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Are UiPath shares worth it?
I initially wrote about UiPath (NYSE:PATH) for SA when the shares were $70 a little more than a year ago. At that point, they were too highly valued to recommend. Fast forward to June 2022. The shares are now selling for less than $18 on Monday, June 12th. The shares fell by 8% during Monday’s stock market rout; that was not really unusual performance for the shares of IT vendors. Previously the shares had risen about 16% in the wake of a strong earnings report, at least relative to very weak guidance that the company had provided the prior quarter which precipitated a substantial share price implosion. Now, they have given back all of those gains as the market is pricing in massive Fed rate hikes, and many economists have pivoted their expectations to forecasting a recession more than a growth slowdown.
It would be naïve on my part to in any way suggest that PATH shares will outperform so long as the market sheds risk, as risk is perceived these days. Is the current valuation a bottom? Fear is animating much of trading activity and it can be difficult to determine when waves of fear about a hard landing, and a recession might abate. Many technical analysts suggest that the market still has room to fall. There has been, and will be noticeable levels of forced liquidation of high growth shares by both individuals and from hedge funds. UiPath shares, regardless of their compressed valuation, and regardless of their outlook, will fall with the shares of other high growth IT companies until this bloodletting abates. At this valuation, the shares are certainly no longer uniquely vulnerable to a relative valuation compression.
But I think it is reasonable for readers not to look at how far UiPath shares might fall, but what is the company’s longer term outlook, and what are its business opportunities. This is a company with a leadership position in a very hot space, and with newly hired, experienced management running sales and field operations, it should be able to grow strongly, and to reach decent profitability over the next 12+ months. And with $1.8 billion in cash on its balance sheet, liquidity will not be an issue, and could be a significant asset as private companies fail to find funding in this environment.
I accept that some kind of recession seems likely before inflation and inflationary expectations are killed. The spread of inflation into the services sector seemingly ensures that. But what is basically unknowable is how UiPath’s business might perform during a recession; the company essentially was in its development stage in Romania during the financial crisis and it didn’t release its first products until 2013. I will return to the discussion of how a recession might impact the company’s business trajectory later in this article, but at this point, investors are locked in on the thesis that software companies will see falling demand, and encounter severe business problems in a recessionary environment.
Just for the record, the analogs between this economy, and that of the economic trends during the financial crisis are quite weak, and they are even weaker when considering the dot.com implosion in 2000/2001. For what it is worth, this company was fortunate when it launched its IPO in that it raised about $600 million, and it now has a net cash position of $1.8 billion.
Specifically, at the time of the prior conference call at the end of March, the company had guided to $225 million in revenues; it actually reported $245 million. The company manages the business based on its ARR metric. It had forecast that net new ARR would grow about $40 million from the level it had reached at the start of the fiscal year in its Q1. It actually was able to grow new ARR by $52 million last quarter. The company raised guidance, although the increase in guidance was from the extreme trough levels of the prior quarter. The company had forecast that full year ARR would reach around $1.21 billion, that full year revenues would be around $1.08 billion and that it would slightly exceed break-even in terms of non-GAAP operating income after the absorption of $10 million of net FX impact. The CFO commented during the call that he felt that the current growth in ARR was at trough levels, and indeed the full year guide for ARR is such that it suggests that metric will increase considerably in 2H.
Its new full year guidance for ARR is $1.225 billion; its new revenue guidance is now $1.09 billion and it now expects a non-GAAP operating margin of a bit more than 1%. The guidance includes absorbing an additional FX headwind of about $10 million in terms of ARR, and $20 million in terms of revenue. The company is forecasting positive free cash flow generation in the second half of the year. Most likely the guidance remains cautions. Management called out closing a super-sized deal in April with a health care provider, and talked about a strengthening pipeline and large deals in the pipeline solidifying. Needless to say, after last quarter, analysts and this writer as well, have found it a bit off-putting to see the story reverse 180 degrees. I am going to put it down to public company inexperience and a desire to present a prudent outlook. I have been doing this a long time now, and have seen lots of companies try to game the system, so to speak. I am not sure how much the company’s excursion to the dark side actually cost shareholders; whatever else, it certainly had an impact on credibility and on the willingness of covering analysts to extend any level of trust to positive management statements.
