IONQ - D-Wave Q2: Profitability Issues But Its Product Is Seeing Traction From AI

2023-08-11 11:17:08 ET

Summary

• D-Wave Quantum Inc. has just released its second-quarter 2023 results, missing on both the top line and bottom line.
• The company's quantum computing, or QC, technology has potential applications in artificial intelligence, or AI, improving performance and efficiency.
• D-Wave faces competition from other quantum computing providers, but its commercialization efforts and advancements in technology may drive stock gains.
• However, it is also important to look for profitability given that this is a loss-making company.

D-Wave Quantum Inc. (QBTS) has just announced its second quarter (FQ2-2023) where it missed both earnings and revenue expectations.

Now, as shown below, the current share price of $1.48 is well below the post-IPO high of $12.4 reached on August 9 last year. One factor that contributed to market enthusiasm was the announcement of commercial access to an experimental prototype of its Advantage2 Annealing QC (Quantum Computer).

Now, considering this is a loss-making company that obtains most of its revenues through research-oriented products and services , my objective with this thesis is to assess whether going commercial on the QC prototype has improved the financial position, which would in turn justify an investment.

First, I provide insights into how QC, which is already expected to play a disruptive role in the computing industry, could get more traction through its association with artificial intelligence or AI.

The Relationship between AI and QC

These are two rapidly growing fields with QC based on the principles of quantum physics and using quantum bits (or Qubits) to process data. In this way, computers based on technology can carry out specific tasks much faster than conventional computers which we commonly use. Examples of application areas include cryptography and search optimization. As for AI, it can be envisioned as aiming to simulate human intelligence through applications like image and speech recognition, but the one with which most of us may be familiar includes the intelligent reports generated by ChatGPT, whose software algorithms use Generative AI.

Coming to the dynamics between the two, QC could improve the performance of AI systems in several ways like accelerating computations needed for certain tasks. In addition to speed, AI-related problems could be solved more efficiently using QC while also dealing better with complex data models than commonly-used computers. For this purpose, D-Wave’s technology is already used in practical applications in AI, as well as in logistics, materials sciences, drug discovery, scheduling, cybersecurity, fault detection, and financial modeling.

As for clients, these are some of the world’s most advanced organizations as pictured below.

Now, one of the challenges in operating in the innovation field is that sales are not that straightforward as it takes time to come up with a commercially-viable product that is appealing enough for the large organizations above to invest their money into, which initially often takes the form of research funding.

Sales and Estimates for FQ2-2023

This funding translates into revenues, and, looking exclusively at the last quarter's disappointing top line may be misleading. Thus, focusing on the longer term and with its first-mover advantage in QC, D-Wave, as seen in the table below has still managed to show progress. From the quarters starting in September 2022 and ending in June 2023, revenues have totaled $7.4 million, or a 9% increase over the preceding four quarters (September 2021 to June 2022). This is, in turn, explained by an increase in the average deal size for revenue-producing commercial customers increasing over time.

Another explanation for the top line miss of $0.05 million below the $1.76 million expected is again explained by the nature of D-Wave's quarterly revenues which, unlike those companies that depend exclusively on economic cyclicality, are also dependent on the timing of professional services delivered. Thus, to obtain a better idea of demand, one can look at bookings, or orders expected to generate future sales which, at $2.5 million for FQ2-2023, represented a 146% surge compared to the same period last year.

Furthermore, the sales of $1.71 million represented a 24.8% YoY growth and, due to a growing appetite for its products by commercial, educational, and government customers, D-Wave's YoY growth is forecasted to reach 71% and 122% for the third quarter and fourth quarters, respectively, as shown below.

Now, with such expectations, it is not surprising that the company's forward Price-to-Sales multiple at 18.6x is 584% higher than the median for the IT sector despite its recent 12.4% slide. Thus, from a purely valuation perspective, this is not an opportunistic buy.

On the other hand, given that it is still at a one-month low of 24% when compared to peers IonQ ( IONQ ) and Rigetti Computing ( RGTI ), D-Wave's stock could produce gains as a result of news-driven catalysts pertaining to QC's role as an AI improver.

However, I have a Hold position on the stock as amid all the opportunities, there are also risks.

