Getting contracts signed is a foundational business process that is slow, expensive, and hasn't changed in centuries. DocuSign (DOCU -0.54%), a leading provider of e-signatures solutions, is on a mission to change that. The software-as-a-service business makes it easy for businesses of all sizes to move the signature process online and saves them time and money in the process.
On this week's edition of Industry Focus: Technology, host Dylan Lewis and Fool.com contributor Brian Feroldi dig into DocuSign's business model and financial statements to find out if this is a stock that should excite investors.
A full transcript follows the video.
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This video was recorded on Nov. 16, 2018.
Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It is Friday, November 16th. We're doing another deep dive on a recent tech IPO. I'm your host, Dylan Lewis, and I'm joined on Skype by Fool.com's Brian Feroldi. Brian, what's going on?
Brian Feroldi: It's the middle of November, and I'm looking outside at my house right now, and I see three inches of snow. That's what's going on. What's going on with you?
Lewis: [laughs] We got a little snow here in the D.C. area, as well. A little surprise. It's going to be interesting, because I'm smoking a turkey later today as part of a Friendsgiving get together. I was anticipating having a decent amount of deck space to do that. Now, there are a lot of wet leaves and snow out on my deck.
Feroldi: We're having a Friendsgiving dinner today, too. We'll be celebrating together in different states.
Lewis: What are you on the hook for? What are you cooking, Brian?
Feroldi: We have a ham that's going in the oven, and then we're going to be playing some board games tonight, which sounds like fun to me. How about you?
Lewis: That sounds awesome. We're doing an oven turkey. I'm doing a compound butter thing that I like to do. And then we're doing a smoked turkey, as well. It's on the friends to bring sides. We're hosting, so I feel like it's on them to bring the mashed potatoes and the veggie options and maybe some mulled wine, that kind of stuff.
Feroldi: That's the way to do it!
Lewis: That is. Before we can get to our fun Friendsgivings, though, we are going to be doing another breakdown of a company that has been publicly traded for a little bit, and that is DocuSign. This is another software-as-a-services company. Brian, I know how much you love the SASS space, so I had to bring you on to talk about them.
Feroldi: Absolutely. I love SAAS companies. DocuSign is a recent IPO. I went through my checklist on them, and I think there's a lot to like about this business.
Lewis: When we did that episode on Upwork (UPWK -1.34%) a little while back, we got so much positive listener feedback on your approach that it only made sense to do this again. Why don't we start out with the backstory on this company, how they got to where they are now?
Feroldi: DocuSign, as I'm sure many listeners know, they are a leader in the move to e-signatures. DocuSign was founded in 2003 by an entrepreneur name Tom Gonser. He looked around the world and he saw that everything was going digital, but the foundational business process, like the agreement where two sides of parties agree to some terms, that was still done using pen and paper. That process had not been updated in centuries. He decided to disrupt the process, and he founded DocuSign with the goal of moving the entire agreement online. The opportunity that he saw would be, if you could move it online, you would make it far faster, lower cost, and you would greatly improve accuracy over the traditional way.
And if you look at DocuSign today, they now have hundreds of thousands of customers that pay them for their services. Millions of people have used DocuSign in one way or another. They have been wildly successful.
Lewis: Not only have we researched this company, we are users of the platform. I've used it to make some signatures for Fool internal stuff, and I know you've used it, as well, Brian.
Feroldi: I used it actually just this week to open up a new account with Vanguard. When I was on the phone with the rep trying to open my account, he told me that he was going to send me a DocuSign. I think there's an argument to be made that the name has become synonymous with the product.
Lewis: And we love to see that as investors, because it means that a company has a pretty good foothold in a space. With that background, on today's show, in case anyone missed the episode we did on Upwork, we're going to put DocuSign through Brian's patent-pending six-step stock ringer. That is going to be a look at the financials, moat, potential, customers, management, and risks facing this business. Then, we'll wrap up talking a little bit about what we think of the stock, and anything else people should be aware of. Brian, why don't we kick things off looking at the books?
