CS Disco: What Happened To Operating Leverage? (NYSE:LAW)

In the summer of last year I called CS Disco (NYSE:LAW) a strong law play, as it was digitalizing and automating legal services, as the nature of the business allowed for strong operating leverage amidst growing demand for its services. Unfortunately, this potential was already reflected in a high valuation, as the overall business remained interesting enough to keep a long term eye on.

Technology In Law

Disco provides cloud-based artificial intelligence solutions in the legal field to simplify discovery, review and case management, not just for law firms but government and other service providers as well.

This involves automatic identification and review of documents, with machine learning technologies applied to expand the scope of services. Founded in 2013, the company has grown to hold and store billions of files and data, with the company having nearly a thousand customers at the time of the IPO, including 85% of the top 200 law firms.

With the importance of legal documents on the rise, yet manual processes still being slow, expensive and error-prone, the set-up for a solid growth play was clearly seen.

The company went public last year in July, selling 7 million shares at $32 in order to raise $224 million with its offering. With 56 million shares outstanding, Disco was awarded a $1.8 billion equity valuation, including a quarter of a billion net cash position.

This operating asset valuation just north of $1.5 billion was applied to a business which generated nearly $49 million in revenues in 2019, on which it posted a $30 million operating loss. Revenues were up 40% in 2020 to $68 million as operating losses came down to $22 million. Momentum was very strong, with first quarter sales up 34% to $21 million and second quarter sales seen as high as $29 million, for a run rate over $100 million. Moreover, first quarter operating losses of $2.8 million mark continued progress on that front, all looking quite promising.

Despite a 15 times sales multiple (remember we were in a different market mantra) shares rose to $41 on the first day of trading, pushing up the operating asset valuation to $2.0 billion, leaving shares far too expensive at 20 times sales (at least in my eyes). Risks included mostly a slowdown of growth, valuation and on the operational front there could be mistakes in documents, yet the overall promise and potential of the solution looked good.

Implosion

After shares hit a high in the fifties not too long after the public offering, it has been all downhill from there, with shares sliding alongside the rest of the technology and recent IPO market. By this summer shares were back to the $20 mark as shares halved overnight in August on the back of quarterly results being released, now trading at just $9 and change.

Earlier this year, the company posted 2021 results as all looked pretty solid on the sales front, with full year revenues up 67% to $114 million, as revenues were even up by 76% in the final quarter of the year to more than $33 million. That was about the good news as GAAP operating losses increased to $23 million, up in absolute basis, but still narrowing a bit on relative basis.

The problem is that post the IPO the reversal in margin trends have been seen after a near $9 million operating loss was posted in the final quarter of the year, only in part explained by a $3 million stock-based compensation expense which is prevalent following the IPO.

The problem was even more so in the outlook. The issue was not so much that 2022 sales were set to rise by around 30% to a midpoint of nearly $149 million, but that EBITDA losses were seen around $47.5 million. This compares to an EBITDA loss of $16 million in 2021, indicating that losses are set to rise $30 million amidst a roughly $30 million increase in sales as well, indicating terrible operating leverage.

After releasing its first quarter results in May, the company hiked the midpoint of the sales guidance to $151 million for the year, while leaving the EBITDA guidance unchanged. The issues were the second quarter results (released in August) as revenues were up a mere 14% to $33 million and change, forcing the company to reverse the minimal increase in the full year sales guidance.

Full year sales were now seen at just $134 million, with EBITDA losses seen rising further to $58 million, dreadful results by all means as I was still surprised to see shares trade in the $20s ahead of the second quarter earnings results, given the lack of operating leverage, or actually the reversal of this seen already.

In November, the company posted a 15% increase in third quarter sales to $34 million and change, as the company maintained the full year sales guidance, now seeing EBITDA losses at $52 million for the year. The issue is that adjusted EBITDA losses are seen at $33 million so far this year resulting in operating losses of $52 million so far this year.

And Now? Not On The Right Side Of The Law

Right now the 58 million shares outstanding value equity of the company at $580 million at $10 per share, or around $370 million if we back out $213 million in net cash. Based on the sales outlook, sales multiples have collapsed from 20 times at the time of the IPO to just about 2.5 times here, yet the issue is that near break-even levels have translated into huge losses, nearing 50% of sales here. These are just awful results, indicating mismanagement of the growth and cost trajectory.

The combination of revenue growth slowing down dramatically and losses increasing rapidly, makes that even as sales multiples have contracted 80-90% since the public offering, I have no reason to get involved here.