No matter the strategy of an investor, whether it be growth or value, all can appreciate the role that market share plays in a strong investment prospect. It is the reason Amazon is Amazon and Microsoft is Microsoft. These companies have a suffocating stranglehold on their respective market. These companies took advantage of their dominating market share by revolutionizing their respective industries. I believe there is another company emerging that through its dominant market share and innovative new product has the opportunity to change how deals are signed, sealed, and delivered forever. This is DocuSign. The company is to digitalized agreements what Kleenex is to tissues.
DocuSign (DOCU), a San Francisco company, is not an unfamiliar name to most of us as their eSignature software has allowed hundreds of millions of people worldwide to easily and efficiently sign a document online. The eSignature makes receiving signatures far simpler as it can now be received in seconds online as opposed to being handed off in person or obtained through a fax machine. This is a great product and a nice convenience to have in order to expedite an aspect of the deal process. However, where I see DocuSign truly revolutionizing how we do business is through their DocuSign Agreement Cloud. First unveiled in March, this new product digitalizes the entire agreement process through a suite of more than a dozen products and 350 integrations- from preparing, to signing, acting on, and managing the agreement. Paper is slowly being phased out. We see this in money, standardized testing, and the newspaper. It should come as no surprise that the endless paperwork that goes along with any sort of agreement is the next to be eliminated. Market share in an enormous industry is the driver of this business and the introduction of an application that automates the entire process just doubled their total addressable market.
In the first quarter of FY20, DocuSign experienced top-line growth of 37% YoY to reach $214 million in revenue. $12.5 million of this was earned through professional services. This represented a 64% increase in professional services revenue YoY as customers required more assistance to install the Agreement Cloud than the far simpler eSignature software this quarter. Although services make up a small portion of total revenue this trend in increasing service revenue should continue as more Agreement Cloud sales increase. Services income currently operates at a loss but I expect this segment to benefit from economies of scale and generate a profit as employees become more efficient and service opportunities increase. DocuSign also continued its impressive ability to generate cash as it netted $45.7 million from operating activities as opposed to just $15 million in the same period last year.
These are impressive headlines; however, DocuSign fell 14% in pre-market trading due to a slowdown in billings growth. Billings grew by 27% in the quarter which was a lower rate than in previous quarters. This is an important statistic as it could mean less revenue moving forward for DocuSign.
Reason For Slowdown in Billings
Management was far less concerned with this slowdown than the markets were. CEO Dan Springer explained that the slowdown was caused by the company’s shift from selling simply its flagship eSignature product to marketing a broader suite of services with its DocuSign Agreement Cloud. The rationale behind this makes sense. The sales team is making the long pitch to try and sell the more expensive, all-inclusive product that helps businesses manage contracts throughout the entire deal process. This sales cycle was not going to be perfectly executed from the get-go as customers have important questions regarding the Agreement Cloud. At the end of the day the question is: will this make life easier or is it a product full of unnecessary features. I believe that the Agreement Cloud will not only make life far easier for customers but it also has the potential to make the process faster, less risky, and less costly. As the sales team adapts to the new process of selling this multi-faceted product the billings will experience rapid growth once again. In the meantime, I do not see this slowdown in billings as DocuSign losing business. I just view the longer sales cycle as forcing what could have been first quarter billings to roll into the second quarter. Due to this shift in billings from the first quarter to the second I expect a significant increase in billings growth in Q2 and the return of DocuSign’s past “beat and raise” earnings day success.
Another adjustment that has been made to the sales team is the implementation of a both a new customer specific sales team and recurring customer specific sales team. Given the greater complexity of the new sales cycle I believe this is an excellent move as the more specialized sales teams will be able to better refine their specific strategies and expedite the sales process. This allows the new customer sales team to just focus on getting the customer to adapt the eSignature software. This is an easier sell as it is the cheaper and more easily understood product. Then, upon satisfaction, the recurring sales team can come in and sell the customer on the more lucrative Agreement Cloud. This process will lead to the compounding revenue that drives the top-line of so many subscription software companies.