My interest in UiPath is essentially because it is the leading company in the Robotic Process Automation space, and in automating software creation through the use of the company’s technology, essentially the use of software bots, although this company offers a platform, and that is one factor differentiating its offering from competitors. Automating software creation is a major long term opportunity. Just how major is the subject of some debate as a couple of the contending linked later in this article suggest, but the growth ramp is of sufficient magnitude to support strong growth for UiPath for a number of years.
There are, no doubt, many broken IPOs in the high-growth IT space as well as many other companies in the IT space and elsewhere whose share prices and valuations have compressed enormously. I am not going to try to answer the question if PATH shares are uniquely deserving, but rather, if taking a position in the shares makes sense in this new world where growth sells at a huge discount to historical levels of valuation, and investors seek the comfort and stability that current level of free cash flow bring. The short answer is that the company’s shares now do offer reasonable, although not extraordinary relative value. I will discuss the specifics of just how reasonable later in this article.
The quarter reported last week definitely had a different flavor to it than was seen in the conference call and guidance from the prior quarter. Last quarter, the company was discussing how demand tailwinds had deteriorated in the wake of Russian aggression against the Ukraine, and even because companies in North America were seemingly pausing their investments in enterprise software. Simply put, that scenario didn’t play out, and the company started to close large deals, both in North America and in Europe. Many analysts of course, were more than a little dubious about what had actually changed; I suspect the answer is that the company’s sales management structure and its CEO didn’t read signals properly and showed some level of unwarranted negativity.
For example, in the prior quarter which ended 1/31/22, which was a fiscal Q4, and thus the strongest quarter of the year for ARR growth, net new ARR rose by $107 million, 72% growth for that metric compared to the prior year. This last quarter, net new ARR grew by $52 million, which was a step back from the $72 million for that metric the company achieved in the year earlier period. Of course, the quarter just reported quarter saw a $5 million FX headwind and an additional $5.5 million impact from the imposition of sanctions against Russia and the end of the company’s business activities in that country.
This quarter, the company is forecasting that ARR will grow by about $65 million which also is net of about a $5 million additional FX headwind. That compares to an ARR growth of about $74 million the in the year earlier quarter. The company’s RPO balance, or backlog, rose by 56%, again adjusted for FX impacts which are more noticeable for this company which has a relatively higher proportion of international business than for the average enterprise software vendor. The company’s software gross margin was 92%, essentially consistent with the prior period. The full year net new ARR guide, adjusted for FX and the suspension of Russian business, is actually flat year over year, a considerable upside from what the company had been forecasting, and what most observers had been expecting, and is consistent with the company’s commentary regarding the progress of large deals through its pipeline.
The company growth in operating expense was 49% year on year, although the sequential growth in opex was just over 2%. The company’s free cash flow was a negative $54 million for the quarter. Most of that related to payments of bonuses and full year incentive sales commissions; the company is projecting a modestly positive free cashflow attainment this year, which seems consistent with the numbers just reported and typical seasonal patterns.
Can UiPath return to hyper growth?
The simple answer to the question is that UiPath has a major market opportunity, and a leadership position in its space. From here on out, realizing that opportunity is a function of basic blocking and tackling. And the company has recruited sales leadership that has the experience and track record to make this happen. These high-profile hires include Rob Enslin who is now the co-CEO, and Chris Weber who has become the company’s Chief Business Officer. Weber is essentially replacing the former Chief Revenue Officer, and has responsibilities for leading the company’s go-to-market strategies, and for managing the worldwide sales, service and partner organizations. Weber had a senior sales role at Microsoft (MSFT). Enslin had previously been the head of Google Cloud Sales. Before Google (GOOG) (GOOGL), he had spent 27 years at SAP where he had been President of that company’s Cloud Business Group. So, notionally, at any rate, there is a lot more adult supervision in place that ought to be able to avoid the unforced error that seems to have been the genesis of the guidance given the prior quarter.
