CS Disco Q4 Earnings: No Turnaround In Sight (NYSE:LAW)

Introduction and investment thesis

CS Disco (NYSE:LAW) is a legal tech company trying to reshape and modernize the legal services industry. The company’s flagship product is its eDiscovery solution, which collects and prepares electronically stored data for lawsuits and legal investigations, thereby eliminating a lot of manual work for lawyers. The company has gradually expanded its product portfolio over time and is making strong efforts to become a true multiproduct company.

Until the end of 2021 it seemed that this strategy is working well as DISCO grew revenues by 67% back then. However, since the beginning of 2022 stellar revenue growth has turned into stagnation, leading the share price to collapse gradually. It turned out that the exceptionally strong year of 2021 has been characterized by some one-time, big-ticket deals related to the DISCO Review product. These larger deals didn’t materialize since 2022 Q2, effectively suffocating top line growth. Management called this out only in retrospect, which I believe resulted in the loss of investor confidence.

On the top of that, the latest quarterly results suggested that the company’s flagship eDiscovery product is suffering growth headwinds as well, which topic hasn’t been discussed properly by management either in my opinion. With this, DISCO became definitely a show me story.

On the 19^th of January, the company pre-announced its revenues for the Q4 quarter, showing conviction that they can achieve their previously set (in my opinion, conservative) target. Besides, DISCO announced a workforce reduction that affected 9% of its employees. Although I didn’t see material reasons in this news to become optimistic on the outlook for the company, the share price began a significant climb since then.

Now that Q4 earnings have been published yesterday, I believe that this optimism was premature indeed, as there is still no turnaround in sight. I think this could send back the share price to the previous declining trend, leaving those investors disappointed who began to trust in a possible reversal.

Q4 earnings: Sequential decline in revenue with disappointing 2023 guidance

DISCO reported revenues of $31.5 million for the 2022 Q4 quarter. Although this has been a 4% decline yoy and a 6% decline compared to the previous quarter, it was basically in line with management’s conservative guidance. This has marked the 5^th straight quarter that top line growth at the company went flat and based on 2023 Q1 revenue guidance of $30.5-32.5 million this tendency could prevail:

Looking at the chart above, this tendency is still not encouraging, suggesting that DISCO shares will remain in the penalty box in my opinion. One important reason behind the slowdown in revenue growth has been the absence of larger DISCO Review deals since Q2 2022, but this doesn’t explain why revenues didn’t grow since then. The main reason for this is that the company’s flagship product, DISCO eDiscovery, which made up more than 77% of revenues in 2022 suffered growth headwinds in H2 as well. The current Q4 earnings call has been the first one where management acknowledged this publicly, however, I already warned investors after the Q3 earnings release that this could be the case.

The future doesn’t look promising as well, because if we look at management’s revenue guidance for fiscal 2023 ($135-145 million) we can see the same tendency:

Analysts have been expecting revenues of $155 million on average for 2023, so this has been a further source of disappointment and confirms that currently there is no turnaround in sight.

Looking at the bottom line doesn’t give much reason for optimism as well. DISCO closed 2022 with an adjusted EBITDA margin of negative 33% significantly worse than the negative 14% in 2021. Although this has been partly the result of Covid related one-time cost efficiencies during 2021, we are still back to 2020 levels. Furthermore, no significant change is expected for 2023:

Management tried to reassure investors that they take profitability as a priority and intend to close 2023 with negative adjusted EBITDA margin in the mid-teens and reach breakeven for the end of 2024. However, until there are no signs for this, I wouldn’t give much credit for it, because I believe that management has lost investor confidence in recent quarters and made another step into this direction with the Q4 earnings call.

Q4 earnings call: Management transparency is still an issue

My general impression on the Q4 earnings call has been unfortunately the same as on the preceding ones. Management avoids sensitive topics and tries to highlight those achievements, which aren’t necessarily the most important ones, but present company fundamentals in a better light. Let me give you two examples:

• Management called out strong customer numbers in the Q2 (1,255) and Q3 (1,318) quarters, highlighting the exact number of total customers. During the Q4 earnings call management didn’t call out the exact customer number and used the following wording for describing customer growth: “First, we continue to experience strong customer growth, up to more than 1300 customers today”. Later, after an analyst question, it turned that DISCO closed Q4 with 1,327 customers reaching total net adds of 9, which has been a significant slowdown after the average of 55 in the previous three quarters. If there hadn’t been a question on this during the Q&A part, I believe that investors listening to the earnings call could have gotten the impression that customer growth continued to track well in Q4.
• After 5 quarters of stagnating revenues management admitted on the Q4 earnings call that on the top of DISCO Review, DISCO eDiscovery, the company’s flagship product is suffering growth headwinds as well: “Revenue growth last year was impacted by a decline in usage of our review product, especially on large reviews, and by volatility in usage of all our products, including eDiscovery, especially in the latter part of the year. This was compounded by difficult comps created by exceptional growth in 2021. Difficult comps that will continue in Q1 of this year.” I believe this has been an insufficient explanation for investors as revenues have been stagnating throughout 2022 and difficult yoy comparisons are not the reason why revenues are stagnating qoq. Later, on the Q&A session management added that DISCO experienced negative effects of cost optimization efforts by its customers, which could have been communicated much earlier in my opinion, perhaps already on the Q3 earnings call.

Based on this, I believe that the combination of deteriorating fundamentals and the continued lack of transparency from management make the company’s shares “uninvestable” for the time being. One slight beam of hope regarding transparency is that management called out a new metric on the Q4 earnings call, the so-called multi product attach rate. It shows the ratio of customers who generated revenues from more than 1 product during the year. For 2022 the ratio stood at 11% and has been up substantially yoy. This shows that revenues could have a long way to increase, but unfortunately that’s not the reality for a while.

Valuation

Shares of DISCO closed the previous trading day at a forward Price/Sales ratio of ~4 when calculating with management’s recent 2023 revenue guidance. Based on the 15% after-market decrease in the share price this ratio should be currently closer to ~3.4. Comparing this to the ratio of ~2.2 of the S&P500 (SPX), it’s still 50% higher. I believe that currently investing in the S&P 500 is not a worse investment than investing in DISCO shares as there are so many uncertainties surrounding the company. Based on this, I believe DISCO shares have further room to fall.

Conclusion

CS Disco fundamentals didn’t improve in the Q4 quarter, and management guidance for 2023 didn’t imply a possible turnaround around the corner as well. On the top of that, management transparency is still not satisfying in my opinion, making things worse from an investor perspective. In the light of these, I believe that valuation is still not depressed enough.

Under these circumstances, I stick to my Sell rating for DISCO shares. Even if there would be one financial quarter in the future that would show somewhat improving fundamentals, it would not be convincing enough in my opinion to change my Sell rating. I believe that, at this point, significant changes are needed to turn the tide.