After reporting third-quarter results on Dec. 2, DocuSign (DOCU -2.35%) saw a massive 40% drop the following day. While Q3 results were solid, the guidance given by management for the fourth quarter was disappointing. Management and investors expected slowing growth as the pandemic tailwind wore off. However, management did not expect the shift to happen as quickly, shaking investors' confidence in DocuSign's leaders.
If you're a DocuSign shareholder like me or looking at becoming one, you may be wondering if the stock is a buy, sell, or hold. Each case has some merit, but I believe one side stands above the others.
Image source: Getty Images.
The company
DocuSign makes e-signature software, allowing legally binding contracts to be completed from opposite ends of the earth. Contracts often copy and paste several sections that might include legal jargon or other hard-to-comprehend portions. DocuSign's contract analyzer uses AI to reduce risk and speed up the agreement process, ensuring no abnormal phrasing is present. It also has a contract lifecycle management segment that produces contracts fast and correctly.
Contracts can be difficult and frustrating for many companies. DocuSign eases this pain point and minimizes the time employees spend analyzing contracts, freeing them to do their job.
Buy
Although Q4 revenue guidance was disappointing, it still represents 30% growth over the same quarter last year. DocuSign's dollar net retention rate -- how much all customers increased their spending -- remained high at 121%. It also converted 17% of revenue into free cash flow, allowing DocuSign to generate more cash to use for business endeavors.
Its price-to-sales ratio has now tumbled to where it was before the pandemic.
DOCU PS Ratio data by YCharts.
Even though DocuSign's business has gotten stronger by growing its total and enterprise customers by 88% and 113%, respectively, since Jan. 31, 2020, the market has forgotten that DocuSign is still a strong company.
International revenue grew 68% in Q3 and only comprised 23% of total revenue. As of Q3, DocuSign is focusing on eight countries, leaving a large chunk of the world remaining.
DocuSign is still growing and has plenty of room to expand internationally. As demonstrated by its net retention rate, customers expand their spending over time, but the market is discounting this potential from all of the pandemic-era customer wins. If you're on DocuSign's buy side, the market is giving you an early Christmas present.
Sell
Management's mishandling of potential growth is concerning. While investors can be disappointed about DocuSign not hitting projections, management also uses this guidance internally to influence spending decisions. If the company has over-hired or purchased new technology that is no longer needed, the effects will ripple through quarterly results throughout 2022.
DocuSign is also fueling its growth with heavy stock-based compensation. During the quarter, it handed out $109 million in stock to its employees, more than 20% of revenue. This increased the share float 6% year over year, meaning one share bought a year ago now controls the same amount of DocuSign as 0.94 shares do now.
Adobe (ADBE -1.73%) is also a fierce competitor within the e-signature space. It reported $532 million in document cloud revenue during its fourth quarter ending Dec. 3, nearly matching DocuSign's $545 million. Adobe has massive resources and could be a difficult competitor for DocuSign.
While few people will return to signing many documents physically, DocuSign's investment thesis hinges on upselling customers to adopt its contract analytics and life cycle management. Failure to do this would also be a disaster for DocuSign.
Hold
With botched guidance, understanding DocuSign has become difficult. The next quarter could see phenomenal growth and great guidance, or it could hold another warning from management. The only way to know this is to hold on to shares and wait and see.
DocuSign is also close to breaking even on an unadjusted basis. Its generally accepted accounting principles (GAAP) loss per share was $0.03 in the third quarter, whereas non-GAAP earnings landed at $0.58. Once DocuSign consistently turns a profit, it will ease many investors' nerves, ones who may have feared DocuSign was destined to become another serially unprofitable company.
Finally, DocuSign also must get its share dilution situation under control. If its float increases by a smaller amount over the coming year, it is a sign DocuSign is heading in the right direction.
The verdict
Although management issued a troublesome warning, I believe DocuSign is a buy today. The market sell-off discounts the pandemic growth and DocuSign's upselling ability. Additionally, the growth is reverting to normal levels instead of going negative.
However, I can understand the stance of holding the stock without adding to ensure management navigates this tricky environment. If this path is chosen, I would recommend choosing a metric -- like revenue growth, valuation, profitability, or free cash flow margin -- to signal a buy point. Without one, emotions can take over and keep investors from purchasing the stock.
After falling off a cliff, DocuSign has given up a lot of its earlier gains. However, the business is still strong, making this a case of a broken stock, not a broken company. I believe it has a strong chance to rally throughout 2022.
