The DocuSign share is a winner, but be careful with the valuation risks

<p>
A corporate technology portfolio that has shown impressive resilience in the midst of the market’s coronavirus in recent weeks is DocuSign (NASDAQ: DOCU). The DocuSign stock is currently trading at just 3% of its highest levels in February. The S&P 500, on the other hand, is trading more than a 10% discount on its peaks in February.

This resilience makes sense. DocuSign provides digital lifecycle management (CLM) solutions to businesses. The coronavirus crisis worldwide does not significantly affect the demand for these digital CLM solutions unless the economy stays for a long time, which it will not do.

At the same time, resilience is meaningful when you consider that the DocuSign share is a long-term winner, supported by a first-class product in a market with robust growth tailwind, a significant runway for great growth to last much longer a favorable margin profile that provides large potential gains on a large scale.

All in all, one should therefore not be surprised that DocuSign only drops by 3% among all this market volatility.

But DocuSign shares are not without risks. The company has a lot of competition in the digital CLM space, that competition can ultimately limit the company’s long-term profit growth potential, and the valuation of the DOCU share is very rich.

All in all, the investment dissertation here is simple. I would not hunt DocuSign layers here. But I would own this stock in the long run. Wait for a dip. Buy on that weakness.

DocuSign is a winner

On the whole, DocuSign is a long-term winner.

The company is a best-in-class provider of digital CLM solutions, at a time when every company worldwide is carrying out the paper-to-digital conversion. This means that all companies everywhere go from a paper-based CLM program (where you sign contracts, close deals and do all the contract-related things on paper) to a digital-based CLM program (where you do all this online).

DocuSign is the unique leader in the CLM digital marketplace. So as more companies migrate to digital CLM applications in the next few years, more companies will pay for DocuSign’s products.

In this market, DocuSign already has a lot of momentum. Revenues increased by 40% compared with the previous year. Customers increased by 30%. More importantly, there is plenty of runway here for DocuSign to sustain great growth much longer.

According to my estimates, there are over three million small to large companies in developed economies that can use digital CLM solutions. DocuSign has only 69,000 such customers today, which means that the company has utilized less than 2% of its addressable customer pool.

In addition, the company works with a very good 80% gross margin. The large sales growth also drives a positive leverage effect across all major OPEX lines. If this continues as it should, the company has an opportunity to produce large profits on a large scale.

In other words, DocuSign has all the benefits of a winning stock. Winning is exactly what the stock has done so far. Shares have increased by 60% over the past year.

The DocuSign share carries risks

Winning in DocuSign does not come without risks. Note that I think stocks have three major risks here that prevent me from chasing this rally.

First, there is a lot of competition in this space. The paper-to-digital transformation company is nothing new. It’s been around for a while. And many companies, such as Adobe (NASDAQ: ADBE) with its Document Cloud offering, have a formidable presence and strong products in this space. The competition does not die soon. If anything, it will pick up.

At present, DocuSign has been able to eliminate these competitive risks. This is because they are a very small company operating in a very large market. But as the company gets bigger, it will more aggressively rub its elbows with competitors. This can lead to reduced growth for customers and revenues in the coming years.

Second, DocuSign will need to invest heavily in things like market research, product development, sales and marketing to cope with increased competition on a large scale. So while the company is benefiting from the hugely positive leverage effect today, I think the size of that leverage will decrease as the company gets bigger and gets more competition.

Third, the value of DocuSign is very rich. The shares are traded at 210 times the forward result. It is rich, even for a software company with high growth. It is particularly rich for a software company with hyper-growth with competition, growth and marginal risks.

Conclusion

The DocuSign share is a long-term winner. But the price tag today seems a bit rich. I’m not chasing this rally. Instead, I believe that a growth hiccup in the next few quarters is likely and that such a growth hiccup will cause a significant reversal of shares. I’ll buy to pull back.

Luke Lango is a market analyst for InvestorPlace. He has professionally analyzed equities for several years, previously worked in various hedge funds and currently runs his own investment fund in San Diego. Luke is a graduate of Caltech and has been consistently recognized as one of the world’s best stock pickers by various other analysts and platforms and has developed a reputation for leveraging his technical background to identify growth stocks that deliver outstanding returns. Luke is also the founder of Fantastic, a social discovery company backed by an LA-based Internet company. At the time of writing, Luke Lango had no position in any of the above securities.