2023-08-10 05:41:44 ET
Summary
- PagerDuty is a high-quality company with a gross margin above 80% and potential for profitability improvement as it scales up.
- The company has demonstrated impressive revenue growth with a 37% CAGR over the past five years.
- Despite facing short-term volatility, PD is well-positioned to capture a significant portion of the large addressable market and sustain its growth trajectory.
Investment thesis
I like companies that are demonstrating high gross margins consistently. A high gross margin means the company has vast room to reinvest in marketing and innovation. The first is the excellent fuel to boost short-term sales dynamics, and the latter is crucial to differentiate and build long-term value for shareholders. PagerDuty (PD) is a high-quality company that can deliver above 80% gross margin. Despite a relatively small scale, the company is very close to start generating positive free cash flows. That said, as the business scales, PD is poised to expand its profitability metrics notably. At first sight, the valuation might not look attractive, but I think companies like PD should trade with a premium over the long term. All in all, I assign the stock a "Buy" rating.
Company information
PagerDuty is a digital operations management platform that manages urgent and mission-critical work for a modern, digital business. PD generates revenue primarily from cloud-based subscription fees. Mid-market and enterprise customers account for the majority of sales.
The company's fiscal year ends on January 31 with a sole operating segment. According to the latest 10-K report, in FY 2023, the company generated about a quarter of its sales outside the U.S.
Financials
PagerDuty went public in 2019 , so we have a relatively short earnings history for the analysis. The company has demonstrated impressive revenue growth over the past five years with a 37% CAGR. The gross margin is stellar at above 80%, meaning the company has vast opportunities to invest in marketing and innovation. PD can generate over 80% in gross margin because of the low cost of generating revenue, which includes primarily employee benefits and payments to third parties for using the infrastructure. Despite PD being a relatively young company, I like that the free cash flow [FCF] margin ex-stock-based compensation [ex-SBC] is close to breaking even.
The gross margin might look deteriorated in FY 2023, but this was due to increased amortization for intangible assets, a non-cash expense, and one-off restructuring costs due to a 7% headcount cut. The SBC also grew notably, but I do not consider it a big problem since it is a non-cash expense and part of the team's incentive package to build long-term value. Therefore, the relative weakness in the FY2023 gross margin compared to previous years is temporary and not secular. It is also important to emphasize that the gross margin will benefit from the efficiencies generated after restructuring in the upcoming quarters.
PD spends substantially on selling and R&D expenses to fuel revenue growth and improve customers' experience by increasing value from PD's offerings. The company reinvests more than 30% of its revenue in innovation, which is a good sign for investors. The SG&A to revenue ratio is high at 75%, meaning there is a big room for profitability improvement while the business will scale up.
The company's balance sheet is sound, with solid liquidity metrics. The leverage ratio might look high, but PD is in a substantial net cash position, and the major part of the debt is long-term. Given that the company is close to achieving a consistent positive FCF margin, the balance sheet is in excellent shape.
The latest quarter's earnings were released on June 1, when the company confidently topped consensus estimates. Revenue demonstrated solid growth momentum with a 21% YoY increase. The adjusted EPS followed the top line and improved from -$0.04 to $$0.21. A solid bullish indicator is that the company's operating margin improved significantly, from -38% to -15%. That said, the FCF ex-SBC was slightly above zero, compared to -$11 million last year.
The upcoming quarter's earnings release is scheduled on August 31, revenue is expected to increase about 17% YoY. That said, the strong revenue growth momentum is still in place. The non-GAAP EPS is expected to expand YoY notably, from -$0.04 to $0.11.
I like the company's financial performance and positive trends in profitability metrics. A stellar gross margin is also a vital bullish sign for me, meaning the company has vast room to invest in R&D and achieve a strong FCF margin once the business scales up enough. Substantial R&D investments mean the company is highly likely to differentiate its services and successfully provide long-standing value to customers. That said, the company is well-positioned to absorb industry tailwinds of the secular shift to greater digitalization. PD's management assesses the company's total addressable market over $38 billion, which is massive. I also like the management's strategic plans to develop ways to improve revenue per customer by introducing new products and functionality. That said, new cross-selling and up-selling opportunities are likely to appear in the nearest future. I also see international markets as a great growth opportunity for PD.
Valuation
The stock significantly underperformed the broad market this year, with a 7% decline in price. Seeking Alpha Quant assigns the stock a low "D+" valuation grade due to high multiples, which are substantially above the sector median. On the other hand, the company's current TTM price-to-sales ratio is almost two times lower than the five-year average.
PD is a growth stock. Therefore, I use the discounted cash flow [DCF] approach to proceed with my valuation analysis. I use a 10% WACC for discounting. I have consensus earnings estimates for the upcoming five fiscal years and project a 10% revenue CAGR for the years beyond. I expect the FCF margin to be zero in the upcoming fiscal year and to expand by 150 basis points yearly starting from FY 2025.
The stock looks fairly valued with almost no upside potential. I want to emphasize that the company's net cash position does not affect the fair value significantly. Therefore, I ignore it for my valuation analysis. Based solely on figures, I cannot conclude that the stock is undervalued valued based on DCF. On the other hand, given the company's impressive revenue growth profile and stellar gross margin, the stock should trade with a premium to the present value of its future cash flows. Let me cite the great Warren Buffett here:
It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
PD looks like a wonderful company, in my opinion. That said, the stock looks attractively valued.
Risks to consider
As a growth company, PD's investors face a significant risk of changes in underlying assumptions for future cash flow projections. Any downgrades to both near-term guidance or long-term estimates will likely lead to investors' disappointment and a potential stock sell-off. For a relatively small growth company, it might take multiple quarters or years before the stock regains positive market sentiment. That said, investors in PD shares should be ready to tolerate short-term volatility and have a long-term mindset.
Since the company's TAM is massive at $38 billion and the business has relatively low entry barriers, there is a significant risk that the competition will intensify in the upcoming years. Therefore, PD should be ready to protect its market share and growth prospects by differentiating itself from the competition. This includes not only the direct benefits to customers from PD's offerings but also cybersecurity and data safety issues.
Bottom line
To conclude, PD stock is a "Buy" for long-term investors ready to buy and hold. As a growth stock, it is highly likely to face intense volatility and market overreaction even to minor signs of temporary weaknesses. But the company operates in a young and large addressable market. It is well-positioned to capture the notable part of the pie due to its ability to reinvest a substantial portion of revenue in R&D to marketing. The past five years' solid financial performance gives me a high conviction that the company can sustain its impressive revenue growth trajectory and profitability metrics expansion.
For further details see:
PagerDuty: A Solid Long-Term Buy