Summary
- As many other growth-oriented stocks, PagerDuty has rallied so far in 2023, up 17% YTD so far.
- As a consequence, the stock is trading at a premium valuation while still being far from showing clear scale in its operation results.
- An investment in PD is inherently risky at these prices, moreover, the company has been diluting shareholders on average 5% per year.
PagerDuty, Inc. (PD) operates in the interesting DevOps niche of incident management by providing companies and professionals with alert monitoring, escalation support, on-call scheduling all integrated with the most widely used enterprise software. The company has grown quite consistently since becoming publicly traded in late 2019, however the stock is still trading below its IPO price.
I have looked at PagerDuty in the past but I never found the stock to trade at a very compelling price, and my opinion has not changed yet. The stock is still trading at what I consider to be a premium valuation despite being still an unprofitable company, albeit basically operating at break even. That adds by itself a high degree of uncertainty in terms of how to value the company, before even taking into consideration a high impact of stock-based compensation to shares dilution and the general market sentiment around this kind of growth companies. For these reasons, I consider PD a watchlist stock that can be interesting only at much lower prices, or after proving very clearly that it is reaching scale.
Good top-line growth, no clear sign of scale
PD 3Q 2023 results (PagerDuty Q3 Presentation)
The latest quarterly results published by the company on December 1 were well accepted by the market, with the stock up about 5% on the day but more importantly up a total of 36% from that day, buoyed also by the market rally we have witnessed in 2023 so far. Let’s briefly review what was reported at the time and why the reaction was so positive.
PagerDuty managed to still post a high revenue growth rate of 31% YoY to $94.2 million, more or less in line with the latest results which shows a certain degree of resilience by PagerDuty in an economy that saw many cloud operating companies post a slower rate of growth.
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Welcome news also on the Gross Profit Margin side, as a downward trend that was pretty much ongoing for the past two years finally reversed, with a higher gross profit margin of around 80% realized in the quarter. Management did not unfortunately offer particular commentary on the reason behind this slight outperformance, and more importantly if this has to be expected going forward or not.
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Operationally the company is still losing money, despite management cheering the adjusted, Non-GAAP operating margin of 3% for a non-GAAP net income per share of about $0.04. In reality, during the quarter the company did not even reach positive cash from operations (which came in at negative $400,000), for a negative Free Cash Flow of about negative $2.2 million.
Guidance and what to look for in the future
PagerDuty is set to release fourth quarter and full fiscal year 2023 results in about a month, on March 15. Management has guided for a slower rate of revenue growth for the fourth quarter between 25% and 27%, while on a fully year basis PD should close FY2023 with an overall top-line growth rate of 31%. The slowing revenue growth rate is somewhat concerning as historical data does not show seasonality in PD’s results, hence the subdued growth rate comes as a bit of a surprise.
What I don’t particularly like about PagerDuty is that 2022 saw a sudden stop to a growing trend of positive cash from operations. As evidenced from the chart posted below, PagerDuty was able in 2020 and 2021 to consistently grow cash from operations which seemed to indicate that the company was reaching some sort of scale. Nevertheless, 2022 came in and the trend quickly reversed and the stock value followed suit. The real question is, was the upward trend just a fluke caused by the COVID-induced economy or was it just a peak at the future to come? I honestly do not know the answer to the question, which is the main reason why I don’t see PD as a good investment at the moment from my personal standpoint.
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The evolution of cash from operations is definitely the number one metric I will monitor going forward to understand how this business is actually growing. Management has already stated that they expect positive FCF in the fourth quarter which is a positive, however I am curious to see how positive it will be.
Despite good organic results, PD also acquired few businesses along the way to complement its offerings, the latest of which being the low-code and no-code platform Catalytic acquired for about $66 million in cash judging by the company’s financials at the time. I will look for more details in the full year report that will be published next quarter as for now it is unclear if there has been any material positive impact from Catalytic to PD’s revenue as management has not shared much details. During the latest call however, when asked about its integration by an analyst CEO Jennifer Tejada expressed her appreciation for what was accomplished so far:
One of the critical success factors for us has always been to make the app that our users are engaging with as simple and usable as possible. [...] It felt like a really natural next step to really move into no code or low code workflow automation, because you can't get much simpler than sort of drag and drop.
[Large enterprise customers] want to change what has been historically a very deterministic workflow and so flexible workflows and no code workflows really open up a lot of that opportunity for us and just make it easier for customers to deploy PagerDuty's automation into different types of incident response process and more broadly different types of interrupt work.
Stock-Based Compensation
As many other tech companies, PagerDuty relies extensively on Stock-Based Compensation (“SBC”) to remunerate its employees. I do not have any ideological adversity to the practice as I do appreciate the tangible effects on preserving cash that can be used to grow the business. That is particularly true for young, growth-oriented companies exactly like PagerDuty. However, SBC always raises two very important questions in relation to what the business is achieving with the retained cash, and how much shareholders have been impacted by shares dilution.
As PD has not achieved consistent profitability at least on the cash flow basis, clearly an ample liquidity cushion is a must-have in order to operate. At the moment the company has a balance sheet in a good shape, with about $459 million of cash and cash equivalents and $282 million of long-term debt. The business does not appear to be very cash intensive either as CapEx have always been less than $10 million per year, although the company has used cash over the years to perform some acquisitions.
At the same time, Total Shares Outstanding have been growing between 4% and 6% per year since the company became public, which is actually the price that shareholders are paying primarily for the SBC expenses. Is the price worth it? I would argue that for the moment PD has not shown particular ability to create any meaningful economy of scale but the SBC has helped the company maintain a cash cushion on the balance sheet. As the company operates pretty much on a break-even level, the cash retained from the SBC would allow the company to fund its operation for several years to come which is probably the goal management was shooting for all things considered. Nevertheless, shareholders have been impacted substantially and this has to always be taken into consideration when valuing the company.
Valuation and key takeaways
PD is currently trading at a market cap of about $2.7 billion, at a somewhat premium valuation of about 7.6 TTM P/S. That is a far cry from the peak of about 24 reached in 2020, but nevertheless it is still indicating in my opinion a general positive sentiment that the market attributes to PagerDuty, and I can see why: the company could very well turn out to be a good bet, as it has very high gross margin and is basically at breakeven point from a cash flow basis. This indicates that if PagerDuty ever takes off and manages to reach scale, create a moat, charge customers more this will potentially translate to a very high quality business generating ample free cash flows.
The point is however that there is no guarantee of that happening. Granted, the word guarantee seldom belongs to anything even remotely related to investments, however the point I want to make is that I fail to see a clear catalyst that suggests to me that PD has indeed what it takes to make it. It could happen, but it could also very well not. And at the current valuation of 7.6 P/S any bad news or negative market sentiment can easily cut the stock in half. In addition as explained above, if the SBC trend stays the same investors should also expect a 5% headwind to yearly returns due to shares dilution. I can see PD as an interesting risk-reward scenario at a much lower valuation, which could happen if the bear market resumes its downward trend and everything crashes. It is a watchlist stock at the most for me, which explains my hold rating.
For further details see:
PagerDuty: Add It To Your Watchlist, Not Your Portfolio