Description

With the risk of standing in front of a running “high-growth SaaS” train, I recommend shorting the shares of Domo which have now rallied 122% since the beginning of the year. Domo has one of the worst unit economics I’ve ever seen on the public markets, having raised ~$730m of equity capital since 2010 only to reach around $106.7m of run-rate ARR before going public at a 85% discount to its latest private funding round. Nonetheless it seems that investors in this market are quick to forgive a growing SaaS name, and a couple of solid quarters combined with some pump from a highly promotional CEO and a general melt-up in some SaaS names in early 2019 have pushed the shares to a ~3X increase since the lows recorded in November of 2018, just five months after the company went public.

Quick technical note before I proceed: Domo’s financial year ends in January, so FY19 has basically just ended and when discussing current financial year I’ll be using FY20.

Background

Domo is a BI/Data Insights/Data visualization/Marketing Management/all-in-one tool, built mainly for the use of executives in large enterprises. The company was founded in 2010 by Joshua James, a veteran entrepreneur who founded and sold Omniture to Adobe for $1.7B in 2009. Domo describes its product as an “Operating System for Businesses” and touts the breadth of its platform as the main reason for its mounting losses over the years and the elevated (unprecedented) customer acquisition costs. Despite Domo’s description of its platform as “seven startups in one”, or “the Ferrari of dashboards”, the offering isn’t much different than other BI startups like Looker and Birst, and for most use cases still falls short of industry leaders Tableau, PowerBI (Microsoft) and Qlik. This is not the crux of the thesis but I would point out that building a very broad, multi-segment SaaS offering from the get-go is usually not the best road to commercial success in the software world. Most if not all SaaS success stories have started with doing one thing exceptionally well and then widening the offering, initially organically by adding more features and modules, and ultimately with some acquisitions as well. Domo has gone completely the other way and two clients we spoke to described a very long (and costly) implementation period, and an actual use of limited number of the available features in their day-to-day work (although admittedly both of them liked the product and are happy with the decision to implement).   

Gartner’s BI Magic Quadrant for 2018 and 2019 shows Domo made little progress in both market positioning and product offering. I’m not a fan of these rankings but just wanted to show that nothing in their positioning within the industry has really changed despite the stock’s run-up and the CEO’s upbeat comments during recent earnings calls.

Note that Looker, a well-funded startup that just raised its series E round, improved its positioning pretty significantly when compared to Domo (Looker has also reportedly grew 2018 revenues at 70% compared with 30% for Domo while starting from a similar base). Our research indicates that Lookers is the solution of choice for many tech-savvy/innovative companies, while Domo targets enterprises from more traditional industries and concentrate its sales pitches on high-ranked executives who have limited ability to understand what's under the hood. 

Not all SaaS Are Created Equal

After failing to raise more money from its VC investors, and after taking on $100m of expensive debt (we calculate 11% effective interest rate) in early 2018, Domo tried, and surprisingly succeeded, in going public in June of 2018. The company raised $200m at a painful ~85% discount to its latest private funding round ($330m pre-money valuation vs. reported $2.2b valuation in its last private round in early 2017). The IPO took place in an extremely lucrative market for growing SaaS companies, immediately after high-flying names like Docusign, Dropbox, Zuora and Avalara. But there are different kinds of SaaS - there are great ones, good ones, and bad ones. And then there’s Domo, which I believe is in a league of its own. I’ll discuss Domo’s specific KPIs and future prospects a little later, but before that I wanted to just give a statistical overview of where Domo stands within the 2018 batch of SaaS IPOs.

• A total of 16 SaaS IPOs took place in 2018, among them the median ARR run-rate at the IPO quarter was $202.5m. Domo was ranked #15 with $106.7m.
• In terms of new ARR added in the most recent quarter Domo was ranked last with $8m (annual rate) vs. a median of $18m.
• Median gross margin was 73%, Domo was #14 at 59.8%.
• Operating margins are where Domo really excels, and its negative 147% margin (not a typo!) was a distant last among the group (2nd worst of the group had a negative 49.6% margin). The median margin was negative 29.3%, which is also a sign of our times I guess but this belongs in a different discussion.
• Median dollar retention rate rate was 117%, and Domo is #13 with 105%.
• Domo has a relatively high average ARR per customer with ($66.9k), which was enough for #4.
• #15 in revenue per employee with $146k vs median of $190k.
• #15 in sales efficiency.
• #1 in cash burn since company was founded. In fact, Domo is so successful in burning cash that in the 8 years until its IPO it burnt $658m, more than Dropbox, Zuora and Elastic combined.