Feroldi: DocuSign went public in April. They raised about $629 million at their IPO before subtracting fees. A good chunk of that, about $440 million, went right into the company's bank account. Another $150 million was used to cash out existing shareholders. After the IPO, they had over $818 million in cash on their balance sheet as of the end of the second quarter, and no debt. Just a couple of weeks ago, they added another $500 million through a convertible note offering that closed in September. That did bring debt into their books, but it's convertible, so there's a possibility that they might not have to pay that back. So, this company has lots of cash and a little bit of debt now.
Lewis: While there is cash in there from this IPO process, and while the company is growing a decent amount, it is currently operating at a GAAP loss, as people might expect for a relatively early stage as-a-service business. This is something pretty common for the space.
Feroldi: Yeah. DocuSign is purposely operating at a small GAAP loss because they are investing aggressively into growing out the company. Specifically, they're spending heavily on sales and marketing. To put the number in context, last quarter, the second quarter, they lost in total about $36 million. That's really a drop in the bucket compared to their $1.3 billion plus in cash that they now have on their balance sheet. It's also important to know that that loss was on a GAAP basis. If you look at their free cash flow, they actually produced $18 million in free cash flow during the same time period. So, I don't think the GAAP loss is a huge issue.
Lewis: Turning our gaze to the second criteria you like to look at, Brian, that is moat. One of the reasons why you really focus on the SAAS space is because these products tend to be very sticky. Once you get people using them, you get very comfortable using them, there are pretty high switching costs of doing that. People get used to the interface. It gets built into workflows at businesses. It's really difficult to break that once it's there.
Feroldi: DocuSign, I think, has a couple of advantages going for it that will make it continue to be the leader in the space. First off, DocuSign works with many different tech giants and has their software embedded in 300 different pre-built integrations with some very popular programs that are made by giants like Alphabet, Microsoft, Oracle, Salesforce. If you want to use a DocuSign, and you're using those products natively, it's a very seamless integration because it's already pre-built in. That convenience is one of the reasons why its software is very, very sticky.
A nice metric that you can look at to determine how sticky a SAAS business is a dollar-based net revenue retention rate, which basically says, from one year to the next, how much money are the same existing customers spending with the platform? Most recently, that figure was 115%. So, not only is DocuSign keeping its customers around, but its existing customers are spending more with DocuSign each and every year. And those just lead to wonderful economics over time.
Lewis: That dollar-based net retention rate number is a little wonky. People in the SAAS space know it well. If you're not familiar with it and you follow restaurant stocks, think of it as a comps number. You have a store that was open a year ago, you have it open now. How are those sales performing? That rate of 115% is pretty darn high. Correct me if I'm wrong, Brian, they've typically been in the 112-119% range with that metric. There are a lot of SAAS companies that would kill for that type of net revenue retention rate number. Most of them are slightly over 100% if they're doing OK.
Feroldi: Yeah, that's exactly right. Another thing that I think is working in DocuSign's favor is that its brand is extremely well-known. The name DocuSign, as I mentioned before, is quickly becoming a verb. People say, "I'm going to DocuSign something." That creates instant name recognition. Another reason that stands out is, when a company is looking to adopt an e-signature platform, the name DocuSign not only instantly comes to mind, but there's a lot of social proof out there, because these guys have so many customers. That makes it easy for them to choose DocuSign because they're the leader. And DocuSign has the data to show that their signature has never been challenged in a court of law. They have the data to prove that, when somebody signs using their e-signature platform, it stands up in a court of law.
Lewis: Turning to item #3, this is potential. This is really just a look at what is out there in terms of a total addressable market? What is out there in terms of a customer base? It seems like this is a company that is going to benefit from some pretty strong tailwinds.
Feroldi: The paper and pen, despite how long DocuSign has been out there, is still the dominant way that agreements are made in the world of business today. But DocuSign does have hundreds of thousands of customers. As of the end of the last fiscal year, it had over 370,000 customers that were paying DocuSign, including tens of thousands of them that had at least 250 employees. These are fairly big-sized customers. That number sounds impressive, but DocuSign believes that it's penetrated about 1% of its total core target market. When you take all the potential agreements that are out there that are made every day, only about 1% of them are currently made through DocuSign's platform. Management estimates that its total addressable market, when you add everything together, is about $25 billion. When you compare that to the $518 million that it hauled in last year, there's plenty of room left for this company to grow.
