PagerDuty Shows Signs of Growing Strength – CML


Top Pick PagerDuty (PD) reported earnings on 12-3-2020.

We have not given the company the Spotlight imprimatur.

We added PagerDuty to Top Picks les than six months ago on June 15th, 2020 for $26.40.

The stock is trading at $39.63 as of this writing, up 50%.

We still find it to be well worthy of Top Pick status but are also hesitant, for now, to promote it to a Spotlight.

Remember Back in June…
On June 15th, when we introduced PagerDuty to Top Picks, in that dossier we made some comments, and they are not intended for the faint of heart.

Here is a “copy and paste.”

COVID-19 is real as are its impacts.We will see breathtaking stock drops. Whatever you think is the bottom, cut it in half again — that might be the bottom.

While the Digital Transformation (DX) thematic in general has been thrust forward, that does not mean that revenue and profits for all companies will increase.

[We refer to this as the “Two World’s Syndrome.”]

Trends will accelerate but revenue may not catch up for a couple of years.

There will be mass layoffs, a recession, enterprise spending cuts, and possibly far worse.

That means while the thematic has thrust forward, it will take time for the dollars to flow forward as well.

PagerDuty freely admits that some enterprise customers are pausing on previously agreed upon expansion deals, small businesses are under strain, and there is uncertainty whether sales cycles will lengthen.

As usual, Statista does a fantastic job of expressing these words in a chart.

The trend was obvious, and it will return to obvious, but for 2020, yeah, things will be bad.

Further, to assume 2021 will be “good,” is, well, a guess, not a matter of fact.

Then we wrote “It won’t be a smooth ride for PagerDuty [], but we think the ride will be worth it in 3-5 years.”

It is with that perspective that we move forward.

In the earnings release in the prior quarter we were unimpressed with earnings with regard to a tailwind from the digital transformation (DX), but were impressed with reality given the economic devastation that the United States is facing.

The two world’s syndrome struck PagerDuty stock hard.

This quarter we get a fresher bit of data and we maintain our bullish view while also maintaining a cautions tone.

The company has, thus far, been able to survive COVID-19, turn cash flow positive, increase its dollar based net expansion rate, and maintain exceedingly high growth with large enterprises.

These are very good numbers — these are very good descriptions.

First the numbers, then the perspective.

Revenue: $54 million (up 25.8% year-over-year) vs analyst estimates of $52.68 million
This is a small beat.

* Dollar-based net retention improved from 116% in the previous quarter to 119%, which means that customers (of a certain size) from last year are paying 19% more this year.

EPS: -$0.09 versus analyst estimates of -$0.10
This is a small beat.

Full Year Revenue Guidance: $211.5 million (at the midpoint) versus analyst estimates of $208.41 million.
This is a small beat.

Full Year EPS Guidance: -$0.295 vs analyst estimates of -$0.29.
This is essentially in line.

This slight miss reflects the impact of the company’s recently completed acquisition of Rundeck, which provides IT automation software.

— Commentary

* A noteworthy piece of data we received was that “Customers with annual recurring revenue over $500,000, up 40% year-over-year.”

* Another good metric was cash flow: Net cash provided by operations was $4.8 million, or 9.0% of revenue, compared to $3.4 million, or 8.0% of revenue, in the third quarter of fiscal 2020.

* Free cash flow was $4.5 million, or 8.4% of revenue, compared to $2.3 million, or 5.3% of revenue, in the third quarter of fiscal 2020.

* PagerDuty saw approximately a third of its enterprise and mid-market customers expand within the quarter.

* The CEO noted that: “The reception to new products launched in September exceeded our expectations, especially their response to our expanded automation and auto remediation capabilities with the acquisition of Rundeck which we closed in October.”

The company has, thus far, been able to survive COVID-19, turn cash flow positive, increase its dollar based net expansion rate, and maintain exceedingly high growth with large enterprises.

These are very good numbers — these are very good descriptions.

CEO Jennifer Tejada said in an interview with Barron’s that the company should continue to benefit from increased business adoption of cloud-base software, even after the Covid-19 pandemic ends.

Or, as she put it, “Digitization of the universe is a one-way door.”

PagerDuty’s free plan, which was formally introduced in the quarter.

The number of companies benefiting from the PagerDuty platform, both paid and free, grew by 18%, which isn’t huge, but it’s good.

A part of PagerDuty’s moat revolves around its rather large integration platform.

In the third quarter of fiscal 2021, along with Rundeck, PagerDuty reached over 500 partner ecosystem integrations, many of which were built by partners like CloudFlare, GitHub, Puppet and Zoom.PagerDuty also had a record quarter for channel partner sell-through and formed a global strategic alliance with Tata Consultancy Services, one of the top five global systems integrators.