UiPath has, I believe, a compelling and well tested solution to help enterprises improve the efficiency of their software development. It has had issues in presenting that capability broadly, both in terms of using digital marketing, and within the largest enterprises. The founder of the company doesn’t have that kind of background, and perhaps the former head of sales had issues as well. The two new hires, given their experience, seem to be well suited to developing an efficient and methodical sales process that can reaccelerate growth, and which will avoid a reprise of the rather embarrassing situation in which the company’s outlook went from positive to dire to positive in 90 days.
At this point, an enterprise software conference call wouldn’t be complete without a discussion of the impact of the macro environment on the outlook for a particular business. And given the negative sentiments expressed by this company during its prior call, it was not surprising that many analysts wanted to understand what had changed in the last 90 days to encourage a stronger tone on the call and somewhat greater guidance.
At the time of the prior call, management, citing issues in Europe, particularly, suggested that its visibility had deteriorated and it was concerned about the appetite of users to close large deals. So now, a couple of months later, the company has presented, at least qualitatively, a different outlook. I think it is appropriate to let the principal actors speak for themselves, in terms of their own take on the environment. I recognize that this is a lengthy thread, but given the significance of the topic, I decided to quote both the CEO and the CFO:
Daniel Dines
Hey, Raimo, thank you for the question. And let me start first, and then I’ll let Ashim give you more color. Look, I’ve been in a long trip before this earnings call Europe and Asia. And I’m talking with a lot of customers. We are seeing a renewed interest for automation and that to – we are seeing also kind of positive maturity on the big deal evolution through our pipe. But overall, the – in this macro economical and we put a lot of pressure on our customers to become more efficient. And they are turning to automation in one of the easiest ways to navigate through these more key waters. Ashim, over to you.
Ashim Gupta
Yeah. I think – Raimo, thanks for the question. What we talked about last quarter was there was no denying the macro volatility. And we reiterated the fact that, we weren’t losing deals. Automation was important. These deals existed in our pipeline. It was just a question of uncertainty as our customers were gripping with the new realities that we’re hitting a new war inflation, et cetera. We’re 30, 60 days later. And what we see is we see deals progressing through all the stages of our pipeline. And as Daniel said, positive maturation in terms of the way they take shape. So we – as we look and we track deals through our pipeline and we see that movement, we really feel we have more confidence or we’ve had moderated confidence on the conversion of those deals, and we reflected it appropriately in our guidance.
I think this current evaluation is more balanced than what was said at the time of the earlier call, but because it flies in the face of fierce negative sentiment, and also because the actual increase in guidance was very modest, it probably will not do as much to animate the shares in the short term as would have been the case in a different market environment. And the fact is that many analysts, and myself as well, as was acknowledged on the call, were just plain puzzled about what can be seen as a stunning reversal in just a couple of months. Rather than me theorizing or interposing between management’s specific rejoinder to the reversal, this following thread summarizes the sentiment that the company portrayed,
Alex Zukin
Hey, guys. Thanks for taking the question. So I guess all of us who are sitting here, we’re trying to figure out, kind of, I think, where the incremental confidence is stemming from? Is it the feeling that deals that were maybe previously out of the pipeline are now back into the pipeline that are large and strategic? Is that, that your – you’ve got a greater confidence in the close rates in general? Is it some of the initiatives that you’re putting into place on from a sales change perspective that they’re going to materialize maybe faster than you initially anticipated? Because now the guide for the year on a constant currency basis for net new ARR is flat, which I think is a really positive surprise to all. So I think just maybe touching on where that incremental confidence in the backdrop of we’re all reading the same headlines from a macro perspective, that’s at least for me, I think, something that stands out.
Ashim Gupta
So, Alex, good to hear your voice. I think first is we recognize the macro impact early and acknowledged it. I think that’s really important to emphasize. So in some ways, we were a step ahead in terms of how we were looking at things.
In terms of our confidence, our guidance is always to guide what’s in front of us. So this isn’t for us, just we look at our pipeline. We’ve talked about the strength of our pipeline overall, and that has been consistent. We’ve expressed confidence in our pipeline even in first quarter. We never felt like things were coming out of the pipeline. We just felt an uncertainty of how and the timing in which they were moving through.
