Nagarro initial note
Shares Out: 13.3mn
Market Cap: €1bn (€75/share)
Enterprise Value: €1.2bn
Total Debt: €265mn
Cash: €91mn
Net Debt: €174mn
DBO liability: €13mn
1. About
Nagarro is a digital engineering specialist listed in Germany. The company delivers digital transformation projects to more than 1,000 customers in 63 countries operating in 10 different industry verticals. Nagarro has 19,182 employees of which 17,728 are professionals in engineering (mainly devs). Over 70% of their employees are based in India.
Nagarro’s revenue by customer geography in 2023:
Europe: 40% (Germany is half of this)
North America: 34%
Rest of world: 26%
Nagarro’s revenue by industry verticals in 2023:
Automotive, Manufacturing and Industrial: 23%
Financial Services and insurance: 14%
Retail and CPG: 13%
Travel and logistics: 9%
Other 6 verticals: 40%
2. Financials
Historical earnings for reference:
Management’s medium term target:
As can be seen above, management is aiming to grow revenues by 10% in 2024 and 20% organically in the medium term (which I assume means 3 years) with an EBITDA margin of 18%. Should they reach this target, 2026 revenues will be €1.44bn with EBITDA of €260mn.
Revenue growth
Between 2017 and 2023, Nagarro’s revenues grew at a CAGR of 27%. Nagarro’s revenues are correlated to global software and IT Services capex budgets as well as the changes in their market share.
Below is a breakdown of the historical growth rates of global IT spend from Gartner figures. The yellow highlighted ‘software’ and ‘IT services’ segments is where Nagarro mainly operates. A forward organic growth rate of around 10% per year seems reasonable.
It seems plausible that incremental revenue growth will come from companies incorporating Gen AI into their operations. It doesn’t make sense that hundreds of billions is being spent on building AI datacentres and training models if adoption isn’t going to be large. Nagarro’s FY2022 annual report contained the following statement: ‘’We predict that the improved capabilities of artificial intelligence solutions will drive a race in each industry to harness this new technology to improve customer experience and delivered value, to win growth and market share, and to enhance safety, security and efficiency. A lot of digital engineering work will be required to enable these goals.’’ Similar comments are made by Nagarro’s competitors.
Globant FY23 earnings call – ‘’As we close 2023, we saw a higher demand for projects with AI components. The AI-related business is outpacing the total growth of our service offering.’’
It is probably true that most of companies’ AI spend will come in the form of subscriptions to GenAI models as opposed to them training their own LLM’s. This implies that most of the spend will go through the income statement as an operating expense as opposed to capex through the cashflow statement. Basically just looking at capex and R&D projections won’t capture the true AI spend.
For companies to extract true benefit from GenAI models will require more than just a subscription however. Background work will be required like cleaning data, creating databases, building API’s, interfaces and integrating this to the rest of the business. This is likely where Nagarro will come in. It is not possible to project the revenue growth from this but the direction will be up.
Considering historical ‘organic’ growth in software & IT spend of around 10%, plus incremental revenue growth from GenAI projects and a possible increase in market share can potentially get Nagarro to revenue growth of around 15% for the next couple of years. This is more conservative than management’s target of 20% organic revenue growth.
Increased margin potential
Nagarro’s EBITDA margin has averaged 15% in 2017-2023. Management’s medium term margin target is 18%.
75% of Nagarro’s operating expenses are in the form of wages. I think there is a non-zero chance that GenAI code editors, such as Github Co-pilot, increases the productivity of Nagarro’s developers. This could lead to them being able to deliver more projects with the same or lower number of employees thereby increasing margins.
Nagarro stated the following in their FY2022 annual report which at least signals that they are paying attention to the AI potential internally: ‘’A significant opportunity is the increase in productivity that AI-assisted software development, and low-code and no-code software development will deliver.’’
From reading through many blogs and Reddit posts from developers on the topic of Co-pilot, it seems that in general junior devs are the ones that use co-pilot extensively and extracts the most value from the tool. Senior devs seem less inclined to use co-pilot, which makes sense since they are already proficient in their job.
Studies suggest that co-pilot increases the productivity of junior devs by around 50%[1]. This is a huge boost in productivity. Co-pilot is good at creating boiler-plate code, which can then be adjusted into a full solution. It is also good at creating suggestions of how to approach/implement a coding problem. It also saves time in the form of senior devs not having to assist junior devs as much anymore.
Another study looking at the accuracy of co-pilot generated code found that 80% of its output was correct or requiring minor adjustment.
