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DocuSign Stock Is a Winner, But Keep a Close Eye on Valuation Risks

One enterprise technology stock that has shown impressive resilience amid the market’s coronavirus plunge over the past few weeks is DocuSign (NASDAQ:DOCU). At present, DocuSign stock trades just 3% off its February all-time highs. The S&P 500, in contrast, trades more than 10% off its February all-time highs.

This resilience makes sense. DocuSign provides digital contract lifecycle management (CLM) solutions to enterprises. The coronavirus crisis across the globe won’t materially impact demand for these digital CLM solutions unless the economy comes to a screeching halt for a prolonged period of time, which it won’t.

Concurrently, the resilience makes sense when you consider that DocuSign stock is a long-term winner, supported by a best-in-class product in a market with robust growth tailwinds, a significant runway for big growth to persist for a lot longer, and a favorable margin profile which lends itself to huge potential profits at scale.

All in all, then, one shouldn’t be surprised that amid all this market volatility, DocuSign is down only 3%.

But, DocuSign stock isn’t without risks. The company has a ton of competition in the digital CLM space, that competition may ultimately limit the company’s long-term profit growth potential, and the valuation on DOCU stock is very rich.

All things considered, the investment thesis here is simple. I wouldn’t chase DocuSign stock up here. But I would own this stock for the long haul. Wait for a dip. Buy on that weakness.

DocuSign Is a Winner

In the big picture, DocuSign is a long-term winner.

The company is a best-in-class digital CLM solutions provider, at a time when every company across the globe is pursuing the paper-to-digital transformation. That means every company everywhere is going from a paper-based CLM program (where you sign contracts, close deals, and do all contract-related things on paper), to a digital-based CLM program (where you do all of that stuff online).

DocuSign is the unparalleled leader in the digital CLM market. So, as more companies migrate to digital CLM programs over the next several years, more companies will pay up for DocuSign’s products.

In this market, DocuSign already has a ton of momentum. Revenues rose 40% year-over-year last quarter. Customers rose 30%. More importantly, there’s ample runway here for DocuSign to sustain big growth for a lot longer.

By my calculations, there are over three million small-to-large enterprises across developed economies that could use digital CLM solutions. DocuSign only has 69,000 such customers today, meaning the company has tapped into less than 2% of its addressable customer pool.

Even further, the company operates at a very healthy 80% gross margin. Big revenue growth is also driving positive operating leverage across all major opex lines. If this continues, as it should, then the company has an opportunity to produce sizable profits at scale.

In other words, DocuSign has all the makings of a winning stock. Winning is exactly what the stock has done so far. Shares are up 60% over the past year.

DocuSign Stock Has Risks

The winning in DocuSign doesn’t come without risks. Of note, I think shares have three major risks here which are keeping me from chasing this rally.

First, there’s a lot of competition in this space. The enterprise paper-to-digital transformation isn’t anything new. It’s been around for a while. And a lot of companies, like Adobe (NASDAQ:ADBE) with their Document Cloud offering, have formidable presences and strong products in this space. This competition won’t die down anytime soon. If anything, it will pick up.

At present, DocuSign has been able to brush aside these competition risks. That’s because they are a very small company operating in a very big market. But, as the company gets bigger, it will more aggressively rub elbows with competitors. This could cause customer and revenue growth slowdown in the coming years.

Second, in order to fend of elevated competition at scale, DocuSign is going to have to invest big in things like market research, product development, sales, and marketing. So, while the company is benefiting from hugely positive operating leverage today, I think the magnitude of that leverage will decrease as the company gets bigger and runs into more competition.

Third, the valuation on DocuSign is very rich. Shares trade at 210-times forward earnings. That’s rich, even for a hyper-growth software company. It’s especially rich for a hyper-growth software company with competition, growth, and margin risks.

Bottom Line

DocuSign stock is a long-term winner. But the price tag today seems a bit rich. I’m not chasing this rally. Instead, I think that a growth hiccup over the next few quarters is likely and that such a growth hiccup will cause a material pullback in shares. I’ll look to buy on that pullback.

Luke Lango is a Markets Analyst for InvestorPlace. He has been professionally analyzing stocks for several years, previously working at various hedge funds and currently running his own investment fund in San Diego. A Caltech graduate, Luke has consistently been recognized as one of the world’s top stock pickers by various other analysts and platforms, and has developed a reputation for leveraging his technology background to identify growth stocks that deliver outstanding returns. Luke is also the founder of Fantastic, a social discovery company backed by an LA-based internet venture firm. As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.

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