2023-04-14 08:15:00 ET
Summary
- Execution has been strong even during unfavourable macro situation. I still consider the stock a 30% grower and the forecasted ~20% growth in FY '24 temporary.
- PagerDuty has also evolved from a point- to multi-product solution provider, diversifying new land entry points, addressing my prior concern outlined in past coverage.
- There is a potentially large TAM for digital operations globally, but velocity of digital transformation will vary and there is a risk. Strong execution is therefore a safety net.
Having rated PagerDuty ( PD ) as neutral in my past coverage back in April 2020, I am initiating a follow-up coverage with a buy rating.
As per my observation over the past few quarters, I conclude that there are a few favorable fundamental factors - ranging from the overall strategic direction, financials, to go-to-market performance - that should make the stock a compelling long-term buy. More importantly, these factors have also evolved over the same period to soften my earlier concerns about the stock (in particular, difficulty in assessing the true TAM potential).
Timing-wise the stock is also attractive. While the stock has been up ~20% YTD, it is still trading at 7.7x P/S, a reasonable price for a 30%+ grower with a path to profitability. It has been gaining momentum coming off a solid Q4 2023 and can potentially surpass yearly high on another strong quarter. Q4 2023 was also the first quarter where PagerDuty surpassed the $100 million threshold in revenue.
Here, I will discuss my updated view on the most recent Q4 results and financials, TAM opportunity, positioning, overall strategy, and then valuation. I will also do my best to try to identify the risk factors / catalysts relevant to each item.
Background
My initial SA coverage about PagerDuty was in April 2020, back when the stock was trading at ~$17 per share). There are two key lessons derived from that coverage:
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The stock already appeared somehow attractive: Path to profitability, growth, solid expansion potential, and 80%+ gross margins were all there. Moreover, the stock was also priced at ~6x P/S, a relatively good entry point.
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I erred on the side of caution a bit too much: The key risk factor for the stock was the uncertainty regarding its actual TAM. My worst case scenario was to see the stock having a few years of good run and then experiencing tapered growth. I felt that the lack of new logo acquisition and overreliance on install-base expansion for growth was an early sign of the long-term challenge in establishing this new category of “digital operations management”.
Obviously, this was published before the acquisitions of Catalytic and Rundeck , two software companies developing AI-driven automation and low-code/no-code solutions. As per my discussion in the latter section, I feel that the expansion into AI and automation is greatly supporting PagerDuty’s strategic direction, reversing my prior view in the process.
Q4 Results Review
Here is a recap of the key financial and operating metrics as of the most recent quarter, Q4 2023 :
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PagerDuty closed the FY 2023 with $371 million, which is a 32% YoY growth.
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Q4 revenue was $101 million, a 29% YoY growth. It beats the guidance by $2.01 million.
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Q4 CF from operations was $18 million, and Q4 FCF was $16 million.
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Q4 gross margin of 86%.
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Q4 Customers spending over a $100,000 ARR grew to 752, a 27% YoY increase.
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Q4 Free and paid companies grew to over 24,000, ~20% YoY growth.
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Q4 Dollar-based net retention / DBNR of 120%.
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Expected FY 2024 revenue in the range of $446 million to $452 million, a growth rate of 20% to 22%.
In summary, the Q4 numbers were solid. As I scan through the results, here are a few things worth mentioning:
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Under the currently tough macro and IT spend environments, the 32% annual revenue growth in FY 2023 demonstrates strong resilience and execution. Given the guidance for slower growth into FY 2024, I expect the slowdown to continue for the time being. However, while the forecasted ~20% revenue growth for FY 2024 might look like a significant slowdown, growth can potentially reaccelerate into FY 2025 for two reasons:
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The macro-driven impact towards the stock is relatively softer than what I have seen towards some other cloud stocks.
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there has not been a transformative change in the stock’s fundamental and broader competitive landscape. Digital operations management remains a nascent category and a growing necessity as corporations go through digital transformations globally, albeit at different rates. As demand picks up again into FY 2025, PagerDuty remains well-positioned to capture most of that. We have seen how a similar situation played out during COVID 19, where growth came down to ~28% before re-accelerated into 30%+.
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FY 2023 Non-GAAP gross margin has looked steady at 85%+. It has been that way for the past few quarters, and is already in line with the target model. 85% is already among the best in class in the cloud software stocks universe.
It is also worth mentioning that PagerDuty has been adding headcounts quite regularly every year and incurring non-cash stock-based compensations / SBC accordingly, which eventually come at the expense of potential dilution via exercised options.
While hiring may demonstrate progress, over-hiring is damaging, especially under the current environment. In certain fiscal years - like the last one in FY 2022 - personnel-related costs contributed to more than 50% of the increase in cost of revenue. The figure was much higher than the ~30% share in FY 2023, where hiring was less aggressive. In fact, PagerDuty made a 7% cut to its workforce in January 2023 , signifying a potential over-hiring.
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Enterprise go-to-market execution and demand remain relatively strong. The increase in the number of customers with ARR >$100k (27% YoY in Q4) was in fact higher than the increase in the total number of customers (20% YoY in Q4).