As we look at our pipeline today, we have several of those deals that we’ve seen movement on and the movement through a sales process gives us increased confidence of their conversion and what shape they are taking, and that is what we’ve been able to reflect in our guidance.
In addition, when you just hear the sentiment from the field, automation continues to be a priority at a macro level. Like the market continues to be and our TAM continues to be felt big. We’ve invested in our company in many of our areas, in many other markets. So we’re also — we feel very good about our connection with our customer to be able to continue to execute. Those are the factors that led us — that allow us to kind of raise our guidance
And then in terms of the bottom line, that is a point of focus. So we’ve crossed $1 billion, and we feel like we can both grow while execute efficiency, and we reflected that in our guide as well.
Daniel Dines
And I would like to add our renewed confidence in the executive team. I think Rob and Chris are leading a lot of shops to our team. We are seeing really positive response from our teams. And again, I would like to mention all the discussions we are having, not only me, but every people that I’m meeting, talking to our customers are coming reenergized by this discussion. So overall, it’s a better environment than we were seeing two months ago.
I will forbear commenting on the CFO’s comment about being first to forecast a slowdown. Taken by itself, the company’s guidance for ARR growth on an adjusted basis is about $65 million, and that seems fairly reasonable, if not to say prudent. That guidance puts ARR growth up by about 25% sequentially, but not up year on year. Presumably, particularly under the unsettled conditions that have been called out in numerous company presentations, this expectation is thoroughly scrubbed and is probably a minimum. So, I think there is a reasonable prospect that what is being seen now is trough growth-at least in terms of reported revenues-and of course the company is explicitly forecasting better margin performance the rest of the current fiscal year. Ultimately, of course, the increase in ARR is going to have to start growing again as part of a process of rebuilding the hyper growth story.
The company’s DBE ratio of 139% remains at strong levels, and of course, as a reported number, it has seen pressure because of Russian sanctions and FX. The company’s large customer count was actually a considerable upside as part of the company’s overall Q1 performance.
Reviewing What UiPath does and why it seemingly has been less affected by macro perturbations
UiPath has a leadership position in what is called Robotic Process Automation (RPA). It is a technology that is designed to simplify the process of building, deploying and managing software robots (most often called bots). The bots themselves have the ability to understand what’s on a screen, complete keystrokes, navigate systems, extract data and perform many other predefined actions. Needless to say, the bots do their job more efficiently than humans.
Most users regard RPA as part of any digital transformation strategy. Benefits from implementing RPA obviously relate to costs, accuracy, productivity, and getting employees to focus their attention on non-repetitive tasks that leave them with greater job satisfaction. These days, some more sophisticated bots can interpret texts, they can engage in chats, and they can help advance machine learning models.
The RPA market is growing at a substantial rate. One projection linked here suggests that the CAGR for the space is 25%, with a 2028 value of $7.64 billion. Another research company, whose study is linked here, says the market is growing at 28% and the total size will reach $24 billion by 2030. The most optimistic analysis published earlier this year suggests that the market will grow at a 36% rate and will reach $46 billion.
When this company went public, the S-1 at that time estimated the TAM to be $60 billion. That was a function of UiPath’s platform which encompasses more than just RPA functionality. I really haven’t seen anything that might suggest that this market isn’t continuing to grow at one of the faster rates in the enterprise software space.
UiPath’s offering is a superset of just bots and RPA. The company has a platform it offers and some of the functionality of the platform comes from a host of prebuilt APIs which actually better enable the functionality of other applications. Further, like much else in software these days, PATH uses AI to facilitate understanding of documents so that their preparation can be automated.
UiPath also offers what is called Process Mining. I imagine many readers will never have heard of process mining-it does not roll easily to my pen either. But Process Mining is a rather considerable business opportunity these days and UiPath offers a set of tools that facilitate users to take data from event logs which are embedded in applications such as Salesforce (CRM) and SAP-ERP (SAP) in order to remediate broken or sub-optimal processes.
