2023-06-22 11:55:52 ET
Summary
- CS Disco is still a buy as its valuation does not reflect its potential, with 1Q23 performance supporting this view and an accelerated timeline for achieving positive EBITDA in 3Q23.
- The introduction of Cecilia, a fully automated intelligent chatbot, should aid in improving future growth profile.
- Operational changes and cost investments have set the company on track to reach EBITDA breakeven, which I think will serve as a catalyst for the stock.
Summary
I reiterate my belief that CS Disco (LAW) is still a buy as valuation still does not reflect its potential, and performance in 1Q is supportive of my view. The key development here is that management has accelerated their planned achievement of positive EBITDA by one quarter, to 3Q23. This is likely to have a significant impact on the stock price, as investors today tend to favor profitable companies. The introduction of Cecilia has also enhanced my growth outlook for LAW. Ultimately, I anticipate that LAW will continue to ride the wave of digitalization in the legal industry while progressing toward EBITDA breakeven. The balance sheet remains in net cash position so there are no concerns on dilution or interest rates movement.
Optimistic about growth ahead
My sense is that things are slowly but surely improving, as evidenced by LAW adding 61 customers in 1Q23 (for a total of 1,388 customers in 1Q23), a significant acceleration from the 9 adds in 4Q22. While management's FY23 guidance indicates a slowdown in y/y growth will continue in 2Q23, I expect this to be a temporary hiccup that will be corrected as the economy recovers over the next few quarters. I say this because I believe that the low 2Q23 results were caused by underlying customers reducing their usage of the LAW product in an effort to optimize their cost expenses. The sequential drop in annualized revenue per customer from $98.1k to $95.5k, as well as the rise in ECA utilization, are indicative of this trend. Customers who are still buying LAW products may rekindle this outlay of cash once optimism about the economy returns, providing a boost to LAW's growth in the near term. Crucially, management has noted an acceleration in their pipeline since the beginning of the year, giving me hope for accelerated revenue growth in the near-term ahead.
Faster path to profits
With the operational changes they have implemented, I am confident that LAW will soon reach EBITDA breakeven/positive status, which will be a key catalyst for LAW stock to work. As the major cost investments have been made, I expect nothing less than what management is guiding for (3Q23 EBITDA breakeven). LAW has finished cutting back on staff, investing in its employees, and setting up its presence in India (to provide low cost 24/7 support). With lower investment needs, improved efficiency and productively, I see a clearer path towards adj, EBITDA profitability. Given that the market is not factoring in a breakeven point for LAW until 1Q25, I anticipate a substantial uptick in share price action if management is successful at driving this. LAW achieving breakeven EBITDA in 3Q23 will force consensus to upgrade their estimates, which should drive a positive headline momentum.
Implementation of generative AI
Cecilia, a fully automated intelligent chatbot with access to sensitive data in the ediscovery database, was recently released by LAW. Customers and salespeople have praised this product for making their lives easier by streamlining the search and queueing processes, so it stands to reason that LAW overall product offering will benefit from this innovation. This should reduce the friction during the adoption phase, thereby increasing the conversion rate. That said, I do not expect this to have an immediate impact on growth in the near term as it will be rolled out gradually. While the use of Cecilia has not been factored into FY23 guidance, it could be a tailwind to revenue growth in 2H23 if LAW is able to implement this sooner than expected.
Valuation
According to my model, LAW remains undervalued after hitting my previous target price. At this price, investors can expect a 29% return over a two-year period.
My model assumption is based on management's FY23 revenue guidance and my belief that the company can accelerate its growth as it rolls out Cecilia and budget normalization in customers that are cutting back usage today. One critical assumption is the price at which LAW will trade in FY23. LAW is currently trading at 1.8x forward revenue, and I believe the multiple should inflect when LAW achieves EBITDA breakeven in 3Q23, which is likely to drive a wave of positive estimates upgrades, thereby driving strong stock sentiment.
Risk
Digitalization might not be a top priority for many firms yet
As one might expect, law firms exist to fight legal cases, and there are a plethora of cases out there for the limited number of law firms to address. My greatest fear is that, while the LAW solution is excellent, it will never be a significant priority for law firms simply because existing solutions can still be effective. As a result, while LAW TAM is enormous, the rate of growth may be slower than expected.
Competition
LAW is not the only one doing this in the market. There is a lot of variety, rivalry, and flux in the market for legal technology services. The vast majority of businesses that might be interested in LAW services already have ediscovery and legal document review solutions in place. These services are typically provided by a mix of on-premise point solutions and human professional service providers. Competitors include large international firms like Consili and Epiq Systems as well as smaller regional and local ones like Deloitte and KPMG.
Conclusion
I maintain my buy recommendation on LAW as its valuation still does not reflect its potential, and the company's performance in 1Q23 supports this view. The accelerated timeline for achieving positive EBITDA in 3Q23 is a significant development that is likely to positively impact the stock price, given investors' preference for profitable companies. The introduction of Cecilia and the expected improvements in the economy should drive LAW's growth in the near term. With operational changes and cost investments already made, I expect LAW to on track to reach EBITDA breakeven, which will serve as a catalyst for the stock.
For further details see:
CS Disco: Reiterate Buy Rating As Stock Is Still Undervalued