One of the most attractive artificial intelligence (AI) investments in 2023 has been C3.ai (AI 3.02%). When someone searches online for "AI stocks," it's often the first to come up, making it a natural entry point for many investors looking to gain exposure to this massive trend. With the stock up around 150% this year, it's safe to say that it has benefited from this search optimization.
However, one key concern that many investors (including myself) have with C3.ai is its unprofitability. Is C3.ai too unprofitable to invest in? Or is it just temporary? Let's find out.
C3.ai is dependent on a few industries
C3.ai provides plug-in AI solutions for multiple industries. However, one area it's finding success in is the defense industry. In the first quarter of fiscal year 2024 (ended July 31), 67% of bookings (or newly added business) came from the defense industry. This is a significant change in focus, as oil and gas made up 34% (the most of any industry) of bookings in fiscal 2023. In the latest quarter, oil and gas made up a minuscule 1.5%.
While contracts vary from quarter to quarter, this is something to watch, as C3.ai cannot afford to struggle in one of its most valuable industries. Even if C3.ai shifts its focus to defense, this would mean a massive revenue hit for the company if oil and gas isn't a significant contributor.
Despite C3.ai operating in an industry that many might assume would be high-growth, C3.ai isn't generating much growth. In the latest quarter, revenue rose about 11% to $72.4 million, and management issued guidance for about 19% growth in Q2. While some may point to this as business picking up, it just marks the one-year point of moving to the usage-based billing model versus a subscription one. This transition caused C3.ai to post negative revenue growth for most of fiscal year 2023, so it shouldn't be too surprising that C3.ai appears to be growing due to easy comparisons.
While its revenue growth isn't concerning, its margins are.
C3.ai's margins are moving in the wrong direction
In previous guidance, C3.ai told investors it expected to produce non-GAAP (adjusted) profits by the fourth quarter of fiscal 2024 (ending April 30). However, because management believes there is massive market opportunity in the generative AI field, it is shifting its focus from profits to developing its product pipeline. While this may be disappointing, investors should applaud C3.ai's focus on the long term rather than short-term profitability.
Still, the hole C3.ai has dug itself into is concerning.
Starting at the first line item after revenue, C3.ai's gross profits substantially dropped in the most recent quarter. Why? Because the cost of revenue went up 73% year over year. This is a major red flag for investors, as most software companies have gross margins in the 70% to 80% range, but C3.ai is well below that.
AI Gross Profit Margin (Quarterly) data by YCharts
Fewer gross profit dollars make it even harder to turn a profit, but C3.ai has reversed this trend, as operating expenses fell 5% in the fiscal first quarter. However, that didn't fully offset the gross profit decline, so C3.ai's loss from operations ticked up 1% from last year to $74 million.
If you're paying attention, you'll have noticed something strange: C3.ai lost more than what it brought in. That's right; C3.ai's expenses are more than double its revenue, giving it an operating loss margin of 102%. That's an unbelievably high loss margin and should concern investors.
But how would management turn a profit in by the fourth quarter of fiscal 2024 if it is already this far in the hole? The key here is that it was going to claim non-GAAP profitability. This accounting method, which does not follow generally accepted accounting principles, doesn't add in stock-based compensation expenses, which accounted for $50.9 million of C3.ai's expenses.
By stripping this out, management can claim some level of profitability, but it is far from true profitability.
But the question here is, is the hole too deep? For me, I'd say yes. While I'm OK with investing in unprofitable companies, they usually grow much faster and don't have that large of a hole to dig themselves out of. Additionally, they aren't dependent on one or two industries like C3.ai is. With C3.ai's stock not meeting any of those qualifications, I think it's best to avoid it until margins improve.