Lewis: I think there's a really big opportunity for this business internationally, too. Right now, most of their revenue, about 80%, is coming from the U.S. Management has talked a decent amount about how there's a pretty big international opportunity out there. I'm inclined to agree.
Feroldi: I totally agree. DocuSign also can make use of M&A and also layer in additional services over time to expand its total addressable market, too.
Lewis: We are at item #4 on your checklist. This is a look at a company's customers.
Feroldi: Customers are the lifeblood of any business. I like to think about how a company interacts with its customers from a multitude of angles. The first thing I look at is how expensive they are to onboard. As we mentioned at the top of the show, DocuSign is spending lavishly on sales and marketing right now to grab as much of the pie as they possibly can. Last year, they spent $278 million dollars on sales and marketing, and they added about 85,000 new customers onto their platform. That's a huge amount of money to spend on sales and marketing in any given year. But since their customer base is growing so quickly, and there are high switching costs, that's a trade-off that I think investors should be happy about, especially since it is leading to top line growth.
Next, I like to think about how dependent a customer is once they sign on. I think that DocuSign's dollar-based net revenue retention rate of 115% is a really good indicator that once a customer becomes a customer, they not only stick with it, but they spend more over time. That's something that I like to see.
The next thing I check is, is the revenue recurring? About 93% of DocuSign's revenue is recurring in nature, and it was earned from subscriptions last year. DocuSign also has a small services business where they onboard companies. But that's basically a break-even business form and it's almost immaterial. You can say that the vast majority of their revenue is recurring.
Lastly, I like to look at pricing power. Does this company have the ability to raise prices or at least expand its gross margin over time? If you look at their recent history, DocuSign's gross margin was 71% in fiscal 2016, which is a very good number on its own, but that number expanded to 77% in the most recent fiscal year. That's a clear sign that they are leveraging their fixed costs and growing over time, which is great.
Lewis: I'm with you on the customer acquisition costs being a little concerning. What I think that ultimately boils down to is, they're spending a lot for these customers. Are these customers going to behave the same way that past cohorts of customers have? If they are able to maintain this mid-teens dollar-based net retention number, then I think we're in OK shape. Because that other metric is so strong, I'm not as worried about it, but you want to keep an eye on, they're spending so much to bring these folks in, are they behaving the way that all these other customers that they've brought in in the past have behaved?
Feroldi: Totally agree. Like any software-as-a-service business, that net revenue retention rate number is a key metric for investors to watch.
Lewis: Brian, #5 on this checklist is management and company culture. This is something that we really focus on here at The Fool writ large. I think that it's so much easier to get on board with an investment when you know that the company is being run well, that employees like working there, that they like management. Those are the kinds of things that lead to employee retention, and generally tend to lead to pretty strong business results.
Feroldi: Yes, exactly. This is a tech company. Hiring and maintaining the best and the brightest is an absolutely critical business function for them. As I've said before, we like to check in on a company's culture to make sure it's a good place to work, and that it has good leaders. Ideally, you'd see that the founder of the business is still running the show, or at least involved. In DocuSign's case, Tom Gonser is on the company's board of directors. He doesn't hold a management position within the company, but he does have some influence since he is on the board. He also still owns about 2.1 million shares of DocuSign's stock. That's worth about $85 million at current prices. So, you can say that he absolutely has an incentive to see this business continue to succeed.
Moving on to their CEO, they hired a new CEO about 18 months ago named Dan Springer. He joined right before the IPO process. He owns about $20 million worth of stock. He's relatively new, and I would like to see his ownership rates be higher. But if you look at the company's Glassdoor ratings, it's very clear that Springer is beloved by his employees. His approval rating among his employees is 98%. That's so good that he literally placed third on Glassdoor's annual rating of CEOs. He was ahead of leaders like Jeff Weiner of LinkedIn, Marc Benioff of Salesforce, and Mark Zuckerberg of Facebook. Employees really like working for Springer. If you look at their overall rating, they get 4.6 stars out of 5. That's a very good indicator that this is a great place to work.