Process Mining is in its infancy these days, and 3rd party analysts believe that the size of the market was just $627 million last year, but it is supposed to enjoy a CAGR of 50% through 2029 by which time the market will reach about $15 billion. UiPath is thought to be one of the leaders in this space, although a company called Celonis, with current revenues approaching $400 million, almost certainly is larger than any of its rivals in terms of process mining revenues. Given the current environment, it isn’t likely that Celonis will be able to launch an IPO.
Before leaving the subject of Path’s return to hyper-growth, I thought it relevant to follow another thread from the conference call. I chose to include this selection to provide a qualitative flavor of the change from one conference call presentation to another.
Alex Zukin
Hey, guys. Thanks for taking the question. So I guess all of us who are sitting here, we’re trying to figure out, kind of, I think, where the incremental confidence is stemming from? Is it the feeling that deals that were maybe previously out of the pipeline are now back into the pipeline that are large and strategic? Is that, that your – you’ve got a greater confidence in the close rates in general? Is it some of the initiatives that you’re putting into place on from a sales change perspective that they’re going to materialize maybe faster than you initially anticipated? Because now the guide for the year on a constant currency basis for net new ARR is flat, which I think is a really positive surprise to all. So I think just maybe touching on where that incremental confidence in the backdrop of we’re all reading the same headlines from a macro perspective, that’s at least for me, I think, something that stands out.
Ashim Gupta
So, Alex, good to hear your voice. I think first is we recognize the macro impact early and acknowledged it. I think that’s really important to emphasize. So in some ways, we were a step ahead in terms of how we were looking at things.
In terms of our confidence, our guidance is always to guide what’s in front of us. So this isn’t for us, just we look at our pipeline. We’ve talked about the strength of our pipeline overall, and that has been consistent. We’ve expressed confidence in our pipeline even in first quarter. We never felt like things were coming out of the pipeline. We just felt an uncertainty of how and the timing in which they were moving through.
As we look at our pipeline today, we have several of those deals that we’ve seen movement on and the movement through a sales process gives us increased confidence of their conversion and what shape they are taking, and that is what we’ve been able to reflect in our guidance.
In addition, when you just hear the sentiment from the field, automation continues to be a priority at a macro level. Like the market continues to be and our TAM continues to be felt big. We’ve invested in our company in many of our areas, in many other markets. So we’re also — we feel very good about our connection with our customer to be able to continue to execute. Those are the factors that led us — that allow us to kind of raise our guidance
And then in terms of the bottom line, that is a point of focus. So we’ve crossed $1 billion, and we feel like we can both grow while execute efficiency, and we reflected that in our guide as well.
Daniel Dines
And I would like to add our renewed confidence in the executive team. I think Rob and Chris are leading a lot of shops to our team. We are seeing really positive response from our teams. And again, I would like to mention all the discussions we are having, not only me, but every people that I’m meeting, talking to our customers are coming reenergized by this discussion. So overall, it’s a better environment than we were seeing two months ago.
Beyond the comments during the conference call, there is more than a little logic for the renewed confidence. Most of the tasks that are being automated are common to all businesses in all geos; and they solve similar pain points. it is so easy to quantify the benefits of RPA, and because implementation is quick, simple and painless, the acquisition of these solutions is usually a priority endorsed by the CFO. Much of the acquisition of RPA is driven by competitive pressures in that the use of RPA in the various use cases delivers a better user experience. The justifications for broad scale adoption of RPA are numerous; basically the ROI is very high, the improvement of user experience is very obvious, and those businesses that don’t adopt RPA broadly will be at a competitive disadvantage.
While UiPath is the acknowledged leader in the space, there are alternatives. Both IBM (IBM) and Microsoft (MSFT) have entries in the space, although at this point, the entries are not considered highly by the reviewers in the link I have provided. Appian (APPN) also offers a competitive service. Users believe that UiPath’s offering is easier to deploy, satisfies most requirements, and winds up achieving the advertised benefits. I have seen nothing that suggests that any of the competitors in the space are likely to overtake UiPath’s leadership position in the foreseeable future.
Will UiPath’s expected growth return to levels of the recent past? The company is certainly more confident in that regard. But of equal importance-there is more than a bit of logic in suggesting that the growth in RPA will be in spite of, and not a function of macro conditions.
