Summary
- Revenue fell for the first time in LAW's history, and I have some concerns about whether the deteriorating growth profile is due to internal execution or external competition.
- Management aims to reach EBITDA profitability by the end of 2024 and expressed confidence in achieving this goal.
- As LAW's margin improves and growth reaccelerates, I believe it will attract more investors to invest in it and lead to an upward rerating in valuation.
Summary
Although CS Disco's ( LAW ) 4Q22 results showed a revenue beat of 3% and earnings that were above expectations, I think the real highlight is in the FY23 guidance and management aim of reaching EBITDA profitability by the end of 2024. Management FY23 revenue guidance implies a 3.6% increase at the midpoint, and EBITDA of -28.6% margin. Product wise, eDiscovery is doing well in terms of growth and net dollar retention, which is great to see, but other products are falling behind. With regards to guidance, I think the most important development to track now is how LAW manages costs to hit its margin target by FY24 (less than 2 years).
Overall, I continue to recommend LAW stock as a buy due to its superior enterprise legal platform. I remain positive that LAW solutions will boost attorney efficiency, thereby mitigating the effects of rising demand for legal services and the ensuing complexity of the legal landscape. Valuation wise, it is valued at only 1.4x forward revenue, which is near all-time low. Also, there are also no worries about capital raising because of the net cash position of the balance sheet.
4Q22 results
Adjusted EBITDA margins were -37%, and total revenue was down 4% year over year. Though LAW came in just ahead of expectations, I want to point out that revenue fell for the first time in LAW's history, with management blaming a drop in Review caseloads for the first time. In any case, I'm worried about whether or not the business's deteriorating growth profile is the result of poor internal execution or a more competitive external environment. I also anticipate some short-term revenue headwinds as comps remain tough for 1Q23.
Positives
On the positive side, LAW can get to positive EBITDA much more quickly. Management expressed their confidence in attaining positive EBITDA by the end of 2024. However, achieving this goal will necessitate the revitalization of sales and the implementation of careful cost reductions in operations. While I hope for this to happen, I note that we need to be aware that the guided 1Q23 margin is -49% at the midpoint, which is a huge negative figure. Also positively, the eDiscovery module's has demonstrated strong growth, with annualized growth of more than 30% bringing total revenue to $105 million. Aside from these, with the CEO hinting at potential shifts in LAW's talent mix and heightened scrutiny in non-staff operating costs, I am keeping an eye on where management is going to cut these expenses from (different departments have different impact to the P&L).
Negatives
Those who keep tabs on LAW could see that it printed the lowest NDR in the company's history. NDR came in at 106%, which is significantly lower than the 146% recorded last year. Furthermore, customer growth is slowing down. The year-over-year increase in new customers slowed dramatically, from 26% to 18%, translating to only 9 net new customers in the quarter, which was also the fewest in the company's existence. Even if I pin the blame on things like macroeconomic weakness, I'm still concerned that this slowdown will cause investors to doubt LAW's ability to carry out its growth and cost savings plans, which will have an impact on growth estimates over the medium to long term. Review Product's impact on top-line growth (making it more volatile) is also not positive as I believe it will make it more difficult for investors to accurately assess underlying performance.
Valuation
I believe LAW still has a 22% upside, and the key assumption is that the slowdown in growth is only temporary. I expect growth to reaccelerate as LAW overcomes the current headwinds. What I want to emphasize is that the valuation is near all-time lows, LAW is in net cash position, and management is aiming for EBITDA breakeven by FY24. As LAW improves, I believe it will pique the interest of more investors, causing valuations to rise. Any upward rerating in valuation from here would provide additional upside in my model (I modelled 1.4x forward revenue which is the same as current valuation). Of course, the risk is whether LAW can carry out my expectations, which I believe they can.
Conclusion
The real highlight for 4Q22 lies in the FY23 guidance and management's aim of reaching EBITDA profitability by the end of 2024. As such, I believe the most important development to track now is how LAW manages costs to hit its margin target by FY24. Despite concerns about deteriorating growth profile and short-term revenue headwinds, I continue to recommend LAW as a buy due to its superior enterprise legal platform, net cash position, and low valuation. As LAW improves and growth reaccelerates, I believe it will attract more investors and lead to upward rerating in valuation, providing additional upside.
For further details see:
CS Disco: Margin Expected To Improve Significantly Through FY24