It is unknown by how much, if at all, AI code editors will increase developer productivity for Nagarro, but it doesn’t seem unreasonable to assume that it will. Below is a matrix showing what Nagarro’s ebitda margin could be at different productivity and adoption rates.
You can make your own assumptions. As a base case I assume that adoption will be 30% and that those employees’ productivity also increases by 30%. Using 2023 numbers, this would increase the EBITDA margin from 14% to 21%.
Putting the revenue and margin assumptions together leads to the below outlook. EBITDA can probably get to around €280mn.
FCF and valuation
To get from Ebitda to FCF one has to subtract capex, net interest expense, tax and changes in working capital. Nagarro has quite high working capital outflows which is mainly due to the growth in the receivables book. As they grow they take on more projects and since they mainly get paid when a project is complete, this increases their receivables. I am not taking changes in working capital into consideration in my FCF calc. It is mainly a timing issue imo – it’s not a capital outlay requirement.
Capex is around €5mn per year.
Net interest expense is around €20mn.
Tax rate is around 25%.
Currently, Nagarro is trading at 15.9x NTM P/E. I would argue that this is relatively cheap for a company that looks likely to grow revenues between 10%-20% for the next couple of years. The market is also certainly not pricing in any possible margin expansion from AI code editors. You have potential revenue growth and margin expansion catalysts which aren’t priced in and in the case that they do not play out, there is not much downside as it is not priced in at all.
Assuming 2026 EBITDA of €280, FCF will come out to €190mn or €14 per share. This would mean Nagarro is trading at a 3yr fwd P/FCF ratio of 5.2x. Assuming we apply a conservative 15x multiple on 2026 FCF of €14 we would get to fair value of €210 per share (which is €160 when discounted back to today @ 10% discount rate). The current share price is €75 per share.
Counter argument to Co-pilot being a tailwind
I believe currently about 80% of Nagarro’s work is billed on a time & expense method, i.e the client is essentially billed per hour of work required. The other 20% of work is billed at a fixed bid.
The counter argument to co-pilots being a net positive is that they will speed up development work and thus Nagarro will be billing less hours and revenues will decline. This is certainly a possibility and one of the main risks in my opinion. One needs to remember that this scenario might be deflationary for revenues, but it will be deflationary for costs as well (i.e higher margin). As an example, based on 2023 numbers, if margins can go from 14% to 21% then revenues can decrease by 34% and Ebitda will still remain constant.
I also don’t think that Nagarro and their competitors are just going to sit by without trying to circumvent the deflationary revenue outcome. One way in which they could do this is by moving the majority of their projects to a fixed-bid billing method.
Competitors
Nagarro’s closest competitors are digital engineering firms Endava, Epam and Globant. The two main conclusions from the above table is 1) Nagarro is meaningfully cheaper and 2) Nagarro has a lower operating margin than the competitors (Nagarro at 10% vs competitors at ~13%). I suspect the lower operating margin indicates that Nagarro works on less technically complex projects as compared to their competitors. These projects must be priced cheaper and thus Nagarro earns a lower margin.
I think there is a good argument that with time Nagarro will be able to win higher margin projects. Nagarro is the smallest competitor and has only been a standalone company for ~3 years (prior to that they were operating under another German holdco). It is risky for the CTO of a large corporation to assign a large mission critical IT project to a small relatively new company like Nagarro as opposed to larger more established firms. In case such a project is a failure, questions will be asked around why the CTO didn’t go with the larger well known competitors. As such, the companies with scale tend to win bigger and higher margin projects. I don’t think there is any reason why Nagarro won’t move into the higher margin project bracket as they grow and continue to execute projects successfully. But it will take time for them to do this. Nagarro has the lowest wages per employee vs competitors due to them delivering most of their work out of India. This gives them the opportunity to undercut competitors on pricing when going head to head for new business.
Capital allocation
As mentioned above, scale is important to win projects. I think that is why the companies in this industry tend to use their FCF for acquisitions and grow scale that way. Nagarro will likely continue to deploy FCF into acquisitions, debt paydown and share buybacks. Their capital allocation makes sense and will likely boost per share earnings and equity value which provides additional upside not accounted for yet.
Insider ownership
The chairman of the board holds 21%
Manas Human, CEO, holds 6%
Vikram Sehgal, COO, holds 6%.
Other management holds 4%
This is a large insider ownership and gives confidence that management interests are aligned with those of shareholders. The share free float is 57%.
3. Checklist and conclusion
I feel comfortable having a 8-10% allocation to Nagarro. The current valuation provides a margin of safety in case things don’t go according to plan and in the upside scenario there is scope for more than a 100% re-rating to around €160 per share.
[1] https://arxiv.org/pdf/2302.06590.pdf