The stock we review in this report is highly attractive, even though its financials are misunderstood by many. Specifically, the company is the strong leader in providing a business critical function that is being transformed from an outdated manual process into a 21st century digitized cloud-based solution. And the total addressable market opportunity (to keep growing rapidly) is massive and growing. Unfortunately, many investors misunderstand the high valuation multiples and low profitability as a weakness. To the contrary, it’s an absolute strength and the right thing to do as the company capitalizes on the highly attractive opportunity. This business will eventually become a massive cash cow.

Overview: DocuSign

DocuSign (DOCU) offers an electronic signature (e-signature) tool and other cloud-based solutions for automating the transaction agreement process. Its product and services are offered as part of a broader software suite, called the DocuSign Agreement Cloud, which is designed to allow customers ranging from small companies to the largest global enterprises across industries and around the world to digitalize nearly every agreement, approval process or transaction. The company derives its revenue primarily from a subscription model and generated ~$1.5 billion in the fiscal year ending January 2021 (FY21) and $469 million in the first quarter of FY22. While it derives most of its revenue from the US, it has a growing international presence with offices in 12 countries. Through the digital route, it serves over a million customers in more than 180 countries.

E-Signature Leadership and the Broader Agreement Cloud Software Suite Provides a Compelling Value Proposition

Almost every business function including procurement, marketing, sales, finance, operations, human resources, legal, etc., involves some form of an agreement or contract between parties, that needs to be prepared, signed and completed. Traditionally, organizations have used manual methods to complete the agreement process, but these methods have often been disconnected, prone to errors and delays, and involves needless costs. DocuSign pioneered the digitalization of the signing part of the agreement process through its eSignature offering. This brought numerous benefits to customers using the offering in the form of a much faster (in FY21, 80% of all successful transactions using DocuSign’s e-signature tool were completed in less than 24 hours, and 49% within 15 minutes, compared to days or weeks using non-digital methods), easier, cost effective and less-risky signing process. This helped DOCU capture hundreds of millions of signers on its platform and evolve as a global leader in the e-signatures market.

The success of eSignature triggered the company’s transformation into a provider of a broad spectrum of cloud-based solutions to also digitalize and automate the pre and post signing processes involved in an agreement. DocuSign leveraged its e-signature capabilities to build a versatile cloud-based software suite around it in the form of the world’s first Agreement Cloud, and is using it to modernize the entire agreement process by moving it from a disconnected, paper-based manual sequence of steps to an automated, digital and collaborative system.

The platform consists of more than a dozen applications ranging from e-signature, document generation, contract lifecycle management, clickwrap agreements, guided forms, payments, etc.; features industry and department-specific solutions for financial services, real estate, banking, sales, human resources and procurement; integrates with over 350 common applications, such as Salesforce, Microsoft, SAP, Google, Oracle, Box and Workday; and incorporates APIs that allows users to connect the solutions with tools they already use. It is also easily accessible to users anywhere on their mobile or desktop, supports 44 languages for signing, is instantly updatable, auditable and legally accepted in more than 180 countries.

This strong value proposition has enabled DocuSign to onboard over a million customers, including some of the world’s largest companies across all verticals, as well as multiple government agencies, in a relatively short span of time. For example, its customer base includes 10 of the top 15 global financial services companies, 7 of the top 10 global technology companies, 18 of the top 20 global pharmaceutical companies, and 800 federal, state and local government agencies, among others.

Looking ahead, a wide variety of new add-on features and complementing services such as data visualization tools, improved data verification, video collaboration and remote online notarization service will further enhance the value proposition to customers. Making DocuSign’s services even more compelling is the recent acquisition of the smart legal agreement firm Clause, which will further complement DocuSign’s Agreement Cloud platform by introducing certain elements into existing contracts that will add value through the entire agreement process.

