2023-03-16 08:35:43 ET
Summary
- PagerDuty's bull case always points to its very high gross margins. But there's a lot more to this story.
- PagerDuty's income statement regularly adds back more than 25% of its revenues as adjustments to its profitability.
- With the macro environment becoming more restrictive, I believe that PagerDuty's growth rates will come under pressure.
- PagerDuty's earnings call says the word "tough" 5 times. I believe that sums up this investment.
Investment Thesis
PagerDuty's ( PD ) motto is that the world is always on, let's keep it that way. And true to its motto, the company continues to press forward.
But, like most GAAP unprofitable tech companies, PagerDuty has been a tough investment in the past couple of years.
And even though PD stock is up premarket, I struggle to see the appeal of chasing this stock.
Why PagerDuty?
It's difficult to imagine that this small company has the roaster of customers it does. Case in point, during PagerDuty's earnings call , we are told that PagerDuty has been adopted by nearly 70% of the Fortune 100 companies and close to half of the Fortune 500.
The reason why these blue-chip companies use PagerDuty's platform is that they recognize the need to ensure their operations don't have any downtime.
PagerDuty's focus is on ensuring that its customers' digital assets don't get interrupted. And within these few sentences, we see both the bull and the bear case.
The bull case points to PagerDuty's extremely high customer ROI figures.
PD Q4 2023 presentation
These ROI figures demonstrate the value that PagerDuty's customers get out of embracing one or more of its solutions.
While the bear case makes the argument that PagerDuty's addressable market is constricted since most companies don't need so many incident response modules.
Yes, the digital transformation is underway. But for most companies, particularly those outside of the fortune 500 that haven't got the wherewithal, the macro environment has become too challenging, whereby having to pay several $10K to ensure their IT infrastructure hasn't got any downtime, may be an impossible ask from SMBs.
To echo that, this is what PagerDuty's CEO Jennifer Tejada said on the call,
[...] we saw customers exercising more diligence and adding approval levels for medium to large deals. This has resulted in sales cycles elongating each of the past three quarters and transaction sizes decreasing.
This has been a theme across the earnings season, that customers have the need to modernize their digital operations, but sales cycles are elongating.
Revenue Growth Rates Are Going to Decelerate
Even if we acknowledge that PagerDuty has always been conservative with its guidance, the upcoming guidance shows that its revenue growth rates are slowing down.
Indeed, let's assume that fiscal Q1 2024 ends up with 25% y/y growth rates, which is higher than current guidance and higher than analysts expect, that will be a significant deceleration from the exit rates of fiscal Q4 2023.
Even while acknowledging that the comparables "should" get easier in the second half of the year, I believe we can acquiesce that for now, PagerDuty's +30% CAGR days are not likely to manifest themselves.
Therefore, investors will with time become increasingly mindful of its profitability profile, which is what we'll discuss next.
Profitability Profile, Mind the Gap
Anyone that follows PagerDuty closely will know that part of the reason why the stock has languished is that it is significantly GAAP unprofitable.
In fact, consider the gap between its clean earnings and adjusted earnings.
There's consistently more than 25% of its revenues added back to its bottom line.
And on top of that, given that PagerDuty's share price isn't going anywhere fast, that means that management's take-home compensation package isn't as valuable as it may have appeared two years ago. Hence, there will be more SBC coming through PagerDuty's income statement to bolster management's compensation packages, in order to retain top talent at the company.
PD Valuation - Improving Risk-Reward
The one area where the bulls could make an investment case is that PagerDuty's valuation has been moving lower over time.
However, even then I would push back and remark that PagerDuty's valuation has come down because its growth rates are also trending lower.
So, then, we once again encircle that with its growth rates decelerating, investors will become increasingly attentive to its bottom-line profitability.
The Bottom Line
This is my key contention, even though PagerDuty's platform offers tremendous value in terms of ensuring that its customers' observability needs are met, the cost of its offering is too high, so this restricts its total addressable market.
Along these lines, this is what Tejada stated on that call,
From a new customer acquisition perspective, tighter budget management and more restrictive buying authority added increased friction to landing new accounts, particularly in SMB.
In a bull market, with "free money", PagerDuty wasn't growing that fast. And now? Now, as we look ahead, beyond the Fortune 500, I suspect that its growth rates will come under pressure.
For further details see:
PagerDuty Earnings: Don't Chase These Shares