I saved the best for the last - Domo spends so much to acquire new customers that it needs 98 months to pay it back, and even this is with eliminating all OPEX and simply using incremental gross profit divided by S&M spend in the previous quarter. In a more realistic scenario Domo needs 15 years to achieve positive ROI on a newly acquired customer. As I said before, there’s bad SaaS and then there’s Domo.

Before you think the market has completely lost its mind by letting Domo go public, I would point that the IPO took place at the underwhelming valuation of 2.6x NTM revenues, well below your median/average SaaS business.      

Why shares went vertical

After bottoming at $14 and change in November, shares have started to climb back after a decent Q3, but only went ballistic after the Q4 earnings release and conference call. There was nothing particularly spectacular about Q4 earnings though. Revenues were 4% better than expected (mainly on non-subscription revenues) and operating loss was better than expected but still only marginally better than Q3. q/q growth in ARR actually slowed to 5%, the lowest it’s ever been, and total cash burn was $29.4m, about $3m better than Q3 and $6m better than last year. Guidance was also in-line with expectation at around 20% top-line growth next year. So why have the shares rallied more than 40% in the week since earnings? I think it boils down to three main points highlighted throughout the earnings call:

1. A “fully-funded business-plan” comment made by the CFO (= no equity raise).
2. The CEO talking about accelerating revenue growth in FY21 (“to 40% maybe 50% at some point in the future”) after guiding to a slowdown from 30% in FY19 to 20% this year.
3. Subscription gross margins inflecting from 64% in the year ago quarter to 74% in Q4-19, which was admittedly impressive (though they were already at 73% in Q3).  

There’s some inherent contrast between #1 and #2. Management’s optimism about accelerating FY21 growth is based on a recent decision to increase the enterprise sales team by 30% in the first half of the current year. The story is that there’s a new leadership to the sales team that really knows what it's doing this time around, and James was so thrilled that he decided to ramp up the team. This burst of optimism may have fueled the stock and pushed some internal hiring decision, but is not reflected in the quarterly number thus far, with the latest Q being the slowest in terms of q/q subscription revenue growth (5%), and among the weakest quarters even in $ terms of net ARR added (and remember that more than 50% of that growth actually came from existing customers).

During the call the CEO said more than once that they’ll be rushing the hiring of the new additions to the sales team since they are hoping to see some contribution late in FY20 and the sales cycle is quite long. With these comments I just don’t see how burn comes down in Q1 and Q2 given the slower growth and aggressive hiring (and what looks like a pretty expensive Domopalooza which took place this week). It also makes me think they must be worried even about the 20% they’ve guided to this year, although James made it sound like they can reach the 20% by only selling to their existing base (a claim which isn't supported by their current net retention numbers).  

Just to put some numbers where it's due, net cash used in operating activities was $144.1m in FY17, $148.7m in FY18 and $131.4m in FY19. Guidance provided on the call was for a use of only $76.5m in FY20 and a “fully-funded business-plan” as the CFO put it. In Q4 they just burnt $29.5m (including Capex), and if they front-load the hiring I just can’t see how they burn less than $50m in H1, even if I give them credit for some more gross margin efficiencies and a slight reduction in R&D and G&A. This leaves very little room for error for H2 and a dwindling net cash position of $27m by mid-year, which I don’t think will fly with their creditors (or with common sense) if they have the chance to raise more equity at that point.

[Not necessarily important for this writeup but I found the difference between the CFO and the CEO's answers to the question below pretty amusing.]

For those unfamiliar with what's considered a “normal” burn rate in the SaaS space and just how much of an outlier Domo really is, consider Box - another SaaS company notoriously famous for cash burn and heavy investments in its platform (and one that as a result trades well below the average SaaS name). Box’s cash burn peaked at $92m in FY14, dropping to $85m and $66m in subsequent years. This came with corresponding revenues of $124m, $216m and $303m. So Box grew revenues at a 56.5% CAGR throughout this “peak burn” period, and subsequently reached break-even in the following years as growth slowed down to ~30%. If we look Domo’s equivalent period of 2017-2019, revenues were about 50% lower to start from ($75m, $109m, $142m), and CAGR was 38%. Tableau, a more direct competitor to Domo, which was also criticized at some point for its mounting operating losses (and has been written up as a short on vic about two years ago), was actually able to fund its losses through annual billing and a corresponding growth in deferred revenues, staying cash flow positive practically every year since going public.

