Riskified (NYSE:RSKD) has had a rough ride since its initial public offering in late July. Shares of the company, which uses artificial intelligence (AI) to detect fraudulent orders for e-commerce companies, jumped 40% in their first month of trading. But after concerns arose in its third-quarter earnings, the shares sunk like a stone. The stock recently traded at just $8, 78% lower than its all-time high of over $32.

While Riskified has shown the immense benefits it can bring to its customers, the company's poor third-quarter is worrisome. It will take at least a quarter or two to determine if the risk is valid or not. Until then, I wouldn't be investing in the company even if it is trading at appealing multiples. 

Person scratching his head while looking at a computer.

Image source: Getty Images.

Why it fell

When e-commerce companies try to detect fraudulent orders in-house, it can be a slow process, and they can degrade their customers' experience by asking questions or even denying a potentially real order. This problem is expensive for e-commerce businesses and very time-consuming. 

Riskified uses AI to monitor orders, alerting the seller of potential fraud within seconds, all without disrupting the customer experience. Riskified also provides a charge-back guarantee, through which it pays its customer for the lost goods if it misses a fraudulent order. This completely mitigates any true threat of loss for Riskified's customers, providing immense benefits while increasing customer satisfaction. However, the accuracy of the company's AI was called into question in its third quarter. 

The charge-back guarantee expenses are the major cost of goods that the company has. Although Riskified doesn't explicitly state how much it pays to cover this expense, investors can see it in the gross margin, which abruptly sank in the third quarter. Revenue increased 26%, yet gross profit only improved 10% year over year, resulting in a third-quarter gross margin decline from 53% in 2020 to 46% in 2021. This means that the company likely had to pay a large number of chargebacks to its customers because of failures with its AI.

There are two potential reasons for this, with one being a thesis-breaker. Management explained that this drop was because it entered new markets, like cryptocurrency, where its AI had to learn and gather data, making it temporarily less effective. The second reason (the bad reason) is that Riskified's AI is simply inaccurate. 

What to make of it

If the first reason holds true, and its system is simply taking time to become more accurate as it gathers more data about the market it just entered, that is less concerning. Lemonade (NYSE:LMND), another company that uses AI, is experiencing a similar problem as it sells insurance. But as time goes on and both companies' AI systems obtain more data, they will be able to make more accurate decisions, and these problems will solve themselves. 

On the other hand, if Riskified's AI is just not that accurate, this could be a major problem. The company has historically performed well, refuting this idea: It reported $21 billion in gross merchandise volume in the third quarter from large customers like Wayfair. It has also saved customers up to 60% in operating expenses while increasing revenue by up to 20% in some cases. This is likely why the company has just 2% churn. While its past performance has largely proved this idea of AI inaccuracy otherwise, it is still important to remember that this could be the case.

Either way, this decrease in gross margin did not help the company's bottom line. So far this year, it has lost $151 million, representing 95% of revenue, compared to the year-ago period's $15 million net loss. The road to profitability will be long, and its AI will have to be consistently more accurate over the next few years if the company wants to become profitable. 

A value play or a value trap?

Riskified is trading at just 5 times sales, a rock-bottom multiple for AI companies. Comparatively, AI-reliant companies Upstart (NASDAQ:UPST) and Lemonade, trade at 21 and 23 times sales, respectively.

This low valuation is incredibly appealing, especially if Riskified's gross margin is lower simply because it is expanding into new industries. Yet investors should consider the company's current unprofitability and the drop in margin. The reason its margin fell so much is unknown right now, so investing in something with such a big question mark could be a mistake. The true cause will likely be discovered in the next few quarters, but until then, investors should simply hold their shares or watch from the sidelines instead of buying this dip.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.