INFA - Informatica: Good Progress With Transition To Cloud-Only Sales Model

Summary

• INFA has a strong Data Management foundation and potential to capture a growing share of the digital transformation market.
• INFA is making positive progress in transition to a cloud-native, subscription-based business model.
• I recommend taking a small initial stake and size up as INFA moves beyond the challenging FY23.

Investment thesis

Due to its solid Data Management foundation, Informatica ( INFA ) is exposed to the long-lasting secular theme of digital transformation. I think INFA is in a great position to capture a growing portion of a sizable TAM as a result of its re-platforming to cloud-native products and its subsequent pivot to a subscription business model. Once we get through this transition period, I believe INFA revenue growth is set to accelerate, which will attract back shareholders that have exited shares to sidestep this period. Despite the fact that the market is crowded with established competitors, I have faith in INFA's continued success thanks to its widening customer base and innovative product offerings.

However, while things are looking up in the mid-term, I see prolonged deal cycles and budget scrutiny as potential headwinds. On top of that, maintenance conversions are also expected to be small. The combination of these factors does make me worry about INFA missing guidance. Therefore, I think the best course of action is to make small initial investments and then size up as we move beyond the challenging FY23. For INFA, the most important key performance indicator would be progress toward migrating its maintenance customer base to the cloud. Positive traction on these warrants sizing up, in my opinion.

Earnings thoughts

INFA stock had a strong 4Q, with Cloud ARR exceeding the high end of guidance and an EBIT margin that surpassed Consensus expectations. In particular, INFA declared its intent to hasten its transition to the cloud by shifting its sales efforts to concentrate on cloud-based products while deemphasizing its self-managed offering. My expectation is that INFA will experience a self-inflicted top-line slowdown in F23 as it deals with the implications of changing how it accounts for on-premise versus cloud revenue. INFA's disincentive of self-managed sales is another factor contributing to the slowdown. I think it's a good idea that INFA is incentivizing its sales staff to primarily sell its consumption-based cloud platform; doing so will help the company grow its installed base more quickly and improve its operational efficiency by eliminating the need for a hybrid sales approach.

In addition, the consistent growth of 40% over the past eight quarters and the robust net retention rate are important indicators of the continued momentum of INFA Cloud's ARR. With the recent restructuring and the impending move to the cloud, I am confident that INFA will be able to meet its EBIT margin target.

Earnings results

4Q22 revenue fell 2% year over year and was 1% short of expectations, primarily due to a higher cloud mix that quarter, which delays revenue recognition until a later period. Both the gross margin (at 82%) and the operating margin (at 28.5%) exceeded expectations for profitability. The impact of currency fluctuations was larger than I had anticipated, causing unlevered FCF margins to fall just short of my expectations.

The 42% y/y growth in Cloud ARR was faster than the 39% growth seen in the previous quarter, and it was also about $20 million more than the company had expected. In addition, Cloud ARR increased to $51 million from $30 million a year ago, an increase of 71%. Cloud NARR now accounts for 88% of subscription NARR, up from 67% in the previous quarter and 45% a year ago; this represents a faster-than-anticipated shift in the sales mix from self-managed to cloud, as noted by management. It's also worth mentioning that customers are responding positively to the adjustable pricing of consumption based on IPU licensing. This is evidenced by the fact that IPUs made up 38% of the overall Cloud ARR compared to 33% in the previous quarter and also accounted for 56% of new cloud sales. Also, I expect IPU adoption to increase this year, as INFA's sales efforts become increasingly consumer-centric.

Guidance

Even though INFA's total ARR guidance for FY23 was lower than what I expected (probably due to the uncertainty of this transition), I'm very encouraged by its outlook for Cloud ARR (if INFA can achieve it). As of right now, cloud opportunities account for around 3/4 of INFA's new business pipeline, and the company seems to be doing well with them despite the lengthy sales cycles that are often associated with them. On the other hand, the shift to a cloud-only sales model will have a negative implication on the Self-Managed ARR this year, with guidance indicating an 8% y/y decline compared to 12% growth in 2022. As for the near term (1Q23), management expects cloud ARR to grow 35%.

Valuation

As we move past the more difficult period (FY23), I believe investors will begin to look further ahead in terms of valuation and earnings. As a result, my revised model now includes the INFA FY25 earnings forecast (based on consensus). The underlying assumption is that margins will continue to rise, driving earnings to 330 million, a 50% increase over FY23. Using this assumption and the current valuation (Forward 22x PE), I estimate a 38% increase in the current share price.

Conclusion

In conclusion, the investment thesis for INFA is based on its strong Data Management foundation and potential to capture a growing share of the digital transformation market. The company is making positive progress in its transition to a cloud-native, subscription-based business model and has a growing customer base and innovative product offerings. However, there are potential headwinds such as prolonged deal cycles, budget scrutiny, and small maintenance conversions. I would recommend to make small initial investments and then scale up as the company moves beyond the challenging FY23. The key performance indicator to watch is progress in migrating its maintenance customer base to the cloud.

For further details see: