Since publication, Domo’s stock price is down 15%. Today, I am back to revisit this company, and unfortunately, I still cannot find anything positive to report. The company is burning an unacceptably high level of cash, with SG&A expenses 37% higher than the revenues taken in, and the free cash flow margin is a whopping -60%. For these reasons, I am keeping my neutral rating on Domo.
When it comes to software companies, I don’t rely on traditional value factors; instead, I focus on other measures, such as the software company “Rule of 40” and relative valuation, a concept that I recently developed that compares forward sales multiple versus estimated sales growth.
Domo’s annual revenue growth is 25%, dropping from 33% just one year ago.
Free Cash Flow Margin
Domo’s free cash flow margin TTM is sitting at -60%. The good news is that one year ago it was almost -100%!
The extremely negative free cash flow margin is something I don’t like to see in any potential investment.
The Rule Of 40
One industry metric that is often used for software companies is the Rule of 40. It is an industry rule of thumb that attempts to help software companies ascertain how to balance growth and profitability. There are different ways of calculating the Rule of 40 – some analysts use EBITDA and others use free cash flow margin. I use the free cash flow margin TTM.
The Rule of 40 is interpreted as follows – If a company’s growth rate plus free cash flow margin adds up to 40% or more, then the software company has growth and cash flow in balance and is considered financially healthy. In Domo’s case:
Revenue Growth + FCF margin = 25% – 60% = -35%
The calculation comes out well below 40%; in fact, probably the lowest score in my digital transformation stock universe. Clearly, Domo has a lot of work ahead of it in order to balance growth and profits.
I determine stock valuation on a relative basis by comparing sales multiples and sales growth to the company’s peers. I believe that high-growth companies should be more highly valued than slow-growth companies. After all, growth is a prime factor in valuation models such as DCF. Higher future growth results in higher valuation and, therefore, higher EV/sales multiple.
To illustrate this point, I created a scatter plot of enterprise value/forward sales versus estimated Y-o-Y sales growth for the 152 stocks in my digital transformation stock universe.
(Source: Portfolio123/private software)
The sales multiple in the vertical direction is calculated using the EV and “next year’s sales estimate” mean value based on all analysts from the Portfolio123 database. The estimated Y-o-Y sales growth is calculated using “current year’s sales estimate” and “next year’s sales estimate,” also provided by Portfolio123.
As can be seen from this scatter plot, Domo is positioned well below the best-fit line, suggesting that its forward sales multiple is extremely undervalued relative to its peers, given its estimated future revenue growth rate.
The Sales/EV multiple tells me that the stock is quite undervalued, but my value assessment changes when I substitute next year’s earnings estimates for forward sales.
(Source: Portfolio123/private software)
The results shown on this second scatter plot suggest that Domo is actually extremely overvalued based on next year’s earnings estimates. Domo is one of the three worst stocks when it comes to forward earnings estimates, the other two being CYREN Ltd. (CYRN) and Castlight Health, Inc. (CSLT), both of which are essentially penny stocks, trading just above one dollar.
Summary and Conclusions
Domo provides a cloud-based platform where company-wide data is collected and processed in real-time. Revenue growth has been reasonable, coming in at 25% over the last twelve months, although the decline in growth the last year is noticeable.
Based on the forward sales multiple, Domo is extremely undervalued relative to its SaaS peers. But if I use next year’s earnings estimate instead of forward sales, my assessment changes radically and Domo is very much overvalued.
The company is bleeding money with SG&A expenses 37% more than the total revenue taken in. This level of cash burn is hard to justify given revenue growth of 25% and falling.
Domo also fails on the Rule of 40 which implies that Domo is not financially healthy. For these reasons, I have to give Domo a neutral rating.
Join My Exclusive Service While the Price is Low …
Digital Transformation is a once-in-a-lifetime investment opportunity fueled by the need for businesses to convert to the new digital era or risk being left behind. You can take advantage of this opportunity by subscribing to the Digital Transformation marketplace service. Tap into three high-growth portfolios, industry/subindustry tracking spreadsheets, and three unique proprietary rating systems. Don’t miss out on the digital revolution. We are still in the early innings and there are plenty of high-growth investment opportunities out there waiting for you!
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.