Source: PagerDuty

And while we’re on the topic of moats…

… one phenomenon that has occurred to us throughout the DX has been both the urgent need for better DevOps software (like PagerDuty), but also, a non obvious moat.

We mean this not just for PagerDuty, but for all of them, from DataDog (DDOG) to New Relic (NEWR) and Talend (TLND) among many (many) more.

That is to say, there are legitimate switching costs for customers, but in the realm of winning new business, this is one area in SaaS that feels like “a little bit of this and a little bit of that” is more common than “it must be this company.”

This view has evolved over time.

When analysts place a company like Spotlight Top Pick Elastic (ESTC) in this category, we simply dismiss the lack of industry specific knowledge and Elastic’s recent earnings blow out, which we discussed on 12-2-2020 (Elastic Punishes Doubters and Proves its Moat), is evidence of its moat.

Elastic has a moat driven business due to Elastic Search, and as a “by the way,” it has great DevOps tools.

But we are talking about the DevOps world where the main function is just that – DevOps.

PagerDuty falls into this group, so for now, we like the company, but this is one of the few Top Picks that we really do watch quarter-to-quarter, in particular for signs of a moat (or lack thereof).

Now let’s review the long-term view of PagerDuty and why it is a Top Pick.

PagerDuty lives in the DevOps and IT worlds as yet another cloud software as a service company, this time in the real-time technology monitoring and alerting realm.

The company fashions itself as “the central nervous system for the digital enterprise” and in that goal it is one of the companies that help enterprises accelerate their digital transformation at scale.

Specifically, it harnesses digital signals from virtually any software-enabled system or device, combines it with human response data, and orchestrates teams to take the right actions in real time.

It has a cloud native architecture, a DevOps approach to production, and a programmatic approach to customer success.

This is a start to a new market, not the inevitable conclusion that it will be successful.

A major focus of the selling comes not just from monitoring and alerting, but in fact, in reducing the number of alerts that legacy products provided, while amplifying the truly mission critical alerts and then anticipating them with machine learning.

It’s ambitious, but the company does aim not just to improve operations and accelerate innovation, but to increase revenue for its customers.

In fact, the company claims that it provides a 731% ROI for its customers.

IDC Business Value Research published a report (sponsored by PagerDuty) that gave us some numbers around the ROI claims.

Before PagerDuty

And then the analysis after PagerDuty was deployed.

After PagerDuty

PagerDuty provides a platform for real-time operations.

The platform collects signals from virtually any software-enabled system or device, correlates and interprets signals to identify events, and engages the right team members to take action in real time.

The company mines machine data and human response data to embed analytics, machine learning, and automation within the platform.

The software, as it should, does ‘learn’ from every incident, meaning the more enterprises it gathers, the longer an enterprise sticks with it, and the more use cases the enterprise stacks on, the better it gets.

We can see the circumstantial evidence of this use case through its dollar based net expansion rate (DBNER) of 116%.

Digital data is flowing at a speed and volume that was already unprecedented and with the COVID-19 global health pandemic, all of the adjectives we used to use about data growth had to change to somehow larger words.

‘Massive’ went to ‘Incredibly Massive,’ and all sorts of verbal gymnastics had to be employed. But, as bothersome as hyperbole can feel, this really isn’t hyperbole.

What we have seen in technology in this space is truly a multi-year shift forward within a matter of months, weeks, and in some cases for some companies, days.

We are talking about data from social media, containers, micorservices, networks, security, apps and related services, databases, servers, the cloud and more all flowing at hyper speed forward and with all of that enterprises must adjust, react, and after reacting, become proactive.

The companies that will successfully pull forward their DX will succeed. Those that do not, will not.

For PagerDuty it comes down to a simple phrase for their customers, “make sense of data,” or, if you prefer, “analyze and learn.”

PagerDuty describes a sort of progress step function starting at reactive, going to responsive and proactive, and finally ending at preventative.

PagerDuty’s moat, or its establishment of such, is based in part on its decade of collecting machine data from thousands of customers along with human data (the reactions and steps that flow through the step function of progress).

A part of that moat also comes from its 350 integrations, like the one newly announced with Microsoft Teams.

The digital transformation market revenue worldwide as forecast by Statista in coordination with IDC now tops $1 trillion.

In a survey and analysis done by Flexera a staggering 91 percent of respondents expect the pace of change in digital transformation to accelerate over the next year, with 52 percent saying it will increase significantly.

This survey was done in March, so we can expect even those absurd levels to lean more heavily toward a ‘significant increase.’

This is a small sample but a good real-life example of what we mean when we read that the thematic was already massive, COVID-19 just gave it some other very important sounding adjective in front of the word massive.

Within that colossal opportunity, PagerDuty sees its market as digital operations management, yielding a $100 billion total addressable market (TAM), broken into silos. Here is an image from the company.

The company sells to enterprises, which it categorizes as companies with revenue greater than $1 billion, mid-market (revenue greater than $50 million), and SMB.

