Why I Own DocuSign Shares

DoucSign (NASDAQ: DOCU) is one of the 50-plus companies that’s in my family’s portfolio. I first bought DocuSign shares for the portfolio in December 2018 at a price of US$41 and I’ve not sold any of the shares I’ve bought. 

The purchase has worked out very well for my family’s portfolio thus far, with DocuSign’s share price being around US$79 now. But we’ve not even owned the company’s shares for two years, and it is always important to think about how the company’s business will evolve going forward. What follows is my thesis for why I still continue to hold DocuSign shares.

Company description

DocuSign provides DocuSign eSignature, currently the world’s leading cloud-based e-signature solution. This software service enables users to sign a document securely using almost any device from virtually anywhere in the world. It is the core part of the broader DocuSign Agreement Cloud, which is a suite of software services – again all delivered over the cloud – that automates and connects the entire agreement process. DocuSign Agreement Cloud includes:

• Automatic generation of an agreement from data in other systems; 
• Support of negotiation-workflow; 
• Collection of payment after signatures;
• Use of artificial intelligence (AI) to analyse agreement-documents for risks and opportunities; and 
• Hundreds of integrations with other systems, so that the agreement process can be seamlessly combined with other business processes and data

At the end of its fiscal year ended 31 January 2020 (FY2020), DocuSign had over 585,000 paying customers and hundreds of millions of users. From its founding in 2003 through to FY2019, the company had processed over 1 billion successful transactions (around 300 million in FY2019 alone). DocuSign defines a successful transaction as the completion of all required actions (such as signing or approving documents) by all relevant parties in an Envelope; an Envelope is, in turn, a digital container used to send one or more documents for signature or approval to the relevant recipients.

DocuSign serves customers of all sizes, from sole proprietorships to the companies that are among the top 2,000 publicly-traded enterprises. The company’s customers also come from many different industries, as the chart below illustrates.

For a geographical perspective of DocuSign’s business, its users are in over 180 countries. But in FY2020, 82% of the company’s revenue came from the US. 

Investment thesis

I had previously laid out my six-criteria investment framework in The Good Investors. I will use the same framework to describe my investment thesis for DocuSign.

1. Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market

Has it ever occured to you that the innocuous act of signing documents with pen-and-paper can actually be a significantly wasteful activity for companies? The thought struck me when I was doing research on DocuSign before I bought its shares. Think about it. Signing a paper document requires you to fax, scan, email, snail-mail, courier, and file. DocuSign’s solution can save us both time and money.

There are many use-cases for DocuSign’s software services, ranging from sales contracts to employment contracts, non-disclosure agreements, and more. In fact, DocuSign has a customer that has implemented over 300 use-cases. DocuSign documents are legally accepted and protected with cryptographic technology from tampering. The documents also have a full audit trail, including party names, email addresses, public IP addresses, and a time-stamped record of each individual’s interaction with a document.

DocuSign estimated that it had a total addressable market of US$25 billion in 2017, using (1) the number of companies in its core markets, and (2) its internal estimate of an annual contract value based on each respective company’s size, industry, and location. This estimate remains unchanged (it was mentioned in the company’s FY2020 annual report), though recent business moves may have significantly expanded its addressable market. More on this later. At just US$974.0 million, DocuSign’s revenue in FY2020 is merely a fraction of its estimated market opportunity.

I believe that DocuSign’s addressable market will likely grow over time. There are clear benefits to e-signatures. A 2015 third-party study by Intellicap (commissioned by DocuSign) found that the company’s enterprise customers derived an average incremental value of US$36 per transaction (with a range of US$5 to US$100) when using the company’s software as compared to traditional paper-processes. In FY2020, 82% of all the successful transactions that flowed through DocuSign’s platform were completed in less than 24 hours, while 50% were completed within just 15 minutes. DocuSign’s services help companies save money and time.

2. A strong balance sheet with minimal or a reasonable amount of debt

As of 31 January 2020, DocuSign held US$895.9 million in cash, short-term investments, and long-term investments. This is nearly twice the company’s total debt of US$465.3 million (all of which are convertible notes). For the sake of conservatism, I also note that DocuSign had US$183.2 million in operating lease liabilities. But the company’s cash, short-term investments and long-term investments still comfortably outweigh the sum of the company’s debt and operating lease liabilities (US$648.5 million). 

