input to train and fine-tune its machine learning models. I therefore consider this to have a net-neutral impact for the business in the medium term. The company's CEO however was more optimistic stating: Thus far, we believe GenAI has created more opportunity than risk for TaskUs. Q2 Investor presentation Despite being positive about the return to growth and management raising revenue guidance by 3% , I believe investors need to be concerned about the declining margin trends shown above. I will walk through two main drivers behind this trend which is causing adjusted EBITDA margin expectations to decline further to 22% for the full year. The first driver is lower gross margins, which were 40% in Q2 compared to nearly 42% in the prior year quarter. A key reason for this is the increased revenue contribution from Rest of World, as highlighted below. Rest of World comprises of Europe and Latin America, where margins for the company are typically weaker compared to the Philippines and India. I expect this trend to continue in upcoming quarters given that TaskUs's customers increasingly prefer having operations in Latin America due to a favorable time zone. Q2 earnings report Additionally, it is likely that the company has had to make pricing concessions to win deals over its competitors, as described by its CEO when he stated: In some cases, this business is being taken from the competition, as I outlined in the annual call start of this year, the first growth lever that we're focused on is going after our competition and trying to take business from them, and we've been successful in doing that at this client along with other clients. The second factor driving lower operating margins for the company is the increased level of capex. This involves investments in infrastructure and employee training in order to accommodate the additional growth that the business is forecasting. Management has guided to spending nearly $34 million in the next two quarters, which is significantly higher than the typical capex spend per quarter historically, as shown below. I do not expect this level of capex spend to continue into next year, and therefore I will take this into account in my valuation model. Seeking Alpha Given that the business continues to be FCF generative, I expect management to leverage the solid financial position of $171 million in cash and $260 million in debt, to return capital to shareholders through buybacks, while also having the flexibility for opportunistic M&A, similar to its acquisition of heloo in 2022. Valuation Management's guidance for this year calls for revenue and adjusted EBITDA guidance of $965 million and $212 million respectively. I however find it more relevant to value the business based on its FCF, which management has guided to be around $120 million, at a margin of 12.5%. At the current share price of $13.7, this translates to a Price/FCF valuation multiple of 10.2. Given the elevated investments for growth this year, I believe this figure understates the true FCF generation potential of the business. In a typical year, capex is around $10 million lesser than the $42 million guided for this year. That would imply a more normalized FCF of $130 million, which brings the Price/FCF multiple down to 9.4. Investors should however be aware of the elevated levels of SBC, which have an annual run-rate of above $43 million as shown below. This leads to significantly lower normalized GAAP earnings of approximately $90 million, with margins closer to 8%. This implies a Price/Earnings multiple of 13.5, which is in line with industry peers such as Genpact (G), which is forecasted to have similar medium term growth rates as TaskUs. On the whole, I do not find this valuation very enticing given the outlook for mid-single digit revenue growth as well as the presence of several downside risks, which I will delve into in the next section. Q2 earnings report Risks to consider Certain services replaced by AI One of the biggest risks facing the company is the potential impact of AI, which could automate tasks currently outsourced to TaskUs. While I previously argued that this will likely have a net-neutral effect on the business in the medium term, it is crucial to closely monitor management's strategies, as I anticipate that the impact of AI on its business will intensify over the longer term. Competition In a challenging demand environment, some of TaskUs’s competitors with excess capacity are lowering their prices to attract more customers. This trend is already affecting TaskUs’s margins, and the company will need to leverage its brand and differentiated offerings to maintain its pricing power. Customer concentration TaskUs generates a significant portion of its revenue from a small number of large customers. According to its latest Annual report, its largest customer represented 19% of its revenue last year. A reduction in spending or loss of such a major client could have an adverse impact on the company’s overall performance. Economic weakness In a weaker economic environment, demand for TaskUs’s services from companies is likely to decline, leading to a more subdued outlook for both growth and profitability. Conclusion  Although the business is showing promise with a return to organic growth, several concerns persist for investors in the upcoming quarters. Given the current valuation and the risks I’ve identified, I do not believe there is a sufficient margin of safety. 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