Lewis: What you mentioned was a lot of the softer stuff that we look at with management -- the Glassdoor ratings, and obviously, skin in the game is important. Something that really stands out to me looking at management's role in this business is looking at the executive officers and directors. They control more than 25% of shares outstanding for this company. That is a lot of skin in the game by people that are going to be making big-picture decisions. I love to see that.
Feroldi: Same here. You want to know that the people that are in control of the company will be financially hurt if their stock goes down, just like you would as a shareholder.
Lewis: Last item on the checklist. This is one of my fun ones. This is the "what can go wrong?" element. This is the risks in the stock, painting a fuller picture of what's going on with this company. Why don't we start out with red flags? Then we'll wrap it all up talking about the company, a little bit on the valuation, and what we think of the stock.
Feroldi: The first thing I check for is to make sure it's not a penny stock. I've been burned very bad when I first started investing on those. DocuSign is absolutely not. Shares are trading for about $40 each. The market cap is over $6 billion.
Next, I check up on the customers. I don't like to invest in businesses where there's excessive customer concentration, where if any one customer left, it would cause the business harm. In DocuSign's case, they have hundreds of thousands of paying customers. The largest one accounted for only about 3% of revenue. That's not an issue here.
Then, I think about the industry in general. Is it facing long-term headwinds or long-term tailwinds? I think it's a very clear argument that the market for electronic signatures is growing rapidly, and DocuSign is a big reason why.
The next thing I think about is, is this business reliant on any outside forces for success? Does it need a strong economy or low interest rates or anything like that? I don't see any reason that DocuSign won't be able to grow, even if the global economy does slow down. I don't think that's an issue.
Finally, I think about stock-based compensation. You don't want to see so much of the value that's being created going just to employees through stock-based compensation. When I looked, last year's total stock-based compensation for this company was only about $30 million. That's actually a very reasonable number compared to their $520 million in revenue and their $6 billion in market cap.
This company does not trip any of my thesis-busting of red flags.
Lewis: We talked a little bit about the path that this company has gone on in its life on the public markets. It was very quickly a stock market darling, and really shot up after its IPO. Returns looked pretty good in the first couple months. Then, it came crashing back down to earth. It's now trading roughly around where shares first hit the market. You look at the valuation, and it really makes sense why that happened. This is a company that will do just under $700 million this fiscal year. And there was a period where they were hitting about a $10 billion valuation. Trading at 14X sales, give or take, is pretty rich. We're seeing them come back down to earth. That puts them at a $6 billion market cap. Like I said, somewhere in the neighborhood of $650 million, maybe $700 million, in revenue for the year. 10X sales is a little bit more reasonable. It's still a little rich.
Feroldi: Yeah. This company is priced for growth. There's no doubt about that. Even with its high valuation, though, my personal view is that DocuSign checks so many of the boxes that I like to see in a business that I think this is a great company to buy and hold today. I can tell you that I am personally not a shareholder, but as soon as The Fool's trading rules allow, I do plan on purchasing shares myself.
Lewis: When you look at that valuation, you might balk at it, especially when you consider top line growth is about 30%, and we've seen it come down a little bit over recent quarters. I think the thing that you have to remind yourself of when you look at a company like this is, yes, there might be some decelerating growth, and that growth might not be 40% or 60% year over year. But, with the structure of a subscription business, that's probably going to taper off over a much slower period. The growth that it's enjoying it will probably sustain for a decent amount of time, and the deceleration will be fairly slow, because the expansion rate's great, because they're bringing more customers on board. They've also made some acquisitions where it's pretty clear that they're going to be building out their suite of products, which gives them more upsell opportunities.
So, yes, 30% growth might not be gangbusters. But also realize that the runway's long for this business, and I don't think the drop in growth rate is going to be that severe over the next coming quarters or years, even.