3. A management team with integrity, capability, and an innovative mindset

On integrity

Leading DocuSign as CEO is Daniel Springer, 57, who joined the company in January 2017. Among other key leaders in DocuSign are:

• Scott Olrich, Chief Operating Officer, 48
• Michael Sheridan, Chief Financial Officer, 55
• Loren Alhadeff, Chief Revenue Officer, 41
• Kirsten Wolberg, Chief Technology and Operations Officer, 52

Most of them have relatively short tenure with DocuSign, but have collectively clocked decades in senior leadership roles in other technology companies.

DocuSign has opted not to share details about its compensation structure for senior management because of its status as an “emerging growth company.” And Springer’s total compensation for FY2019 was a princely sum of US$13.4 million. But I take heart in this: 94% of Springer’s total compensation in FY2019 came from stock awards, and around 70% of the stock awards vest over a period of four years. The multi-year vesting of the stock awards means that Springer’s compensation is tied to the long run performance of DocuSign’s stock price, which is in turn governed by its business performance. So I think Springer’s interests are aligned with mine as a shareholder of the company.

Notably, Springer also controlled 2.3 million shares of DocuSign as of 31 March 2019, a stake that’s worth a sizable US$211 million at the current share price.  

On capability

From FY2013 to FY2020, DocuSign has seen its number of customers increase more than 10-fold (41% per year) from 54,000 to 585,000. So the first thing I note is that DocuSign’s management has a terrific track record of growing its customer count.

To win customers, DocuSign’s software service offers over 300 pre-built integrations with widely used business applications from other tech giants such as salesforce.com, Oracle, SAP, Google, and more. These third-party applications are mostly in the areas of CRM (customer relationship management), ERP (enterprise resource planning), and HCM (human capital management). DocuSign also has APIs (application programming interfaces) that allow its software to be easily integrated with its customers’ own apps. 

I also credit DocuSign’s management with the success that the company has found with its land-and-expand strategy. The strategy starts with the company landing a customer with an initial use case, and then expanding its relationship with the customer through other use cases. The success can be illustrated through DocuSign’s strong dollar-based net retention rates (DBNRRs). The metric is a very important gauge for the health of a SaaS (software-as-a-service) company’s business. It measures the change in revenue from all of DocuSign’s customers a year ago compared to today; it includes positive effects from upsells as well as negative effects from customers who leave or downgrade. Anything more than 100% indicates that the company’s customers, as a group, are spending more – DocuSign’s DBNRRs have been in the low-teens to mid-teens range in the past few years.

On innovation

I think DocuSign’s management scores well on the innovation front, since the company has been busy with using blockchain technology and AI to improve its services. 

Blockchain technology is the backbone of cryptocurrencies and DocuSign has been experimenting with blockchain-based smart contracts since 2015. In June 2018, DocuSign joined the Enterprise Ethereum Alliance and showed how a DocuSign agreement can be automatically written onto the Ethereum blockchain. Here’s an example of a smart contract  described by DocuSign:

“A smart contract turns a contract into something like a computer program. The Internet-connected program monitors data and triggers actions relevant to the contract’s terms. For example, a crop-insurance smart contract might use a trusted Internet feed of weather data. If the temperature goes above 85 degrees Fahrenheit in April, the smart contract will automatically trigger a crop-insurance payout, again via the Internet. This total automation eliminates ambiguity and promises large savings in time and effort for all parties involved.”

It’s early days for DocuSign’s use of blockchain, but I’m watching its moves here. DocuSign’s management acknowledges that many of the company’s customers don’t yet see the value of blockchain technology in the agreement process. But the company still believes in blockchain’s potential.  

DocuSign has been working with AI since at least 2017 when it acquired machine-learning firm Appuri during the year. In February 2020, DocuSign inked an agreement to acquire Seal Software for US$188 million. The acquisition is expected to close in the first half of DocuSign’s FY2021. Seal Software was founded in 2010 and uses AI to analyse contracts. For example, Seal Software can search for legal concepts (and not just keywords) in large collections of documents, and automatically extract and compare critical clauses and terms. Prior to the acquisition, DocuSign was already tacking Seal Software’s services onto DocuSign Agreement Cloud. The combination of Seal Software and DocuSign’s technologies have helped a “large international information-services company” reduce legal-review time by 75%. Ultimately, DocuSign thinks that Seal Software will be able to strengthen DocuSign Agreement Cloud’s AI foundation.

