CS Disco Stock: The Legal Dance Continues (NYSE:LAW)

Investment thesis

CS Disco (LAW) is a legal tech company transforming the $767 billion legal services market with its innovative product line. If you are interested in a general introduction, check out my previous article on the company: “CS Disco: Game Changer In The Legal Tech Space“.

The company reported 2021 Q4 earnings recently, showing continued strong momentum in fundamentals. In top of that they announced their first ever acquisition, an excellent fit into their current product line. However, there were some possibly confusing elements around the earnings report, like a very conservative guidance or decreasing analyst price targets following the report. I’ll address these topics in the following and show, that shares at current levels are a really good investment in a transformative name in the SaaS space.

Q4 results: Reaccelerating revenue growth coupled with strong margins

2021 Q4 results reassured investors that the legal growth story of Disco is very much intact. I’ve summarized the key trends in the following table based on company filings:

	Pre-IPO					Post-IPO
	Q1 2020	Q2 2020	Q3 2020	Q4 2020	Q1 2021	Q2 2021	Q3 2021	Q4 2021
Revenue($bn)	15.7	15.7	17.9	19.2	21.1	29.5	29.9	33.8
YoY growth	51%	39%	41%	35%	34%	88%	67%	76%
Sequential growth($bn)	1.5	0	2.2	1.3	1.9	8.4	0.4	3.9
Gross margin	67.6%	71.3%	69.1%	72.1%	72.6%	70.6%	73.8%	74.0%

The most important thing is that revenue growth reaccelerated to 76% YoY in Q4 from an also impressive 67% in Q3. Investors were worried about decelerating growth after Q3 results, although the company tried to prepare them, that the stellar Q2 (88% YoY growth) is not the new normal. This was the reason that already before the general correction in the tech sector, shares began to fall following Q3 results. Now, I think the impressive Q4 numbers will soothe investors’ nerves, which will lead to stable share price appreciation again.

If we look at sequential revenue growth of $3.9 billion, we can see that the strong 76% growth figure was not due to easier comps, but a real good 2021 Q4 performance. Further good news is, that gross margin stayed at ~74%, although the company tried to caution on the Q3 earnings call, that it can fluctuate in the ~70-74% range observed in recent quarters.

As part of Q3 earnings the company didn’t disclose its dollar-based net retention rate (NRR), however this time they did it, for the first time since IPO (it was 122% back then). As of the end of 2021 NRR stood at 146%, which is a pretty strong figure. This supports the thesis of CEO, Kiwi Camarena: After the initial land companies tend to spend more and more on the e-discovery platform, which is then followed by buying into the other two products, Disco Review and Disco Case Builder as well.

Customer number grew 36% YoY in 2021 to 1,126. 214 customers generated revenue of more than $100,000 and 20 of them more than $1 million.

Based on the annual report international sales grew from $1.7 million in 2020 to $7.3 million in 2021, a more than 4-fold increase. Based on this dynamic I think non-U.S. revenue growth could be one of the main stories in 2022.

To sum it up, revenues are still growing strongly fueled by both new customer acquisitions and by increased spending of existing ones. This coupled with excellent gross margin confirms the investment case for Disco in my opinion. However, it’s necessary to point out, that there were some confusing parts of the earnings release, which I think must be interpreted appropriately.

Extremely conservative guidance

Disco’s guidance for 2022 Q1 and FY 2022 was very conservative, which the company explains by their usage-based pricing model and their short history as a public company. For 2022 Q1 Disco predicts revenue of $30-31 million, which would mean a sequential decline of 10% at the midpoint. Just to give you a little perspective, for 2021 Q4 the company guided $28.5 million, which turned out to be $33.8 million in the end, so there is nothing to worry about in my opinion.

For 2022 Disco guides for YoY revenue growth of 30% at the midpoint, which would be a sharp deceleration from 67% growth in 2021. Again, this is extremely cautious. NRR was at 146% at the end of 2021, which means that Disco grew revenues by 46% only from existing customers. I think guiding for 30% growth in 2022 is very unrealistic in this regard as well.