The Competition

First, looking at competitors, IonQ is more of a general-purpose QC systems service provider which has seen a sustained revenue growth rate (pale blue chart below). This success can be attributed to the rapid adoption of its SaaS model to sell Qubits through the cloud platforms of Amazon Web Services ( AMZN ), Microsoft’s ( MSFT ) Azure, Google’s ( GOOG ) GCP, and its own cloud infrastructure.

As for Rigetti, it also sells solutions through the cloud for a diverse range of industries and has a wider geographical footprint, but, with its revenues plunging in the latest reported quarter as per the orange chart below, its timing problem seems to be more pronounced than D-Wave.

As for D-Wave whose latest quarter sales are not included in the above chart, it also boasts its own Leap cloud service, uses Amazon's cloud, and, more importantly, is the only one building QCs using both Annealing and gate-model techniques. Moreover, the commercialization of its Annealing QCs has permitted researchers to solve complex problems much more rapidly than classical computing, which partly explains the higher customer booking numbers. As a matter of fact, the Advantage2 prototype mentioned during the introduction has delivered a fourfold increase in coherence compared to earlier versions.

However, despite all its technological prowess, it is important for the company to execute on commercial and production readiness in order to be less dependent on timing, which would place it in the same league as Ion-Q (above pale blue chart) which has delivered more consistently on sales. Delivering more sustained quarterly sales growth can also ensure that D-Wave does not have to contract more debt (than the actual $31.5 million) to finance operating expenses which amounted to $21.6 million in FQ1-2023, while being equipped with only $7.5 million of cash.

The Risks and What to Look for Before Investing

As a solution, D-Wave contracted a four-year term loan agreement of $50 million out of which $30 million has already been drawn. Additionally, it raised approximately $20 million through a common stock purchase agreement signed with Lincoln Park in June last year for the right to sell up to $150 million of common stock.

Therefore, the company has raised a total of $50 million both through debt and equity funding to ensure having enough liquidity to fund operations.

Noteworthily, while debt implies paying high-interest rates, selling common stock dilutes shareholder's equity as additional stocks are issued and put up for sale given that the share price is significantly lower than in 2022. Also, in view of tighter monetary conditions currently in place after the U.S. Federal Reserve hiked interest rates to more than 5%, investors may punish D-Wave's stock in case it is not able to raise further capital at reasonable rates. As a result, its value could plunge below the $1 level as happened in February this year, further consolidating its position as a penny stock and a risky one too due to the higher volatility associated with holding on to the stock compared to a higher valued one.

Thus, for those interested to position themselves, and bearing in mind that the management aims "to drive the business to profitability," it is important to watch out for profits, especially given that GAAP gross margin for the second quarter decreased by 13.5% on a YoY basis.

Well, an improvement is possible firstly due to the resiliency of the business model in terms of capital spending, which has been kept around $0.08 million as shown by the blue chart below.

This means that the company's quantum solutions are transitioning from a capex-intensive R&D phase to more business-as-usual solutions which can be subject to cost-cutting. Furthermore, on the Opex side, some of the costs related to the preparation and execution of the IPO including legal and accounting expenses as well as stock-based compensation are non-recurring and are on a downtrend.

Here, the metric to focus on is the Earnings per Share which was $-0.16 in the last reported quarter but was expected to decrease to $-0.13. This means that a lot of progress still needs to be made both in terms of cost of sales and operating expenses to improve profitability.

In this respect, given that inflation remains high in developed economies like the U.S., Germany, and the U.K. which accounted for more than 50% of the company's revenues in FQ2 2023, it is also important to assess whether D-Wave can achieve an EPS of $-0.13 for the third quarter.

Conclusion

In conclusion, this thesis has shown that D-Wave Quantum Inc. has indeed improved its top line through the monetization of its QC prototype, but there is also a need to drive profitability. In this respect, more details about cost savings should help, for a company that went public through a SPAC deal valuing the combined company at around $1.2 billion and which is worth less than $220 million today.

Finally, pertaining specifically to artificial intelligence, D-Wave's feature selection tool has already been used by some customers to optimize AI and machine learning models for addressing some of the limitations of classical computing in application areas like TV commercial advertising optimization and fraud detection. In this respect, the management has elaborated on monetizing strategies including availability on Amazon's cloud and investors should watch out for the related sales opportunities.

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