The company sees hyper growth in the larger sized businesses.

That’s it.

That’s the bullish thesis for PagerDuty.

The company will capitalize on its position within DevOps SaaS or it will not.

The rest is just conversation.

About that Digital Transformation (DX)
The digital transformation (DX) due to COVID-19 is a permanent shift in the way technology is used by people, governments, and enterprises around the world.

Fastly is not projecting that COVID-19 is a onetime event. It sees it as a “sustained strength going forward unquestionably.” (CEO)

Almost every other CEO we spoken to echoed those same remarks.

The Internet would have broken if this happened 10 years go.

But this is not 10-years ago, it’s today, and in that vein the Internet has been the technological hero of this global health pandemic.

While this virus is a tragedy, if it happened to us ten years ago, the death toll and economic impact would have been far (far) worse.

Due to breakthroughs in technology, our medical scientists can react faster and with greater precision in an effort to vaccinate this disease.

Due to breakthroughs in technology, individuals are able to use e-commerce for nearly everything.

Due to breakthroughs in technology, the Internet can thrive under immense and sustained traffic.

Due to breakthroughs in technology, enterprises can turn a DX project from three-years into a weekend.

For all the paranoia surrounding technology, make no mistake, due to breakthroughs in technology, lives have been saved, economies have been resuscitated, and the general world order has been preserved itself while pursuing the largest, most coordinated global cooperation in the history of mankind.

So, yes, technology companies that are empowering this change, that are enabling this change, will see their stock prices go up.

PagerDuty attempts to be one of these companies.

For the crew out there, that sits in incredulity at some of these stock prices, in our opinion, it would be incredulous if they didn’t rise this far this fast.

So, yeah, stuff is going to get weird in the stock market.

Really weird.

There has been an unnatural exogenous event that has had an unnaturalnegative impact on human kind.

In response, governments are having to act in unnatural ways to combat an unnatural systemic and human risk.

That’s not legislators being dumb or the Federal Reserve “pumping” the stock market.

It has a different name.

It’s called coordinated and forceful intellect.

It is the understanding that this unnatural disturbance requires an unnatural response.

It turns out that Fed Governors might actually know what they’re doing and sometimes, a PhD from Harvard isn’t a bad thing.

The market will have an unnatural response to this unnatural disturbance and equally unnatural intervention.

It is going to get bumpy and the stock volatility to follow is the only part of this whole thing that is natural.

When the best investors in the world hear consternation about a stock price ‘on that day that time’, they don’t hear it.

It’s not a reluctance to it, it simply means nothing.

A day cannot encapsulate the changes that have already been laid.

This understanding that whatever the market does today has no impact on the view of the future has a name.

It’s called perspective.

The rare (rare) few have it.

It is these rare few that we call the best investors in the world.

It is this group of people that you can join, by making a decision.

You are the best investor in the world with perspective.

Don’t lose it.

PagerDuty has a lot of risk.

The company competes in a field with a lot of legacy players which are, warts and all, deeply embedded into the fabric of many IT departments.

Displacing these legacy providers is costly, arduous, and not necessarily fruitful.

Remember that legacy platforms aren’t stagnant, they too see the changing times and they too will attempt to innovate.

Further, and perhaps a greater risk, PagerDuty faces many companies of the new generation.

A wave of cloud-based software offerings either directly compete with PagerDuty’s offerings, or as threatening, use monitoring as an add-on service.

For example, Spotlight Top Pick Elastic (ESTC) is a masterful software dealing in the world of search, but yes, it too has a monitoring piece to its software.

Finally, COVID-19 is a thing.

It’s not a thing like the stock market sees it, it’s a thing like it could destroy businesses, economies, and lives, not to mention upstart software companies.

We will see breathtaking stock drops. Whatever you think is the bottom, cut it in half again — that might be the bottom.

We will not curl up into a ball and rollover due to the coronavirus risk.

We will look for opportunity if it strikes and keep a long-term perspective as we do so.

PagerDuty is a compelling company to us.

It exists in all the right thematics, it’s growing, it has the makings of a moat, a strong DBNER, fully controlled cash flow from operations, a strong balance sheet and an impressive product suite.

It is an underappreciated opportunity right now, trailing its faster growing peers significantly in stock returns and, fairly, in growth.

It has been a terrible investment since its IPO, and stocks don’t lag for lack of attention, they lag because they aren’t as good as the other opportunities.

We see a shift, an opportunity, and certainly a company we want to keep in the Top Picks tracking portfolio.

We will need to see revenue growth accelerate from newly offered guidance and a stronger competitive position to give it the next step up, which would be a Spotlight Top Pick.

Thanks for reading friends.

The author has no position in PagerDuty (PD) at the time of this writing. The author is also long shares of ESTC of the other companies mentioned.

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