Dec 22 2020 - Domo: Next Catalyst Will Be Profitability

Domo has achieved adjusted positive cash flow status in Q3 FY1/21. Management has executed well under difficult conditions.

The shares have responded to this news, but we believe there is further upside to go as Domo aims to become profitable.

Positive metrics point to quarterly breakeven being achieved during H2 FY1/22.

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Investment thesis

Despite Domo (DOMO) shares rising 90% month to date, they remain undervalued. Focus has been on credit and cash generation, but the next step will be generating quarterly operating profit which looks achievable in the latter half of FY1/22.

No longer a credit risk

Domo shares have risen 200% plus year to date, demonstrating that despite challenging market conditions management has executed well. The key goal was to make sure Domo did not end up being a credit risk event, running out of cash with its sustained cash burn. CEO Josh James stated during the Q3 FY1/21 call that the company has reached a "huge financial milestone", and that they are a "recurring revenue, cash flow positive company".

Back in August 2020 when Domo refinanced its credit facility, the interest rate charged at 9.5% was testament to the apparent lack of credit worthiness. The re-set IPO and the historic cash burn profile warranted caution. And let us not get too carried away after just one quarter of adjusted positive cash generation.

This may be splitting hairs but Domo continued to be free cash flow negative in Q3 FY1/21, burning around .8m. However, cash and cash equivalents did increase QoQ by 1%. We all have to start somewhere, and this does look like a turning point for the company.

What has seen a marked improvement are the performance metrics in Q3 FY1/21, which show that Domo's Business Intelligence subscription service is winning customers over and demonstrating success:

1. Latest Q3 gross revenue retention was over 90%, a record high - a year ago management would mention this metric as 'approaching' or being 'approximately' 90%. Existing customers are getting value and seeing more success with Domo's all-in-one business intelligence tools than before - and churn is declining.
2. Billings grew 25% YoY, showing that new customers are being won, and upsell activity is yielding results.
3. 59% of customers are on multiyear contracts. This compares to 52% a year ago, and a worrisome 39% two years ago. Recurring revenues are indeed on the up.

The next hurdle - profitability

Achieving profitability is the next step. Historically, sales and marketing costs have been very high contributing to operating losses. Spending had been misdirected at unsuccessful campaigns such as digital marketing to win small customers. However, since the company changed direction last year to target the Fortune 500 and develop strong use cases to demonstrate Domo's value, the prominent seven-figure orders began to come through and user churn improved.

Figure 1. Sales and marketing costs as proportion of sales

Source: company, created by author

There is still some way to go, particularly in terms of improving sales efficiency. Using the (SaaS) 'Magic Number' method, the result is a score of 0.37 for Q3 FY1/21 which still places Domo in the unsustainable spending category. The most recent high score was 0.42 in Q3 FY1/20 - a year ago. The pandemic then struck, so arguably Domo is still on the right track. But investors will want to see a score of 0.5 or above, and ideally in the longer term a score of 1.0.

Figure 2. SaaS Magic Number calculation

Source: company, created by author

The company has spoken of aiming for 20% operating margins and clearly this is some way off. Achieving breakeven on the other hand looks realistic given the following in Q3 FY1/21:

1. subscription revenues represented 87% of total revenue.
2. subscription gross margin was 81%, up from 76% same period last year.
3. operating loss margin improved significantly to -35% from -59% same period last year.

These factors indicate that with growing sales volume, profitability is set to rise. The timing of targeting breakeven is not known, and management may be keen to spend on growth into FY1/22.

However, if the company can maintain annual revenue growth of 20% YoY and keep a rein on operating expenses, it does look probable that quarterly breakeven can be achieved sometime in H2 FY1/22. Why? Scale and operational gearing should drive visible uplift in margins, similar to the position seen in Q3 FY1/21.

How much upside?

With tech stocks looking fundamentally expensive, it is difficult to say when the market will wean itself off its appetite for growth (at any cost). What makes Domo different is that:

• Growth is more structural and sustainable with Digital Transformation at the workplace, as opposed to work-from-home players that saw accelerated growth in 2020 which is set to normalize.
• Domo is undertaking a business recovery as well as generating growth.

Consensus forecasts place Price/Sales of 7.1x for FY1/22. Using data preparation peer Alteryx (AYX) as a comparison, its Price/Sales is 14.8x for FY12/21 - more than double Domo's multiple at a similar rate of sales growth YoY. Alteryx is streets ahead in terms of profitability and cash generation, but is indicative of where Domo could end up.

Another peer is Blue Prism Group plc (OTCPK:BPRMF), a robotic process automation (RPA) software company. Also a loss-making entity, Blue Prism offers Digital Transformation with a cloud offering, and trades on Price/Sales of 8.7x for FY10/21. FY10/20 sales growth was 40% YoY, nearly double the growth of both Domo and Alteryx.

A target multiple for Domo looks appropriate somewhere between where Alteryx and Blue Prism are trading. With sales growth at a slower pace than Blue Prism but profitability looking more realistic, the target is Price/Sales 10x for FY1/22 denoting 40% upside.