Well Positioned to Capture a Large Share of a Vast, Expanding TAM

DocuSign estimates that e-signatures represent a $25 billion market opportunity based on its own bottom-up analysis involving the number of potential businesses, use cases, users, pricing and spending data. However, the company’s primary competitor, Adobe is of the view that the e-signatures market opportunity is smaller at around $6 billion, and a number of industry analysts also suggest that the size of this market is smaller and in the range of $8 billion to $18 billion.

Nonetheless, we believe, DocuSign’s estimate of the market size for e-signatures commands merit from a longer-term perspective as it being the largest player holding ~70% share, is better equipped to gauge the size of the market due to its access to the widest range of data of customers using e-signatures.

Further, DocuSign estimates that the addition of more solutions for the pre and post signing phases of the agreement process (i.e., preparation, action and management) on the Agreement Cloud platform presents it with an equally large market opportunity as e-signatures, and doubles its total addressable market from the $25 billion e-signature phase to $50 billion.

Among the solutions on the Agreement Cloud, DocuSign believes contract lifecycle management (CLM) will be its longest-term growth driver. According to Dan Springer, CEO on 1QFY22 earnings call:

“I think CLM is going to be is just an emerging software category within the Agreement Cloud that, you know, several years from now, we're going to look back and say, same way we think -- someone would be crazy not to have any signature solution today if you look at it that way. I think we now will look at CLM when we get to that a few years down the road where people would be crazy not to be thinking about the way they manage their contract across the business. That's probably what I would take as a sort of the big winner, if you will, and what will contribute in the most substantial way to our growth over the long term.”

Notably, the market remains largely underpenetrated, providing significantly long growth runway, as well as greenfield expansion opportunities to players operating in the market. DocuSign is extremely well positioned to capture a large share of this vast market opportunity as it capitalizes on its large installed customer base to expand existing eSignature volumes and use cases, and then optimize the use cases to expand into the broader Agreement Cloud offerings such as CLM, analytics.

We note that the company has a compelling business model, wherein its largest customers often end up paying more every year after initially adopting the platform. Apart from a subscription fee-based pricing model that is based on product functionality and number of users, DocuSign also contracts with customers on a capacity-based model, under which there is a usage cap on the number of e-signatures, which it calls envelopes. The value proposition of the platform to customers often leads them to significantly expand their usage beyond the cap and this results in early contract renewals, often with significantly higher envelope allocations.

We expect the company will also target growth of high paying enterprise and commercial customer base across geographies, with a focus on countries outside of the US in particular. To this end, about 88% of the company’s total revenue is currently derived from only 14% customers (enterprise and commercial grade) that are served by direct selling efforts. As the company ramps up its sales efforts, it will target more of these high paying customers to grow the customer size. In fact, the growth in high paying customers is already outpacing the growth of other customers, as we can see from the following graphs.

Further, the company has ramped up its investments in international expansion, and currently has a direct sales focus in 8 countries. It believes that geographies outside of the US will be the major growth contributor going forward, and be the largest part of its addressable market opportunity.

Continued Strength from the Secular Growth of Digitalization, Expanding Non-GAAP Profit Margins

DocuSign received a big boost from the COVID-19 pandemic induced necessity of businesses to digitalize in order to stay competitive in a remote environment. While the pandemic related tailwinds are slowly waning, it has certainly caused businesses around the globe to think of digitalization as the way forward. With the agreement process being an important element of any business operation, the company continues to see strong demand for its solutions, both from existing and new customers across geographies.

As we can see from the chart above, DocuSign’s growth momentum remained intact during the first quarter of fiscal 2022 as its total revenue surged by 58% y/y to $469 million, with subscription revenue growing by 61% y/y to $452 million and making up 96% of the total revenue. International geographies, particularly EMEA, expanded at a rapid pace as international revenue growth accelerated 84% y/y to $101 million, resulting in continued growth in the contribution of international revenue to the total revenue, which stood at 21% during the quarter, up from just about 1% about five years ago.

Driving the strength was the continued strong demand and consumption of the e-Signature solution by existing customers that expanded the software coverage to more teams and use cases. While e-Signature has remained the major growth driver for long, the adoption of other solutions on the Agreement Cloud beyond e-Signature continue to generate a strong pipeline for DocuSign for the future.

