Docusign (NASDAQ:DOCU) has been one of my top stocks as it has returned nearly 400% since I last covered the company just over two years ago. DOCU has been a clear beneficiary of the pandemic, as social distancing restrictions nationwide gave mission-critical growth to the e-signature market. Can the growth continue beyond the pandemic? DOCU was capitalizing on secular tailwinds even prior to 2020, and it's arguable that the pandemic merely accelerated the growth. I expect DOCU to continue growing the e-signature market moving forward. Shares aren’t cheap and I outline a covered call strategy that can help make shares easier to hold in the near term.
Dominant Player In E-Signature Market
It’s important to understand why I'm so optimistic regarding DOCU’s forward prospects. Nearly every aspect of business involves signing some sort of agreement:
Traditionally, these agreements are done with paper and pen, but this process has not kept with the digital revolution. The old way of signing agreements is less efficient, more error prone, and a hassle to manage:
DOCU’s e-signature product is the natural solution to all the above problems. Thinking of DOCU reminds me of inevitable growth stories. Similar to how retail is moving towards e-commerce or how dating is moving online, DOCU is riding inevitable digital tailwinds.
While there's competition in the e-signature space, I'm not so concerned as of yet due to the large addressable market and DOCU’s place as the market leader.
DOCU has seen accelerating growth rates over the past year as businesses were more or less forced to move signatures online:
It's worth noting the difference between billings and revenue. Billings refers to the cash actually paid by the customer and revenue refers to the income earned when the service is provided. Because billings growth is very strong, this implies that DOCU may continue to see strong revenue growth moving forward. If billings growth was weak, then one may harbor justified suspicions that forward revenue growth might not mirror past revenue growth.
DOCU is not yet profitable on a GAAP basis, but it has made meaningful progress toward generating positive free cash flow. I expect operating leverage to eventually pave the way for strong operating margins:
Some tech stocks face risks of customers utilizing their services less after the pandemic. While DOCU may be exposed to some of that risk, I do not anticipate such drastic consequences because DOCU’s e-signature solution is something that both customers and their counterparties are likely to appreciate even after the pandemic. While it's arguable that many people would prefer to shop in-store as opposed to online, I doubt that many prefer to sign and store contracts with pen and paper.
Balance Sheet Analysis
For a stock to be considered part of the Best of Breed universe, a watchlist available for subscribers, the company must not only have a strongly performing business model but also a best of breed quality balance sheet. As of the latest quarter, DOCU had $598 million in cash and equivalents with no debt except $575 million in convertible notes. These have a conversion price of $110 per share (net of capped call transactions). I estimate this to equate to 5.2 million shares. Since the last quarter, DOCU has closed on $690 million in additional convertible notes with a 0% yield due 2024. DOCU used $460 million of the net proceeds plus 4.7 million shares to repurchase $460 million of the aforementioned notes (if my match checks out, that roughly equals the 5.2 million shares estimated above). After all these transactions, I estimate that DOCU has around $815 million of cash and equivalents versus $690 million in convertible notes. Through the first three quarters of 2020, DOCU generated $234.7 million in cash from operations, suggesting that its projected cash balance is more than enough to protect it from difficult times.
Valuation Analysis
While I cover more than 100 stocks in my Best of Breed universe, only a handful are cheap enough to buy. DOCU trades at 32 times trailing subscription revenues - hardly a cheap valuation. (Note: I do not use total revenues because professional services revenues have negative gross margins.) Based on consensus estimates, DOCU is projected to earn $1.76 billion in subscription revenues over the next year. As of recent prices, shares trade at 22.7 times that number. That still isn't that cheap, and it's understandable if many investors want to wait for a better entry point.
While the stock looks like a potential market beater over the next several years in spite of the lofty current valuation, investors can take advantage of high implied volatility to improve their returns and reduce their risk. One could purchase 100 shares of DOCU for $204 per share and sell a covered call option with an expiration date of January 2022 and strike price of $270 for $21. If DOCU stays at $204 by next year, then it would produce a 10.3% return based on the options premium. We would lose money only if DOCU drops below $183 per share. At that price, shares would trade at 20.4 times sales, which appears reasonable in light of the consensus estimate of 32% growth for then-following 2022 fiscal year. Our max upside is if DOCU trades up to $291 per share, representing 32 times sales - approximately the same multiple it currently trades at. Shares would return 43% in that scenario, which should be more than enough to beat the market.
Risks
DOCU isn’t the same bargain it was only several years ago. Investors should not expect DOCU to deliver triple digit returns in the near term, as much of the past performance has been due to multiple expansion. It's possible that the stock treads water in the near term as its fundamentals catch up - prospective investors should be prepared to hold this one for the long term.
The e-signature market has many competitors, raising the risk that customers might leave DOCU if competitors offer a lower price. DOCU will have to continually invest in its products to differentiate itself from competitors. I find it unlikely that customers would want to go through the trouble of integrating a new software service just to save a couple bucks, but customer churn is definitely something to watch out for.
This last risk is similar to the first risk, but worth repeating. If DOCU is unable to meet analyst expectations for growth, then I expect its valuation to compress significantly. In the long run, such volatility should not affect the total return, but investors should not expect the anti-gravity price performance to continue forever.
Conclusion
DOCU has emerged as the runaway winner in the rapidly growing e-signature market. While DOCU has been a prime beneficiary of the pandemic, I see the company being able to continue growing rapidly even as we move beyond the pandemic. The company generates positive free cash flow with plenty of cash on its balance sheet. The stock isn’t so cheap at 32 times trailing subscription revenues, but a strong forward growth rate coupled with a covered call option strategy can make the stock worthwhile to own even in the near term.
You Can Do Better Than Docusign
DOCU returned 200% in 2020, but its valuation surged from 14 to 32 times sales.
If you want to find the next DOCU, then it isn't enough to search for growth: you have to find stocks with high growth while also trading at low valuations.
You want to capitalize on both growth and multiple expansion: double-dipping at its finest.
At Best of Breed, I invest in the runaway winners of tomorrow. There's a 2-week free trial available.
