Shares of Riskified (RSKD -0.43%) are down 45% over the past month and a whopping 72% from their all-time high, despite being on the market for just four months. This was partially due to IPO hype wearing off as other exciting IPOs came to the market, but it was primarily due to poor third-quarter performance.
For investors who don't know Riskified well, it looked like a solid quarter. And to some extent, it was. However, there was one very important metric that is closely tied to Riskified's investment thesis that dropped significantly, which understandably spooked investors. With this immense drop, is now the time to buy the dip? Let's find out.
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Why I love Riskified
Since its IPO, Riskified has been an attractive company to me. It's using artificial intelligence (AI) to detect fraudulent transactions for e-commerce orders. Oftentimes, fraud can look like real orders and real orders can look suspicious. In this case, many e-commerce companies have to make a tough decision: potentially losing their product to a fake order or turning down a real customer, making that customer angry. E-commerce companies do not want to handle decisions like this, especially when they are shipping out millions of orders a year. So they instead hand this off to Riskified.
Companies that do this in-house might have to ask the customer questions or take other time-consuming measures to determine fraud, but Riskified's AI can make that decision in seconds. This not only gives the company more time to handle business-critical tasks, but it improves customer satisfaction for the e-commerce company. Riskified brings a better customer experience to its platform, along with saving customers money. Riskified's top 10 customers save on average 39% in operating expenses and make 8% more sales when using Riskified.
With benefits like that, it's not surprising that Riskified is being adopted by major e-commerce companies such as Louis Vuitton and Wayfair. This broad adoption has led to impressive growth: Q3 revenue grew 26% year over year to $52 million, and gross merchandise value that Riskified operates grew 28% to $21 billion. The company's net loss did increase substantially to $86 million, but this was primarily driven by $65 million in IPO expenses.
My main concern
Q3 growth slightly slowed compared to Q2, but that was not the main concern. What really worried investors was that gross margin dipped from 52% in Q3 2020 to 45% in Q3 2021. The drop was even greater sequentially: In Q2 2021, the company had gross margin of 59%. In fact, Q3 2021 was the only time that Riskified's gross margin has dipped below 50% since Q1 2020, and before this quarter, gross margin had been steadily improving.
What does all of this mean? Riskified's gross margin primarily consists of a "chargeback guarantee" expense. If its AI ever makes an error in which it approves a fraudulent order, Riskified's policy is to pay for the lost goods so its customer does not lose any money. While this makes Riskified's platform extremely appealing to customers, the guarantee can also shoot Riskified in the foot if its AI is inaccurate. A decreasing gross margin means that the company paid out more in chargebacks this quarter, meaning that its AI was relatively inaccurate.
There are two possible reasons for this increase in chargebacks. First, Riskified's AI could simply be highly inaccurate, which would be thesis-breaking. The second potential reason is not thesis-breaking and much better. Management noted that during Q3, it onboarded new merchants from new geographies and industries, namely cryptocurrency. Management claims that because these geographies and products are new to its system, the AI is currently inaccurate. The company says that as more data is gathered about these new industries, its AI will get more accurate and the chargebacks will decline, improving margin.
How I am moving forward
I am a fan of Riskified, and management's reasons do make sense. However, I am not one to simply take a management team's word as truth. Consider that almost every company nowadays is tossing out the word "AI" in hopes to get hype; it has become hard to decipher which companies use AI effectively and which ones are using it to gain attention. I believe that Riskified is one of the former, but its third quarter shook my conviction.
The only way for me to see the truth about its AI is to hold my shares and watch the next few quarters like a hawk. If its gross margin continues to remain low, I would assume that its AI is not as high-quality as I thought. If its margin improves, however, I can believe that it was simply getting adjusted to new industries. If that happens, I would be more than willing to buy more shares. But until then, I am doing nothing and watching the company closely.
