C3.ai (AI 3.02%) stock has benefited from surging interest in artificial intelligence (AI) applications and services, but the stock has recently come under fire amid allegations of misleading accounting practices and has seen big sell-offs. Even after a precipitous valuation pullback, the company's share price remains up roughly 100% across 2023's trading.
What comes next for the controversial AI company? Read on for a look at bullish and bearish dynamics that could shape its stock performance going forward.
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Green flag: Enough cash to capitalize on industry momentum
Demand for artificial intelligence services has never been hotter, and it seems abundantly clear that the broader industry remains in very early growth stages. C3.ai has integrations with cloud-infrastructure services from leading providers, including Amazon, Microsoft, and Alphabet, and it has continued to roll out new features and service offerings and land new customers. While C3.ai faced macroeconomic headwinds in 2022, the company's management team noted in its most recent conference call that the business is now seeing significant demand tailwinds.
Crucially, C3.ai has a strong cash position to fund operations, address emerging demand, and pursue new expansion initiatives. The company ended its third quarter (which closed Jan. 31) with roughly $790 million in cash, equivalents, and investments against zero debt, and it foresees becoming profitable on a non-GAAP (adjusted) basis in its next fiscal year. While the company is currently operating at a loss, it appears to have sufficient financial footing to fund growth initiatives that could help it capitalize on the AI zeitgeist.
Red flag: C3.ai's reporting practices are under scrutiny
The foundations of C3.ai's business have been called into question by a recent letter from short-selling firm Kerrisdale Capital. In its public note to C3.ai's financial auditors, Kerrisdale outlined concerns that the AI services company had seen high turnover for its chief financial officer role and had an opaque financial relationship with its largest customer Baker Hughes. The short-seller also alleged that C3.ai had made efforts to inflate gross profit margins and misclassified services or consulting-oriented revenue as subscription revenue.
Subscription revenue tends to create a revenue base that's more stable and reliable compared to one-off software or service sales. As a result, companies that generate large portions of their revenue from subscription sales tend to be assigned higher valuation multiples than those that do not. C3.ai reported that 85.6% of its total revenue came from subscription sales in the third quarter of its current fiscal year, which ended Jan. 31.
The letter from the short seller noted that unbilled receivables from Baker Hughes had expanded from $17 million at the end of C3.ai's last quarter to $80 million at the end of Q3 this year, with the latter figure now accounting for 91% of the company's total unbilled receivables. Kerrisdale notes that actual recorded revenue from the oil field services company has been stagnant and suggests that C3.ai has been using aggressive accounting to create the appearance of stronger business performance.
Kerrisdale disclosed in its letter that it had short positions in C3.ai stock and thus stands to benefit from the decline of its share price, but investors should weigh the concerns that have recently been raised and pay attention to developments on these fronts. While bearish coverage from short sellers can be overblown and often doesn't amount to much over the long term, C3.ai has some big questions to answer.
Red flag: Speculative sales outlook and risky valuation
Despite growing across the first two quarters of its fiscal year, sales declined roughly 4% year over year to $66.7 million in the third quarter, and the company's guidance suggests there could be a year-over-year sales decline in the fourth quarter as well. While the company's accounts receivable did grow significantly in the third quarter, it is odd that revenue yet to be collected is growing substantially while actual recorded sales are in decline.
Even if concerns raised in the short report prove to be largely unfounded, C3.ai's path to GAAP profitability remains somewhat unclear, and the company's valuation looks highly risky in light of recent sales performance.
AI PS Ratio (Forward) data by YCharts.
Despite the big pullback for the company's share price following Kerrisdale Capital's letter, the AI specialist trades at roughly 10 times this year's expected sales -- a level that still looks concerningly high.
So should you buy C3.ai stock?
I think that AI will likely prove to be this century's most important technology trend, but that doesn't mean every company operating in the space will go on to be a winner. The issues raised by Kerrisdale Capital deserve real consideration from investors, and C3.ai's valuation profile deserves some scrutiny, even if the short-selling firm's concerns are shown to be overblown.
C3.ai's share price seems to have benefited from surging interest in the overall AI space, and it's not clear that the state of the business justifies the gains that its stock has made this year. Accordingly, I think that investors should avoid the stock right now and look for other opportunities in the artificial intelligence space.
