PagerDuty Stock: Recent Weakness Provides Better Buying Opportunities (NYSE:PD)

Investment thesis

My initial bullish thesis about PagerDuty (NYSE:PD) did not age well, as the stock significantly underperformed S&P 500 over the last quarter. The weakness in the stock price is explained by the management’s cautious outlook, which was revealed during the latest earnings call. However, the company continues demonstrating stellar revenue growth and improvement in profitability metrics as the business scales up. In my analysis, I also explain I am optimistic before the upcoming quarter’s earnings release, which is approaching. My valuation simulation suggests the stock is attractively valued. Therefore, I reiterate my “Buy” rating for PagerDuty’s stock.

Recent developments and earnings preview

The latest quarterly earnings were released on August 31, when the company topped consensus estimates. Revenue continued demonstrating solid growth momentum with a 19.2% YoY growth. The operating margin improved significantly YoY, from -42% to -23%. This is a good sign for investors as PD demonstrates the ability to deliver solid operating leverage as the business scales up. It is also crucial to underline that PD sustained its above 30% R&D to revenue ratio, which indicates a continued firm commitment to innovation.

Notably, $36 million of expenses were represented by the stock-based compensation [SBC], and the company’s operating cash flow was positive in Q2. The net change in cash was positive in Q2, and the company delivered almost $19 million in free cash flow [FCF]. This allowed PD to sustain its fortress financial position with half a billion in outstanding cash, which is substantially higher than the company’s total debt. Having a solid balance sheet means the company is well-positioned to continue investing in growth and innovation.

The upcoming quarter’s earnings release is scheduled for November 30. Consensus estimates project Q3 revenue at $107.7 million, which indicates a robust 14.4% YoY growth. The adjusted EPS is expected to expand significantly from $0.04. to $0.14. However, the stock price declined after the earnings release due to the downgraded near-term guidance from the management.

As part of the upcoming earnings preview, I want to emphasize that PagerDuty has an almost perfect earnings surprise track record over the last couple of years. This suggests the management’s strong planning and that the guidance is usually very conservative. That said, based on the past earnings history, there is a high level of probability that PD will beat consensus estimates once again. Seven downward EPS revisions over the last 90 days also suggest that expectations are very conservative. I think that revenue consensus estimates are also low, which is underlined by the fact that sequential top-line growth is now expected. To add context, over the last multiple quarters, PD consistently demonstrated sequential revenue growth.

Furthermore, looking at the upcoming earnings from a business perspective also gives me optimism. PagerDuty’s “land-and-expand” model seems to work efficiently as the company demonstrates above one hundred dollar-based net retention [DBNR] rates. This means that the company capitalizes on its cross-selling and upselling capabilities. Despite the latest quarterly earnings release unveiling negative trends in DBNR, the management still projects a strong 110% level for the rest of fiscal 2024. A firm commitment to innovation, which we see in substantial reinvestments into R&D, suggests that PD’s engineers are working on adding new features to the platform to enhance cross-selling potential. Apart from the in-house innovations, PagerDuty also boosts innovation with strategic acquisition. The company’s recent acquisition of Jeli will likely enhance customer experience and ensure higher loyalty. While it is implausible that Jeli acquisition will affect Q3 earnings, I believe that it is the long-term bet to enhance PD’s troubleshooting ecosystem.

I firmly believe that more conservative guidance from the company’s management is a temporary factor, not a secular one. The secular shift towards increased digitalization means that the demand for intelligent troubleshooting ecosystems will also grow notably. I am not an IT engineer, but recent developments suggest that PD’s platform stays at the forefront of this niche. According to the latest earnings call, technological superstars like Cisco (CSCO) and Nvidia (NVDA) chose PagerDuty as their real-time operations platform, which is a huge quality sign. Moreover, PagerDuty’s recent award from Amazon (AMZN) Web Services further reinforces the notion of PD’s technological superiority. The company’s gross margin, which consistently dances around a staggering 80%, suggests strong pricing power as the platform brings value to customers.

All in all, I am optimistic about the company’s upcoming quarterly earnings release. I expect PD to deliver strong Q3 results and do not expect negative surprises from the guidance perspective. From the secular point of view, I also see PD as well-positioned to absorb positive secular shifts.

Valuation update

PD’s price declined by 17% year-to-date, significantly underperforming the broader U.S. stock market. Seeking Alpha Quant assigns PD a low “D+” valuation grade because ratios are substantially higher than the sector median across the board. That said, from the point of view of multiples, PD is overvalued.

I want to proceed with the discounted cash flow [DCF] approach. I use a 10% WACC for discounting. Revenue consensus estimates expect revenue to compound at double digits by FY2027, and for the years beyond, I project a more modest 10% CAGR. I use a zero FCF margin for my base year with 150 basis points yearly expansion.

According to my DCF simulation, the business’s fair value is $2.23 billion. This indicates an 11% upside potential, and my target price for the stock is $24.

Risks update

The stock demonstrates relatively weak momentum, which is an apparent drawback for the stock’s near-term prospects. Even strong earnings might not be a strong enough catalyst to break the negative trend in the current mixed environment of the stock market, where a very limited number of stocks fueled the central part of the broader market’s rally this year.

As we saw in the “Valuation” section of this article, more than three-fourths of the business’s fair value consists of the cash flows generated starting from FY 2033, which means the vast level of uncertainty as the company operates in a rapidly evolving and highly competitive technological environment. PagerDuty must demonstrate stellar business execution to protect and expand its market share amidst the potential emergence of new entrants and technological disruptions.

Bottom line

To conclude, PD is still a “Buy”. Even in a challenging macro environment the company continues delivering solid revenue growth and demonstrating operating leverage. Investments in growth and innovation are substantial and will highly likely build long-term value for shareholders. The recent guidance softening looks like a temporary problem, not secular. My valuation analysis suggests that the valuation became more attractive after the pullback after the Q2 earnings release.