The strong expansion across the existing customer base also drove a record-high dollar net retention of 125% in 1QFY22, while billings, a leading indicator of future revenue, also benefited from the strong demand and surged 54% y/y to reach $527 million, although it declined marginally from the highs of the previous quarter.

With regards to profitability, DocuSign typically has a high gross margin business. In 1QFY22, its non-GAAP gross margin expanded 2 percentage points to 81%, driven by 1 percentage point expansion of subscription gross margins, which presently track at over 85%. The non-GAAP operating margin expanded significantly from 8% in 1QFY21 to 20% in 1QFY22 as the company benefited from significant operating expense leverage due to the higher revenue levels, as we can see from the chart below. Operating cash flow more than doubled from $59.1 million in 1QFY21 to $135.6 million, while free cash flow more than tripled over the same period to $123 million.

Strong Guidance: DocuSign anticipates the strong growth momentum to continue in the future and guided to total revenue of $479-$485 million and $2.027-$2.039 billion, respectively for 2Q22 and FY22, which at midpoint represents a very healthy growth rate of 41% and 40%, respectively, and is expected to primarily be driven by strong subscription revenue growth. Billings are also expected to remain strong at $549-$561 million for 2QFY22, representing y/y growth of 35% to 38%, and at $2.338- $2.362 billion for GY22, representing 36% to 37% growth of FY21. Non-GAAP gross margin is expected to remain in the 79%-81% range, while the non-GAAP operating margins is expected to be 16% to 18% for the next quarter as well as for FY22.

Valuation

DocuSign currently trades at a healthy TTM P/S of 34.5x and a 1-year forward P/S ratio of 21.9x. And as you can see from the high sales (revenue) growth rate, the P/S continues to decline into the future as the large TAM continues to allow high growth. DocuSign is a classic misunderstood (but very attractive) investment opportunity because some investors misunderstand the low current profitability and high valuation multiples. DocuSign is spending heavily now to capture future growth (as they should be to capture this massive long-term opportunity). The company’s gross margins of around 80% are an outstanding indication of the future high profitability DocuSign can achieve if/when the growth rate slows (i.e. DocuSign will become a massive cash cow).

Risks

Competition: While DocuSign does not currently have any formidable competitor in e-signatures apart from Adobe, companies such as Dropbox and Box, Inc. have started to pursue opportunities in this space. Also, its other offerings in the Agreement Cloud such as CLM, analytics, face competition from a number of companies operating within these specific industries. Growing competition may force DocuSign to revisit its product pricing and thus limit its growth momentum.

Dependency on strategic sales partners: In addition to direct sales efforts, DocuSign is highly dependent on strategic partners, such as global system integrators, resellers and independent software vendors to sell its subscription offerings. Its agreements with these sales partners are generally non-exclusive, which means they have the freedom to sell competing products. Should any of these partners choose to use greater efforts to market and sell competing products, DocuSign’s ability to grow its business and sell its subscription offerings may be harmed.

Risk of becoming an integrated feature of proprietary software systems of large companies: As e-signature is a relatively simpler software to create and adopt, there is a longer-term risk that it might become a feature that is integrated into in-house workflow management solutions of large companies that typically tend to use proprietary software systems.

Conclusion

If you are looking for a dividend stock, DocuSign is not for you. However, it will eventually become a massive cash cow with the ability to pay much stronger dividends than just about any stock that pays dividends today (think future “yield on cost). Further, the price will continue to rise dramatically in the years ahead (albeit with the potential for plenty of ups and downs along the way—patience is a virtue!). The recent price run up is understandably concerning to some investors. However, its long-term growth prospects (from the expanding product functionality in a vast and unpenetrated markets) remain firmly intact. We currently own shares, and any dips in price from here should be viewed as a more attractive entry point.

Powerful Blue Chip: Highly Attractive, Classically Misunderstood