It is often fun to look at the new, exciting companies that came public within the past year, but there is typically a lot of hype around them. Companies that have been on the market for over a year can sometimes be a great place to search for additions to your portfolio.
PagerDuty (PD -0.56%) could fit that bill. The company is working on solving migraine-level problems to make it easier for companies to move to the cloud. It came public in late 2019, but is it good enough to add to your portfolio?
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A land-and-expand approach to problem-solving
PagerDuty is a software provider that ensures businesses' online platforms are running smoothly and reliably, to ensure good customer relations. When seconds matter, PagerDuty aims to reduce downtime for its business clients.
Among its products, its on-call management tool makes it easy for employees to report issues, and it monitors online operations 24/7. Its incident response tool aims to reduce downtime to as little as possible, and its other tools provide quick detection and readiness for any issues.
As such, PagerDuty has seen increased adoption by businesses.
| Q3 2021 | Q2 2022 | Q3 2022 | |
|---|---|---|---|
| Customers spending over $100,000 | 401 | 501 | 543 |
| Customer growth compared to the year-ago quarter | 10.4% | 6.2% | 5.5% |
Source: PagerDuty.
The company lands customers with a free trial (with nearly 4,500 users taking part) and its core products allow it to expand its relationships with them, leading to impressive revenue growth. In the third quarter, it grew 33% to $71.8 million, and PagerDuty has kept its churn rate below 5%.
The company's primary competitive advantages are its sticky product and the ability to land and expand with customers. PagerDuty offers a mission-crucial service that would be hard for a company to switch away from because of the high contract values and the learning curve for its customers to adopt a new product.
What makes PagerDuty risky?
As appealing as its competitive advantages are, there are plenty of risks with this company. The most concerning thing is that its growth has been rapidly slowing.
| FY 2019 | FY 2020 | FY 2021 | Q3 2022 | |
|---|---|---|---|---|
| Revenue growth compared to the year-ago period | 48% | 41% | 28% | 34% |
| Customer growth compared to the year-ago period | 14.5% | 13.9% | 4.8% | 5.5% |
| Net retention rate | 140% | 122% | 121% | 124% |
Source: PagerDuty SEC Filings. FY=Fiscal Year.
Since 2018 (the fiscal year 2019) -- right before PagerDuty came public -- the company has slowly started to decline. While it is still a good sign to see its customer count increase marginally year over year, it is a meaningful slowdown compared to 2018.
The second risk that I see with PagerDuty is its profitability. Since fiscal year 2020, the company's net loss as a percentage of revenue has continuously worsened.
| FY 2020 | FY 2021 | Q3 2022 | |
|---|---|---|---|
| Net loss as a percentage of revenue | 30% | 32% | 36% |
Source: PagerDuty SEC Filings. FY=Fiscal Year.
Slowing customer growth is indicative that the company's overall growth will start to stagnate, meaning that the company's sales and marketing expenses are becoming less effective. It is still spending over 55% of revenue on sales and marketing for just 5% customer growth, so it is clear that PagerDuty is spending too much on marketing.
I am typically OK with a fast-growing company that has large net losses, but when that company begins to see less growth, its profitability is much more important, and slowing growth combined with increasing losses is concerning.
Is it a buy?
While PagerDuty's products are crucial for businesses, I don't think the stock is a good buy today. It helps solve a migraine-level problem for its customers, but PagerDuty isn't attracting many more businesses. The company is able to grow the relationship with the customers it does have, but that alone is not enough to make it investable.
The slowing growth and the losses concern me. And at 12 times sales, its stock price is not terrible, but it is high. Like a company's net loss, I tend to pay more attention and be more critical of a company's valuation when I see slowing growth, and PagerDuty fits that bill.
While I like PagerDuty's business model, the financial picture tells me a different story. Its products are vital to a business' digital operations, but the financials show me that they haven't been vital enough to sustain continued growth. For this reason, I am staying away from PagerDuty for now. If the company can turn around its growth prospects and reduce its net loss, I would be very interested. For now, however, I will continue to watch this software-as-a-service stock from afar.