Speaking of DocuSign Agreement Cloud, it was released in March 2019. As mentioned earlier, it includes multiple software services. DocuSign sees DocuSign Agreement Cloud as a new category of cloud software that connects existing cloud services in the realms of marketing, sales, human resources, enterprise resource planning, and more, into agreement processes. 

I see two huge positives that come with the introduction of multi-product sales. Firstly, it will likely lead to each DocuSign customer using more of the company’s products. This means that DocuSign could be plugged into an increasing number of its customers’ business processes, resulting in stickier customers. Secondly, DocuSign thinks that covering a wider scope of the entire agreement process could roughly double its market opportunity from the current size of US$25 billion to around US$50 billion. 

4. Revenue streams that are recurring in nature, either through contracts or customer-behaviour

DocuSign’s business is built nearly entirely on subscriptions, which generate recurring revenue for the company. Customers of DocuSign gain access to the company’s software platform through a subscription, which typically ranges from one to three years.  In FY2020, FY2019, and FY2018, more than 93% of DocuSign’s revenue in each fiscal year came from subscriptions to its cloud-based software platform; the rest of the revenue came from services such as helping the company’s customers deploy its software efficiently. 

It’s worth noting too that there is no customer-concentration with DocuSign. There was no customer that accounted for more than 10% of the company’s revenue in FY2020.

5. A proven ability to grow

There isn’t much historical financial data to study for DocuSign, since the company was only listed in April 2018. But I do like what I see:

A few notable points from DocuSign’s financials:

• DocuSign has compounded its revenue at an impressive annual rate of 40.4% from FY2016 to FY2020. The rate of growth has not slowed much, coming in at a still-impressive 38.9% in FY2020.
• DocuSign is still making losses, but the good thing is that it started to generate positive operating cash flow and free cash flow in FY2018.
• Annual growth in operating cash flow from FY2018 to FY2020 was strong, at 45.1%. Free cash flow has increased at a much slower pace, but the company is investing for growth. 
• The company’s balance sheet remained robust throughout the timeframe under study, with significantly more cash and investments than debt.
• At first glance, DocuSign’s diluted share count appeared to increase sharply by 30.7% from FY2019 to FY2020. (I only started counting from FY2019 since DocuSign was listed in April 2018, which is in the first quarter of FY2019.) But the number I’m using is the weighted average diluted share count. Right after DocuSign got listed, it had a share count of around 152 million. Moreover, DocuSign’s weighted average diluted share count showed acceptable year-on-year growth rates (acceptable in the context of the company’s rapid revenue growth) in the first, second, and third quarters of FY2020.

6. A high likelihood of generating a strong and growing stream of free cash flow in the future

DocuSign has already started to generate free cash flow. Right now, the company has a poor trailing free cash flow margin (free cash flow as a percentage of revenue) of just 4.5%.

But over the long run, I think it’s likely that there is plenty of room for DocuSign’s free cash flow margin to expand. I showed in my recently published investment thesis for Alteryx (NYSE: AYX) that there are other larger SaaS companies such as Adobe, salesforce.com, and Veeva Systems that have much fatter free cash flow margins. Here’s the table I showed in my article on Alteryx:

Valuation

Right now, DocuSign has a market capitalisation of US$14.34 billion against trailing revenue of US$974.0 million. These numbers give rise to a price-to-sales (P/S) ratio of 14.7, which makes the company look pretty darn expensive. For perspective, if I assume that DocuSign has a 30% free cash flow margin today, then the company would have a price-to-free cash flow ratio of 49 based on the current P/S ratio (14.7 divided by 30%). 

But DocuSign also has a few strong positives going for it. The company has: (1) revenue that is low compared to a fast-growing addressable market; (2) a business that solves important pain points for customers; (3) a large and rapidly expanding customer base; and (4) sticky customers who have been willing to significantly increase their spending with the company over time. I believe that with these traits, there’s a high chance that DocuSign will continue posting excellent revenue growth – and in turn, excellent free cash flow growth – in the years ahead. 

The current high valuation for DocuSign does mean that its share price is likely going to be more volatile than the stock market as a whole. I’m also keeping in mind that stocks have been very volatile of late because of COVID-19 fears. But the potential volatility is something I’m very comfortable with.