And if we already touched deferred revenue growth, an interesting fact about Domo is that unlike practically any SaaS business out there, it wasn’t able to significantly boost cash flows through advanced billing. While the balance sheet shows impressive growth in deferred revenues over the past couple of years, it came with a corresponding growth in AR. So Domo was basically billing but not collecting (as of the balance sheet date), which raises some questions to say the least. Note in the table below how $44m of deferred revenue growth only translated to ~$18m of cash benefit over the last two years.

One last point of comparison to Tableau - both companies went public with a similar level of revenues of just over $100m, but while Tableau has done so with approximately $31m in equity funding prior to its IPO, Domo needed $730m to reach that same revenue base. 

Governance

Nothing that will drop you off your chairs but over the years Domo was notoriously famous for dealing with other companies controlled by James and his family: Domo leased a private jet for business use from a company owned by James, used catering services from a restaurant owned by James and his brother, Cubby James; and paid for design services from an interior design firm partially owned by James and another brother, Drew James.

Based on the S-1 all of these have been cut prior to Domo going public so they shouldn’t be a concern, but if you’re trusting James not to do a secondary here because “he said so”, you might wanna rethink that. Also worth mentioning that his A shares have 40x the voting rights of common stock.

Valuation

It’s admittedly hard to pin a specific price target on a co that is unlikely to ever be profitable, but I’ll give it a try. Management mentioned that contribution margin from the average customer reaches 56% in its 3rd year. When I asked IR what does contribution margin include they mentioned some allocation from account management (S&M) but no R&D and G&A and obviously excluding any share-based-comp (never an expense). I took this number at face value and subtracted 25% of revs. for R&D and 12% for G&A (they currently run at 43% and 20%), to come up with 19% "normalized" pre-tax margins for the existing base.

By YE20 they should be at $170m revenues and so "normalized" pre-tax earnings come at $32.3m. Counting outstanding RSUs and vested options which are currently in the money gets me to 30.6m full-diluted shares and a $1.3b valuation. So you're paying 40x pre-tax normalized earnings while management continues to spend dozens of millions with single-digit ROIC at best. Not sure what's fair value exactly but half of that or less strikes me as fair given the inherent risk in the assumptions I've made above. 

Of course, I don’t really expect this to trade based on LT fundamentals or unit economics anytime soon, and the short thesis is based more on the catalysts mentioned below than any reversion-to-fair-value by the efficient market.

Catalysts:

1. Secondary offering - despite management’s comments about a fully-funded business plan, even in their own guidance which seems rather optimistic for reasons mentioned above, they are left with zero net cash by the end of FY20, comprised of ~$100m in cash and a $100m credit facility which pays 11% (part of it in PIK) and matures in 2021. It’s highly unlikely that a cash burning business like Domo will put itself in such a fragile situation where things can go south in a matter of months, and judging by James’ history it seems like he raises money whenever he can. I'm not sure there was ever a better time than today.
2. VCs selling - the 85% down-round in the IPO left a long list of disappointed VCs and other private investors. Some of them participated in the offering, most decided to sit out. Given that at least some of these VCs were basically willing to write-off the investment by not providing additional capital to the company less than a year ago, I think it's safe to assume some of them will be rushing to the exit sooner rather than later.  
3. Short-term results disappoint - as mentioned above, Domo was so excited with its “new sales approach” that management decided to add 30% more enterprise salespersons as soon as possible. James affirmed that they plan on front-loading the hiring, and I think it’s highly likely that this will result in higher than expected burn in 1H20, and just as likely that the productivity of these newcomers will disappoint and fail to contribute anything significant to FY20 results.
4. General market takes a breather after mega tech IPOs - Uber, Lyft, Pinterest, and probably another half-dozen tech/SaaS names are supposed to go public in the coming weeks/months. Wouldn’t be surprised to see the market takes a breather soon afterwards. Domo seems like a good way to play this given the low quality of the business and what is probably a speculative investor base at this point after the recent rally.   

Risks:

The main risk is that Domo “cracks the code” in terms of sales efficiency and CAC improves dramatically from here. Given the competitive dynamics in the industry and high price point of the product, I don’t see how this happens. But obviously this is the most important metric to track going forward.

A secondary risk is that the SaaS melt-up continues for a while. You should size accordingly or just be willing to take some portfolio volatility until the market cools down and rationalize.  

An acquisition is always a risk with those names, but given that Domo was in the market desperate for cash last year, and ended up going public at a 85% down-round, and that nothing has materially changed in the fundamentals of the business since, I think it’s a relatively low risk compared with other high-flying, overvalued names.

Catalyst

• Secondary offering.
• Insider sells.
• Weak H1 results.