Product roadmap and market landscape reviews
PagerDuty started out as a company developing cloud-based software to address incident and on-call management for IT teams (or more specifically DevOps / Software Development and Operations teams). The software digests digital data from various sources, such as servers, apps, security monitoring tools, and others, and then creates alerts whenever an incident occurs.
Given that all of this is happening in real-time, the software would then route the incidents to any on-duty IT team members registered on the on-call management database in the software for resolution. Digital-related incidents can be damaging to customer experience and can theoretically result in revenue loss. An incident can range from a simple bug in the source code affecting retail sign-up experiences to server deployment hiccups impacting regional-wide availability. It is why this type of software is highly desirable by companies with significant digital operations. Moreover, once installed and integrated into the IT environment, software like PagerDuty is considered mission-critical and has high switching cost.
G2 Incident management landscape
PagerDuty is a well-known category leader in the incident management space, and has been serving customers across industries and use cases . What I think can differentiate PagerDuty from the rest is its ease-of-use, ease-of-integration, and depth of functionality. Among others, PagerDuty seems to be the only company with a more ambitious vision and higher commitment in furthering overall innovation in digital operations - a superset of incident management and on-call that is still nascent to-date, but continues to evolve. PagerDuty’s product expansion so far, which aims to deepen the software capabilities in AI and automation, is an example of that vision and commitment.
PagerDuty has also remained as a stand-alone player, while its rivals in incident management, OpsGenie and VictorOps were acquired by two other major cloud software players Atlassian ( TEAM ) and Splunk ( SPLK ). Meanwhile, competition also comes from a slew of other vendors of all sizes such as xMatters, Freshservice, and ServiceNow ( NOW ).
Valuation / Pricing
PagerDuty today trades just under 8x P/S, a reasonable entry point to initiate a long position. Since the IPO, there were only two occasions where the stock traded anywhere below that level.
The first one was in 2020 during my initial coverage, and the second one in November 2022. In both occasions, I observed a P/S multiple of ~6x, which in fact was the P/S' all-time-low.
From a forward-looking perspective, the stock looks even more undervalued. I expect PagerDuty to finish FY 2024 with a full-year revenue of $454 million, just slightly above the guidance ($446 million - $452 million) to grow ~22.56% (0.56% beat). With the current market cap of ~$2.96 billion, I arrived at ~6.5x forward P/S, a level that is comparable to its all-time-low.
Assuming PagerDuty has set a guidance it can comfortably beat, it is highly likely that it will achieve at least a 0.56% full-year revenue beat, as it did in FY 2023.
Moreover, the commitment to maintain a positive FCF by targeting an 8% - 9% FCF margin in FY 2024 means that there is an opportunity for P/S multiple to expand to a level where its peers are currently trading (9x - 12x).
Author's own analysis
The companies in this universe operate in the adjacent space (i.e. ITSM, observability, incident management) to PagerDuty. They provide either a competing or complementary offering to incident/on-call management tools to the similar target persona (i.e. CIOs, PMs, Head of Digital, Site Reliability Managers).
Aside from Datadog ( DDOG ), most of them have annual revenue growth rates between 18% - 37% with consistent positive FCFs and on average trade at higher P/S multiple (~10x). As a comparison, PagerDuty today trades at ~8x P/S with +20% growth and positive FCF.
Risks
Over the next few quarters, I am keen to monitor how well the multi-product positioning is progressing for PagerDuty. The capability to land new clients from multiple product lines that are strategic enough to complement each other is definitely a big plus. However, it is still a relatively new value proposition that needs to be tested.
One of its new offerings, Runbook Automation, for instance, can be purchased separately from Incident Management / On call tool as a stand-alone. However, I think that it still addresses limited use cases as a stand-alone product. As such, there is still a lingering uncertainty about PagerDuty’s actual TAM.
Internationally, PagerDuty may see a different challenge when it comes to TAM. As a company with a meaningful international go-to-market track record (international revenue is 20%+ share of total revenue ) there seems to be a significant market opportunity here. However, digital transformation happens at different paces globally, and it needs to be at a certain level before it makes sense to consider PagerDuty's relatively visionary product roadmap beyond Incident Management / On-call.
The tougher macro situation can also weaken PagerDuty's multi-product value proposition in favor of its direct competitors like Splunk (VictorOps), xMatters, or Atlassian (OpsGenie). PagerDuty still largely operates within a saturated and fragmented Incident Management / On-call space, and as more IT decision-makers are looking to consolidate spending into fewer platforms to reduce cost, Splunk and Atlassian are in a better position to benefit from that trend as they explore potential expansion from their large existing install base in key adjacent markets (Log monitoring and software project management).
Conclusion
PagerDuty had a strong Q4, which further highlighted the management’s solid execution ability. For a few consecutive quarters now, revenue growth and gross margin have been consistently best in class. It also looks to maintain a positive FCF trend.
Overall, the stock remains an attractive growth story, supported by its leading reputation in Incident Management and On-Call space.
As PagerDuty looks to expand into a multi-product platform beyond Incident Management and On-Call, it is exposed to several risk factors that can negatively affect its overall performance.
Nonetheless, the track record of solid execution provides enough safety net to initiate a buy rating, an upgrade to my previous recommendation.
For further details see:
PagerDuty: Solid Execution Reduces TAM Anxiety