The risks involved

DocuSign has a short history in the stock market, given that its IPO was just two years ago in April 2018. I typically stay away from young IPOs. But I’m making an exception for DocuSign because I think its business holds promise for fast-growth for a long period of time. But the company’s young age as a publicly-listed company is still a risk I’m watching.

Adobe is a much larger SaaS company with trailing revenue of US$11.7 billion. Through its Adobe Sign product, Adobe is the primary competitor of DocuSign. So far, DocuSign has defended its turf admirably. This is shown in DocuSign’s strong revenue and customer growth rates. But Adobe’s larger financial might compared to DocuSign means competition is a risk. 

Another important risk for DocuSign relates to data breaches. DocuSign handles sensitive information about its customers due to the nature of its business. If there are any serious data breaches in DocuSign’s software services, the company could lose the confidence of customers and the public, leading to growth difficulties. The signing of documents may be highly time-sensitive events. So if there is any significant downtime in DocuSign’s services, it could also lead to an erosion of trust among existing as well as prospective customers. So far, DocuSign has done a great job by providing 99.99% availability in FY2020. 

Valuation is another risk to consider. DocuSign’s high P/S ratio means that the market expects rapid growth from the company. So if the business performance disappoints subsequently, market sentiment could turn quickly on DocuSign, leading to a cratering stock price.

Earlier, I discussed the advantages that the launch of DocuSign Agreement Cloud brought to the company. But there are downsides too. For instance, multi-product sales involves higher complexity and a longer sales cycle; these factors negatively affected DocuSign’s billings growth and net dollar-based retention rate in the first quarter of FY2020. The ongoing COVID-19 pandemic has caused business activity around the world to slow tremendously, with many countries being in various states of lockdown. A lengthy sales cycle could hamper DocuSign’s business in the current environment. For now, DocuSign’s business does not seem to have been impacted by COVID-19. Here’s CEO Dan Springer’s comment on the matter in DocuSign’s FY2020 fourth-quarter earnings call:

“[T]he vast majority of our implementations are done remote. And of course, if you think about the perfect example of that it’s our web and mobile customers, where they never actually have to speak. Not only do they don’t have to have us in person they don’t need to speak to us to onboard. … We do find with some of our larger enterprise customers that they get more value when some of the installation is done on their premises. But we have not had the opportunity in the past to consider doing that completely remotely. And it may be in the new way of business over the next X period of time here then we’ll do more of it.”

And when DocuSign’s management was asked in the same earnings call if its growth would be affected by a recession, Springer answered:

“Yes, I don’t. Because, I think, for most of our customers, at least half of the focus is around efficiency. And people see the incredibly high ROI. And I can’t speak for all-digital transformation programs, of course, but as I think about the ones that are DocuSign-centric people are laser-focused on the ROI they get from getting rid of those manual processes, the wasted labor, getting rid of things like the transportation cost, the shipping, et cetera.

That’s a big focus. So I don’t think in a recession you would see people pull back on that. I would say that any time if you had a significant recession, you expect people to kind of shoot first ask questions later and that could lead to some delays. But, in general, we think the business case just gets stronger when people need to find those efficiencies.”

Lastly, the following are all yellow-to-red flags for me regarding DocuSign: (1) The company’s DBNRR comes in at less than 100% for an extended period of time; (2) it fails to increase its number of customers; and (3) it’s unable to convert revenue into free cash flow at a healthy clip in the future.

The Good Investors’ conclusion

Summing up DocuSign, it has:

1. Valuable cloud-based software services in the agreements space that solves customers’ pain-points;
2. high levels of recurring revenue;
3. outstanding revenue growth rates;
4. positive operating cash flow and free cash flow, with the potential for much higher free cash flow margins in the future;
5. a large, growing, and mostly untapped addressable market;
6. an impressive track record of winning customers and increasing their spending; and
7. capable leaders who are in the same boat as the company’s other shareholders

The company does have a premium valuation, so I’m taking on valuation risk. There are also other risks to note, such as strong competition and a longer sales cycle that may not be conducive for a business environment that’s struggling with COVID-19. But after weighing the pros and cons, I have to agree with the idea of having DocuSign continue to stay in my family’s investment portfolio.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.