How can you tell if a technology is emerging or disruptive? The former has emerged, but not yet disrupted. Disruptive technologies are those which are actively capturing market share through strong revenue growth, but they’re different from growth companies. Leading global index provider MSCI (MSCI) defines growth using five factors, three of which involve earnings per share. Your typical disruptive technology company won’t have positive earnings until they capture as much market share as their funding allows.
Only one of MSCI’s growth factors – historical sales per share – looks at revenue growth using five years of history. Consequently, disruptive technology companies may not appear on the radar of traditional growth investors. Revenue growth is one of the most important variables we consider when looking at disruptive technology stocks. If you’re not capturing market share, you’re not disrupting. When a disruptive technology company stops growing revenues, it loses its status as a disruptor. So, what’s an objective rule that would indicate stalled revenue growth?
When Revenue Growth Stalls
Revenues that grow at 3-5% per year simply represent natural inflation. Firms will often implement price increases which their clients begrudgingly sign off on when convinced said price increases are accompanied by added value over time. (A price increase notice will almost always make mention of product improvements that have client visibility.) The implication is that companies need to continue evolving products/services development just to achieve 3-5% growth. Therefore, if you back out inflation, actual “double-digit growth” starts somewhere around 13-15% (not 10% as the name implies). Similarly, 8% revenue growth becomes 3-5% real growth. This is a good segue into today’s topic – the mediocre revenue growth over at DocuSign (DOCU) which represents 8% at the midpoint of Fiscal 2024 guidance.
- 2023 Revenue Actual: $2,520
- 2024 Revenue Guidance: $2,719
That’s down from 19% growth last year, so not horribly bad all things considered. Every software-as-a–service (SaaS) firm is reporting weakness in the face of today’s “macroeconomic headwinds,” but our next metric points to some real problems under DocuSign’s hood.
Net Retention Rate (NRR)
SaaS firms typically provide useful metrics such as net retention rate which represents how much money existing clients are spending. At 103-105%, that simply means clients are incurring normal pricing increases that result from inflation and nothing beyond that. In other words, they’re not spending more as time goes on. It’s not just troubling that DocuSign has managed to see NRR decline for eight quarters in a row, it’s that they expect it to continue declining beyond the dismal 105% they’ve already reached.
If existing clients spend less, it’s because your service wasn’t core to their operations and/or they’re giving the business to someone else. Maybe Adobe is using today’s “macroeconomic headwinds” as an opportunity to displace DocuSign by engaging in a price war (which Adobe is more able to win given they’re 20X the size of DocuSign) or by pushing CTOs towards something they’re already planning to do – vendor consolidation.
It’s reasonable to assume a drop in net retention is accompanied by a drop in gross retention. While we’re not provided with the latter metric, there’s another way to gauge if clients are bailing. Usually, SaaS firms like to break down clients into “spending buckets” which should all be seeing healthy growth over time. For DocuSign, they report on “number of customers spending $300,000 annually” which fell this quarter.
Assuming no new customers entered this bucket during the quarter, DocuSign had 17 customers who spent $300,000 per annum last quarter, but are no longer spending that amount this quarter. Perhaps they’re just spending $250,000 instead, or maybe they exited the solution entirely to get in bed with Adobe. This underscores the important of seeing gross retentions rates, though the company’s earnings call explained the reasons as “customer buying patterns, lower expansion rates, and partial churn.”
The Latest Earnings Call
DocuSign’s earnings call starts by emphasizing new product releases and coming product releases with mention of a “more moderate pipeline and cautious customer behavior coupled with smaller deal sizes and lower volumes.” They talk about confidence in solving “complex and high-value use cases,’ something that contradicts at least 17 of their biggest clients spending less this past quarter. While overall headcount dropped, three chiefs were added – a new Chief Financial Officer, Chief Product Officer, and Chief Information Security Officer.
Perhaps the worst bit of news is they expect “the Q2 dollar net retention to continue to experience downward pressure.” One analyst asked about gross retention – twice – and was given an elusive answer that provided no color. What did manage to enter the discussion was (wait for it) generative AI which everyone had some good banter around, but which ultimately left us feeling empty inside. As for DocuSign’s ability to hit guidance this year, the sentiment wasn’t overly positive.
…it is still early in the year and we remain cautious in our outlook, given moderating expansion rates and slowing customer demand driven by the uncertainty in the current macro environment and continued competition, particularly in more basic eSignature use cases.
Credit: DocuSign earnings call transcript
Looks like Adobe is giving them hell on small ticket subscriptions.
Some Thoughts on DocuSign Stock
Our last piece on DocuSign – Is It Time to Worry About the Slowdown in DocuSign Stock? – looked at the pressures being faced from key competitor Adobe (ADBE), and how DocuSign might return to growth via the many adjacent services they could offer in the LegalTech space. That doesn’t appear to be happening yet. Assuming DocuSign hits their revenue guidance midpoint, and then guides to the same for Fiscal 2025 (revenue growth of just 8%), would we bail on the stock?
The weakening metrics we’re seeing at DocuSign – consistently falling net retention rates, declining customers spending more than 300K, single digit revenue growth – point to more fundamental problems with the business. They imply this solution isn’t sticky. Perhaps Adobe’s breadth of product offerings mean they win when it comes to vendor consolidation decisions. Maybe a company uses both Adobe and DocuSign, so they consolidate their larger Adobe contract and renegotiate better pricing while dropping one of Adobe’s key competitors. Everyone wins except DocuSign.
Gross retention rate is a key missing metric here, and hopefully it doesn’t look like their net retention rate which has absolutely plummeted since we last checked in. At this pace, they’ll soon be below inflation adjustments which could imply they’re discounting prices to keep customers from leaving. After all, we see that at least 17 customers who were spending $300,000 or more aren’t now. That leaves us with three key metrics to watch closely:
- Revenue growth: Later this year DocuSign will announce next year’s guidance, perhaps at the same time they release this year’s actuals. Any disappointments here will underscore our concerns.
- Net retention rate: Has now dropped for eight quarters in a row. This our biggest concern – existing customers find increasing spend with DocuSign as optional.
- # of Clients over 300K: Large clients are spending less, and there should be a correlation between this number and the net retention rate.
If they can’t improve two out of three by the end of this year, we’ll have to look for LegalTech exposure elsewhere. If we choose to move out of this position sooner – and we may well if these red flags worsen – then Nanalyze Premium subscribers will be the first to know.
Lastly, we recently published a video on ARK’s favorite stocks which talked about how aping ARK is foolish because they’re an active manager that trades for various reasons. We concluded that the only real bearish sentiment coming from ARK would be when they completely exited a position. The below chart taken from Cathie’s ARK shows when ARK exited DocuSign in what appears to be a very sudden reversal.
The purple line above – shares owned – shows how Ms. Wood bought the dip in late 2021, then sold the entire lot just weeks later. What piece of information did ARK’s analysts uncover which would have pointed to the relentless decline in net retention rate that followed shortly after?
Conclusion
Oftentimes we’ll see companies lower guidance a bit and the market overreact by cratering the share price. More rarely, we’ll see a company throw off some red flags which seemingly go unnoticed by the market. DocuSign’s last quarter was seen as largely positive, but we’re becoming more concerned. And if you have concerns, you need objective metrics to analyze whether they’re getting worse or better. Going into the latter part of this year, we’ll be watching net retention rate, customers over 300K, and overall revenue growth very closely. If they don’t improve, we can’t justify holding a disruptive technology company that no longer appears to be disrupting.
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