The eSignature product has given DocuSign the name recognition to be the go-to product for online signatures. In Q1 FY20, DOCU increased worldwide paying customers from 405,000 last year to 508,000. The change that may play a bigger role in DocuSign’s future growth prospects is that customers with annual contract value (ACV) of over $300,000 grew by 51% YoY. This can be largely attributed to the emergence of the more expensive Agreement Cloud.
In the past, DocuSign’s management team has claimed that their company has a total addressable market of $25 billion. The company released guidance projecting them to generate revenue of just under $1 billion this year which would imply that they are operating at approximately 4% of their TAM. In the Q1 earnings call, CEO Dan Springer claimed that the DocuSign Agreement Cloud has doubled the opportunity in TAM. This translates to a $50 billion TAM and implies that DocuSign is operating at just 2% of their revenue potential. The growth potential is easy to see. With partners such as Microsoft (MSFT), Salesforce (CRM), Oracle (ORCL), SAP (SAP), and Workday (WDAY) adoption of the service is very easy as it is already installed in some of the world’s most popular software. There are also serious growth prospects abroad. DocuSign highlights countries such as the UK, France, Brazil, Germany, and Japan as markets to develop moving forward as only 17% of total revenue is currently gained internationally.
This software can be used by all industries and verticals. There is no need to customize it for a particular business as the service is pretty standard across all kinds of deal making. It is quite common for a company to initially use one of DocuSign’s services in one department, realize the significant benefits of the service, and further expand its use to other branches in the same company. As displayed by the small realized percentage of TAM, growth potential internationally, and ease in adoption of the service, it is clear that the penetration story of DocuSign is just beginning.
Comparable Company Analysis
DocuSign’s greatest competition in the market for e-signatures is Adobe (ADBE). However, given the fact that Adobe has an enterprise value of $150 billion (a far different life stage than DOCU) and a diverse portfolio of services in which e-signature is just a small fraction, I decided to omit them from the comparable companies. I instead decided to choose three companies in ServiceNow (NOW), Okta (OKTA), and Zscaler (ZS) that are similar to DocuSign in terms of the stage they are at in their life cycle, growth rate, and gross margin. According to forward revenue guidance for the year, all four companies are due to generate revenue representing somewhere from 2%-5% of their TAM. This gives me confidence that all four companies are at similar life stages and given their other similarities a comparison is warranted. Not only is DocuSign’s FY20 percentage of TAM in line with these competitors but I believe it has a higher chance of reaching its full potential given the luxury the company has in dominating its industry and being threatened by very few viable competitors. This growth stock is unique as it’s risk is mitigated by an extremely strong market positioning in an industry with enormous potential.
As can be seen in the abbreviated comps analysis above, DocuSign is trading at significantly lower valuation in relation to revenue and book value to its comparables despite its significantly higher expected next 5 year EPS growth rate.
DocuSign is undervalued at its current price and much of this can be attributed to the markets reaction to a “poor” quarterly earnings report. However, as I argued previously this earnings performance was far from poor and the decrease in billings simply signaled a transition to a far more prosperous future. The eSignature growth story had a somewhat low ceiling. The introduction of the Agreement Cloud raised this ceiling to new heights yet markets saw a slowdown in billings caused by an adjustment to a new sales cycle and got spooked. This learning curve and the end of a long streak of “beat and raise” earnings performances for DocuSign has given us an opportunity to scoop up this extremely strong stock at low multiples in relation to its peers in software.
We are looking at a company that owns its industry’s market share, is operating at just 2% of its TAM according to management, and trades at a far cheaper multiple than its peers. The long-term growth story of DocuSign is just beginning and its Agreement Cloud will forever change how we view contracts. Where others see a bad quarter highlighted by a slowdown in billings, I see a company shifting its direction from a convenient service to a revolutionary movement.