Mystery of improving fundamentals and decreasing price targets

Despite strong Q4 earnings we could observe that some analysts lowered their price targets for the company after the earnings release. This led to a decrease in the average analyst price target from ~$60 to $50 a share. Don’t be confused, this has nothing to do with fundamentals. In general analyst’s comments were very positive on Disco, but at the same time they lowered their revenue multiples for valuing shares, after the significant re-rating of SaaS stocks induced by higher inflation and interest rates. Even with this lowered average analyst price target there is ~50% upside potential from current levels.

First acquisition: Excellent fit into product portfolio

Parallel to reporting Q4 earnings Disco announced that it acquired two legal workflow products from Congruity 360, LLC. One of them, Hold360, which will be called Disco Hold from now on, is an excellent extension of Disco’s current product line. Disco Hold helps legal departments in managing legal holds, which constitute the first step in legal investigations. A legal hold consists of notifying necessary people to preserve the data potentially needed in the litigation process, which is followed by the collection of the data afterwards.

The next step is to use Disco Ediscovery to look for evidence in this huge amount of data. AI assisted Disco Review can be helpful in this process, by automatically classifying data into legal categories making the review process more efficient. Finally, Disco Case Builder extends this product line to witness testimony utilizing deposition transcripts.

Currently this is how the Disco product experience looks like. Based on independent reviews on TrustRadius and G2, it’s a really cost-efficient, easy-to-use solution for legal document review, and enables to do the same job with less people in a shorter period of time.

Valuation

I have included a detailed analysis on valuation in my previous article, so this time I only want to give you a short illustrative example, which could help to put current valuation into perspective.

The company had revenues of $114.3 million in 2021, growing 67% YoY. If we assume that in 2022 it would grow revenues by 45%, and 5%-points less in every upcoming year for the next three years thereafter (quite realistic assumption in my opinion), it would reach revenue of $407 million for 2025. With current market capitalization of $1.93 billion this would mean a Price/Sales ratio of ~4.7 for a company that still grows revenues by ~25-30%.

Currently SaaS companies with similar expected revenue growth rates (eg.: Splunk (SPLK), Salesforce (CRM)) trade at ~7.6-7.8 times TTM Sales. Based on this comparison there is considerable room for Disco shares to catch up to the prevailing valuations in the SaaS space.

Risk factors

There are a few important risk factors I want to highlight, which could explain some part of the valuation gap to other, more mature SaaS companies I’ve highlighted before.

Currently 79% of Disco’s outstanding shares are free float, which means there is a risk of added selling pressure from institutional investors, who haven’t cashed out entirely since the IPO last year. Besides Disco issued new shares last year diluting existing shareholders, which could easily happen again at higher share prices. These could lead to larger than usual fluctuations in the share price.

Another risk factor is the usage-based pricing model of Disco, which is common in the e-discovery space, but not that common in the SaaS space in general. This can lead to larger than usual fluctuations in quarterly revenue, that could have been evidenced for example in the unusually strong 2021 Q2 results followed by somewhat softer Q3 figures.

In addition to this, the usage-based pricing model results in significantly lower revenue visibility on the long run, as the ratio of current performance obligations (contracted revenue not yet realized) to TTM revenue is quite low. A ratio above 50% could mean at least some indication, in which direction future revenue growth could head. For Disco the ratio is only around 15%, effectively meaning no revenue visibility at all. So, we must have to be satisfied with management commentary and with extrapolating past trends.

Conclusion

Strong 2021 Q4 earnings confirmed the investment case for Disco. First ever acquisition and international revenue growth could be positive catalysts for revenue growth this year. Extremely conservative revenue guidance by management for 2022 should not scare investors, as it is hard to align with current positive fundamental picture. Valuation still lagging the general SaaS space, which could provide larger than average upside potential for shares in the medium term.