Feroldi: I agree with you there. The other thing to note is that this company is, in its most recent quarter, producing adjusted earnings per share. Not GAAP earnings per share, but they're basically right on the cusp of doing so. It's very reasonable to assume that next year and thereafter, this company will actually be producing profits. Because their profit margin will be so small initially, you can expect, I believe, triple-digit profit growth for many years, or at least the first couple of years, as the business continues to scale.
Lewis: Brian, I'm with you on this being a stock that I'm very interested in. It's on my watchlist now. We've given the necessary caveats in the past that when you're talking about a company that has been traded for less than 12 months, you really need to take small bites. I think that's an important approach. We want to dollar-cost average no matter what we're buying into, but I think it's particularly important for companies that haven't even gone through their first four quarters on the public markets. That's just because, to the history that we've seen so far with DocuSign, there are probably going to be some pretty wild price movements. If you are interested, make sure that you are buying in installments with this company, you are not buying all at once and banking on one cost basis.
Feroldi: I think that's exactly the way to go. Also, as we said in the last show about Upwork, you never know how a company is going to react to being on the public side and dealing with Wall Street's expectations for producing a good earnings report every 90 days. This company did exceed expectations in both of its first two earnings reports, which is a good sign. But I typically to give a company at least a year of being on the public markets before I would take a full position. As I said, I do plan on purchasing this stock, but it would just be nibbling as we go along.
Lewis: I think that's a great approach. That's actually something that we talked about in the 13 steps to investing. When we're trying to teach people how to invest, one of the things we mention is, it's good to buy a share of a stock, even if it's just one share, because it gets you following that business. It might be that you're just getting introduced to the stock market, you're just getting introduced to the idea of buying individual stocks. You open up a Robinhood account, where you don't have to pay to trade, and you buy one share. Maybe your entire brokerage account has $100 in it, but you're buying one share. You're going to find yourself following that business a lot more, because you have skin in the game, and because you're following the earnings reports that come out, the news that impacts it on a day-to-day or week-to-week basis. So, yes, there's a lot of value in getting a little bit there so that you can then follow the story and be a little bit more invested, so to speak.
Feroldi: I think that's the right way to think about it.
Lewis: To have a little fun to wrap up, Brian, you mentioned Upwork and our discussion last week. I will put it to you: Upwork or DocuSign? If you're buying one, which one do you like more?
Feroldi: I think there's reason to be bullish on both companies. But if I was forced to choose just one, my personal choice would be DocuSign. I think the corporate culture is a little bit stronger, it's growing a little bit faster, and I see it as the far and away leader in its industry. I think Upwork is, too. But my money would just be on DocuSign. How about you?
Lewis: You know, I think I'm going to take the other side of this one. I think they're both really strong businesses. The as-a-service segment in general has been so strong, and there have been so many great companies that have come out of there for investors. I like that Upwork's a bit smaller. We're working with a $2 billion valuation, roughly, for Upwork, DocuSign is about $6 billion. I think they both have huge addressable markets in front of them. This might be more of a semantic argument than anything else.
But, I'm with you. I think the culture is probably better at DocuSign. There were some issues in Upwork's recent report with growth decelerating a bit. But I like the tailwind of the gig economy. I think DocuSign also benefits from some strong tailwinds, but for my money, I think I like the idea of working with a smaller valuation to start, and maybe blossoming into something a little bit larger. Just by the sheer nature of what it might multiply to, I think I'm a little bit more interested in Upwork.
Feroldi: The awesome thing about investing is, you don't have to make a choice. You can buy both if you want to.
Lewis: It's not a zero-sum game! It's so wonderful. Brian, thanks for hopping on and sharing your thoughts. I hope you enjoy the ham that you and the family are going to be making!
Feroldi: I hope you have fun cooking your turkey!
Lewis: Take care, we'll talk soon.
Feroldi: See ya.
Lewis: Listeners, that does it for this episode of Industry Focus. If you have any questions or if you want to reach out and say hey, you can shoot us an email at [email protected], or you can tweet us @MFIndustryFocus. If you want more of our stuff, subscribe on iTunes, or you can catch all the videos from this podcast over on our YouTube channel. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for all his work behind the glass today. For Brian Feroldi, I'm Dylan Lewis, thanks for listening and Fool on!