E-signature pioneer DocuSign (NASDAQ:DOCU) delivered strong third-quarter earnings in early December. In response, DOCU stock rallied to all-time highs.
Everything in the report looked great. The company’s customer growth was robust, as more and more businesses around the globe start to digitize and automate their contracts. The company’s revenue growth was even more robust, as DocuSign’s “foot in the door and grow” model is working, and current customers are spending more on DocuSign’s suite of Cloud Agreement products. Its gross margins held steady at an impressive 80%, while its strong revenue growth increased its profitability. As a result, its third-quarter profit was sizable, versus its tiny profit during the same period a year earlier.
On top of all that, the company provided healthy Q4 guidance which indicated that all of these positive dynamics will persist into the end of the year.
In other words, the 7% pop of DOCU stock after the Q3 results made sense, right? After all, its numbers were great, its growth outlook is healthy, and all signs point to “GO”… right?
Wrong. While DocuSign is a great company and DOCU stock is a long-term winner, there is one big red flag now which warrants caution. That red flag is the valuation of DocuSign stock. I understand DOCU is a growth company that deserves a premium valuation. But, even aggressively assuming that the company will grow rapidly for the next decade, it’s still tough to justify the current price of DOCU stock.
As a result, I think DOCU stock is riddled with valuation risks. The stock may brush off those risks in the near-term, thanks to the momentum from its earnings. But, at some point, these risks will rear their ugly head.
DocuSign Is a Great Company
To be clear, I think DocuSign is a great company.
The whole growth outlook of DocuSign centers around the digitization and automation of the contract process. That is, the traditional contract process involves a ton of paper (which is bulky and sometimes costly) and requires that paper to be sent back and forth between various parties multiple times In other words, the traditional contractual process is antiquated, lengthy, and costly.
DocuSign fixes all those problems by digitizing and automating the contract process. Among other things, it makes all the documents and the signing process digital, eliminating all the paper involved in those processes. DOCU also transforms the transit, record-keeping, and enforcement of contracts into digital processes. It basically makes the whole contractual process digital, causing it to become modern, fast, and affordable.
For corporations, that’s a good deal. That’s why DocuSign has grown its enterprise and commercial customer base from 23,000 in 2015 to what will be north of 70,000 by the end of 2019. Still, at 70,000, DocuSign’s customer base pales in comparison to the millions of businesses in the world, so DOCU can still grow a great deal.
At the same time, DocuSign is a software-as-a-service (SaaS) company with very little overhead, so its gross margins are running near 80%. Its operating spending rate is very high. But that high spending rate will come down over time, thanks to sustained, high revenue growth.
So DocuSign is at the epicenter of the non-cyclical growth of corporate digitization, has plenty of room to grow in the long run, and could one day generate huge profits.
DocuSign Stock Is Overvalued
Although there’s a lot to like about DocuSign, the one thing that’s bad about it is the valuation of DocuSign stock. That is, even based on aggressive long-term growth assumptions, DOCU stock is simply overvalued today.
DocuSign has customers of all shapes and sizes. But last quarter, roughly 87% of its revenues were generated from the company’s enterprise and commercial clients, or businesses with ten or more employees. Thus, its whole growth outlook at this point centers around signing up more of those clients.
As of right now, DocuSign’s core markets include North America, Europe, and Australia. There are 1.3 million businesses with ten or more employees in the U.S. There are another 1.7 million such businesses in the European Union, about 310,000 in Canada, and 50,000 in Australia. All together, that’s about 3.4 million potential enterprise and commercial clients for DocuSign.
With just 69,000 customers, DocuSign is tapping into less than 0.5% of the market. Its share of the market will grow over time. But it won’t ever get that big because its market is very competitive, with the very formidable Adobe (NASDAQ:ADBE) offering competitive products and various other smaller, industry-specific vendors dominating their respective contract niches. As a result, I think DocuSign’s market share will be roughly 10% by 2030, translating to roughly 340,000 customers.
Meanwhile, DocuSign’s average revenue per contract should grow steadily, thanks to the company’s “foot in the door and grow” model. Its gross margins should stabilize around 80%, thanks to healthy demand growth. Its operating spending rate should fall to 50% (above the tech average of 35% because I think the company will have continue to spend a great deal on product development and marketing to stay competitive).
Putting all that together, I see DocuSign going from a sub-$1 billion revenue company with tiny operating margins today to a $6 billion-plus revenue company with 30% operating margins by 2030. But that still won;t justify a $70-plus price tag for DOCU stock.
I think that earnings per share of $5 is doable by 2030. Based on a forward price-earnings multiple of 35, which is average for application software firms, and a 10% annual discount rate, that equates to a 2019 price target for DOCU stock of below $70.
The Bottom Line on DOCU Stock
DocuSign is a great company, and DOCU stock is definitely a name investors should own over the long haul. But DocuSign stock is not attractive at these prices. DOCU stock is simply overvalued now, as investors are becoming overly euphoric about the company’s long-term profit growth potential. Eventually, this euphoria will die down. When it does, DOCU stock will fall. That will be the time to buy DoCuSign stock.
As of this writing, Luke Lango was long ADBE.
