On Nov. 16, Riskified (RSKD +3.04%) posted financial results for the third quarter of 2021. The stock immediately plunged more than 20% and for legitimate reason: The company's gross margin went down, potentially revealing a problem with the business.
Following the Q3 results I vowed I wouldn't add to my small position in Riskified stock despite the lower stock price. I personally don't buy more of a stock unless the investing thesis improves. And it's fair to say Riskified's didn't. However, several weeks removed from the company's Q3 results, I've adjusted my thinking and gone against my own rule to buy more Riskified stock. Here's why I believe this is a risk worth taking.
Image source: Getty Images.
The risk with Riskified
Riskified's main product is called Chargeback Guarantee and it's for e-commerce companies. When stolen credit card information is used online, credit card owners report it, resulting in chargebacks from credit card companies and leaving the e-commerce companies with a loss. E-commerce companies could try declining more suspicious charges. But accidentally declining non-fraudulent transactions results in lost sales.
With Chargeback Guarantee, Riskified promises to increase approvals and decrease fraud. And when fraud gets through, Riskified pays for its mistake, making this a zero-risk product for Riskified's customers.
Riskified's software makes its approval decisions using a machine-learning algorithm. And if it's forced to pay for a chargeback, this expense is deducted from its gross profit. Therefore, monitoring Riskified's gross profit margin helps determine the software's effectiveness. In 2019, gross margin was 50.3% and improved to 54.7% in 2020. But through the first three quarters of 2021, Riskified's gross margin has taken a step back to 54.1%.
Simply put, it's possible -- not certain, but possible -- Riskified's Chargeback Guarantee won't be a product that creates long-term shareholder value. To create value, it must approve many transactions while accurately identifying fraud. If it fails to do the former, it will struggle to attract new customers -- bad for business. If it fails to do the latter, it won't ever be a high-profit endeavor.
Right now, the decline in gross margin suggests too many bad transactions are getting through, going against my investing thesis for Riskified.
Image source: Getty Images.
But here's the reward
Riskified's Chargeback Guarantee product seems to present an undeniable valuation proposition to e-commerce companies, which should make it an easy sell. We don't know exactly how big its customer base is. But it's only processed $61.3 billion in sales volume so far in 2021, putting it on pace for a little more than $80 billion for the year. That's just 1.6% of the $4.9 trillion in full-year 2021 global e-commerce sales volume estimated by eMarketer. Therefore, it's safe to say Riskified has room to easily grow its customer base from here, with its Chargeback Guarantee product alone.
But Chargeback Guarantee is just a foot in the door. Riskified also has other products to sell its customers. Its Deco product hopes to recover 20% of sales lost to payment glitches. And its Policy Protect product helps identify people creating multiple accounts to exploit reward and loyalty programs. Importantly, management expects these and other ancillary products to account for roughly half of its revenue growth in coming years.
Moreover, don't sleep on ongoing growth in e-commerce. According to the Commerce Bureau, e-commerce accounts for just 12% of U.S. retail sales, suggesting room for more growth. And eMarketer expects annual global e-commerce sales to increase by more than $2 trillion by 2025 from where sales are today. Therefore, I reasonably expect Riskified's revenue to grow just by processing more transactions from its existing customer base.
It's worth the risk
Finally, we don't actually know whether there's anything to worry about with Riskified stock in the first place. Yes, its gross margin has declined slightly. But this doesn't necessarily mean there's anything that needs to be fixed with its software algorithm. The gross-margin decline could simply be some short-term volatility that can be reasonably expected with a small company.
However, if Riskified does need to plow resources into its core product to improve it, it's well capitalized and can do so. As of Q3, it had $534 million -- that's a lot of money -- to fix a software deficiency if there is one. Compare this cash position to its market capitalization of $1.2 billion. Clearly, this opportunity is coming at a cheap valuation for investors today.
There's risk with a Riskified investment to be sure. But the company has a cheap valuation, hundreds of millions in cash, and a huge opportunity. Furthermore, there's a real chance the risk is overblown. In short, I believe this is a risk worth taking at its current price of around $8 per share.