Does UiPath have a path to profitability
OK, that is a bit of a pun, I suppose. Analyzing and managing high growth IT portfolios has been an absolutely abysmal experience for the last 7+ months and using a pun is a way of relieving some of the stress.
UiPath is not yet a profitable, cash generating company. That said, there is a reasonable path to profitability, and unlike some companies, UiPath has acknowledged the need to improve its operating performance in the short-term.
The company’s GAAP gross margins rose by 800 basis points year on year, while non GAAP gross margins were 85%, down 300 bps. This was a function of a growing mix of cloud business, as well as some seasonal factors. Overall, cloud based revenues rose by 55%, while on-premise license rose by 17% and services revenues rose by 50%. Non-GAAP gross margins on subscription revenues were 85%, and software gross margins, as mentioned previously, were 92%.
The balance of the P&L is fairly typical for a software company growing in the mid-30% range. Last quarter, non-GAAP sales and marketing expense was 56% of revenue, up by 59% year on year, but just 4.5% sequentially. Non-GAAP R&D expense was 17% of revenues and was up 52% year on year, and by 6% sequentially. The company, as mentioned, was founded in Romania, and much of its R&D is performed in that country. Romania is a low wage country and UiPath derives some significant cost benefits which can be seen from its R&D expense ratio. Non-GAAP general and administrative costs last quarter were 16% of revenues and were up by 20% year on year, and were down 7% sequentially.
The strengthening of the USD is a fact of life that is going to impact many companies, both in the IT space and in much of the rest of the economy when currency moves are so considerable as this one has been. It seems better to look at constant currency changes in growth rates. Overall, the appreciation of the dollar will impact revenue numbers slightly more than cost numbers, as this company has a higher proportion of costs coming from the EU than is typical for most IT vendors.
Achieving profitability is a focus for this company, and it has significant opportunities to improve cost ratios materially. In that regard, the following comment by the CFO is typical:
“we remain laser-focused on realizing the efficiency that comes with scale to drive both short and long-term operating leverage.”
Many companies articulate similar sentiments. Others talk about achieving growth and realizing their opportunities. Therefore, I look at some of the specifics. In that regard, it was notable, I believe, that the company did improve its operating margin targets for the year: the guide for non-GAAP operating margins is now about 1.5%; it had been 0.5%. I also look at the moderating trend in the sequential growth of opex which should allow the company to achieve operating leverage, even in the short term. Most growth companies have to make trade-offs between maximizing their revenue growth or focusing on margins. There are some companies, such as Veeva (VEEV) and Atlassian (TEAM) that have done both. This will not likely be a similar company, but it will likely achieve positive operating leverage. I expect that the company will manage to exceed its current non-GAAP operating margin targets, consistent with its track record.
Wrapping Up and considering valuation
I think UiPath shares should be considered as part of a growth recovery portfolio. The company, after presenting an ill-considered earnings commentary and forecast during its prior conference call, has now reversed field. I probably spent more space than some might feel optimal in trying to document the reason for the reversal, and it suggests the need the company has filled by bringing on more seasoned sales and operating executives with backgrounds at Google, SAP and Microsoft.
The business opportunity to automate software development is very large, and is a very nascent stage. This company has been the leader in the space for some time now, and that doesn’t seem likely to change any time in the foreseeable future.
After Monday’s implosion, the market seems to be in a mood to consolidate. Of course today’s Fed policy moves and statement are likely to cause a fair amount of valuation volatility. And PATH shares, regardless of their valuation, are not going to appreciate until sentiment ceases to be so completely governed by fears of the macro environment. My positive call is to consider the shares as part of a recovery portfolio.
Currently, the company’s EV/S, which despite current market conditions, is a reasonable valuation metric, is now less than 6X based on my forecast of $1.29 billion of revenues over the next 12 months. The company’s free cash flow margin is slightly positive, but should grow significantly over the next 2-3 years. My DCF estimate for the shares, based on conservative assumptions, is $33. Given the size of the opportunity, there is upside to that number. At some point sentiment will change. And it will do so when least expected. This is an investment to consider when markets resume discounting expected future cash flows.
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