CS Disco Stock: Be Careful With Recent Enthusiasm (NYSE:LAW)

Investment thesis

After a long streak of disappointing earnings results, CS Disco, Inc. (NYSE:LAW) managed to positively surprise investors with its Q2 2023 earnings release. On a quarterly basis revenues have grown at the fastest pace for the past 6 quarters. This has been mainly the result of the better-than-expected performance of the Review business, which saw some long-awaited large deal activity during the quarter. Furthermore, new customer acquisition remained healthy, and cost reduction efforts continued to aid the bottom line.

However, revenues only grew 2% YOY, and according to management’s guidance they are expected to stay flat over Q3. This shows that the core e-Discovery business is far from being out of the woods yet. On the top of that, the midpoint of management’s unchanged 2023 guidance suggests a strong reacceleration of revenues in the Q4 quarter, which will be a high hurdle to jump in my opinion. Finally, do not forget about the high fundamental volatility that prevailed in previous quarters, the vague communication of management in this matter, and the stretched valuation of shares after the post-earnings surge.

All in all, there have been some much-needed positives in the recent earnings release, but I think this is not enough yet to become bullish on the company’s shares. I upgrade my previous Sell recommendation to Hold, but I think more proof is needed before investors could comfortably purchase CS Disco, Inc. shares.

Review business rescuing top line growth for CS Disco in Q2

CS Disco reported revenues of $34.3 million for the Q2 quarter comfortably surpassing the high end of its previous $31-33 million guidance. This has been a quarter-over-quarter increase of $1.8 million, something not seen since the 2021 Q4 quarter. Compared to the results of previous quarters, this has been quite a positive surprise, which sent shares up 25% on the next trading day.

The most important driver behind the revenue beat has been the revival of the Review business (AI-assisted legal document review solution, often used in larger lawsuits), which once generated revenues in the $5-10 million range. All of a sudden, these millions diminished over the course of 2022, which has been the main reason that shares lost most of their value during that year. Now, management shared on the Q2 earnings call that they have seen a rebound in Review activity; there was even one customer who generated more than $1 million in revenues from this product category. Furthermore, in H1 60% of sales representatives generated revenue from the Review product, which has been almost double the rate of H1 last year.

These trends are encouraging, and if they manifest in the stabilization of the Review business, it could change the course for the company over the long run. However, after so many disappointments I believe this is not enough to become bullish on the company yet, especially in the light of the fact that the core e-Discovery business (~70-80% of revenues in 2022) seems to be still stagnating, after growing around 30% YOY not long ago.

According to management, the main reasons behind this are continued cost reduction efforts, especially from the largest customers of the company. The combination of this with the early revival of the Review business resulted in revenues growing ~2% YOY, which is still not convincing in my opinion. For Q3, management guided for revenues of $33-35 million, which means flat numbers QOQ at the midpoint, and suggests no quick turnaround. However, the implied guide for Q4 based on the 2023 revenue guidance is $38.6 million (also penciled in by analysts), which would almost equal to 20% growth YOY and a $4.3 million QOQ jump:

Based on this, the bar is set high for H2, but if the company manages to live up to these expectations shares should definitely continue to appreciate. On the Q2 earnings call, management struck an optimistic tone when asked about this topic, so those investors who regard themselves as risk seekers and have the faith in management could give a try to invest in shares at current levels. But for those ones, who tend to be more rigorous regarding their investments, I suggest staying put, until there is more proof that the rebound in the Review business is a lasting one, and that the e-Discovery solution is able to make a comeback as well.

Finally, a last mosaic piece regarding top line growth is Disco’s customer count, which continued to increase over Q2 by growing 14% YOY:

Although the net addition of 43 customers lags the previous print of 61 in Q1, it’s still a positive QOQ growth of 3%. If these customers began to turn into larger ones over the upcoming quarters, it could also drive revenue growth reacceleration to some extent.

Besides new customers, the widened AI footprint (for more details see my previous article on the company) of the company could be also an important growth driver in the future, with Cecilia – the integrated AI chatbot for large scale e-Discovery – expected to be generally available for customers by the end of the year.

So, there are positive signs that revenues at Disco won’t be stagnating forever, but I believe that the continued muted performance of the core e-Discovery business is still a great risk. This prevents me from taking a more bullish stance.

Further progress on margins

Adjusted EBITDA margin, the main metric used by management to express profitability has been deep in the red during the previous quarters. To counterbalance this trend, Disco laid off employees in two rounds this year, which began to have its beneficial effect on the bottom line recently. This can be evidenced by the significant improvement in Q2, where adjusted EBITDA margin jumped to negative 22% after previous quarters’ -35-40% levels. Based on management Q3 and full-year guidance, further improvement is expected on this front:

The significant improvement in Q4 is based on the midpoints of the company’s revenue and adjusted EBITDA guidance for 2023. The main driver behind this is the possible jump in revenues in Q4 I have described above, combined with an improving operating cost structure supported by the new office in Delhi, India. Besides, Disco is trying to optimize COGS by reaching better terms with AWS, which could also have a beneficial effect on the bottom line. Thanks to these efforts, management expects the company to become adjusted EBITDA positive in 2024 Q3.

The trends described above are welcome news after the significant losses in recent quarters. However, there is still a long way until Disco could reach profitability on a sustainable basis.

LAW stock valuation and risks

The share price of CS Disco increased significantly over the past few months while there has been no significant increase in 2023 sales estimates. This has led to a material expansion of the company’s forward Price/Sales multiple over the past three months, from 2.4 to 4.3 (market cap of $604 million divided by 2023 revenue estimate of $140 million).

Currently, the S&P 500 (SP500) trades at a forward P/S ratio of ~2.5, so Disco’s shares are valued 70% higher by the market. I believe this shows that the market got ahead of itself, and many positives are already priced in. The companies in the S&P 500 grow their revenues by 5-10% on average, Disco is currently below this level.

It’s true that, based on management’s guidance, this could change from Q4. However, there are many uncertainties surrounding that. Furthermore, the S&P 500 has a net margin of 10%+, while Disco is still far from reaching GAAP profitability. Based on this comparison, the 70% valuation premium compared to the S&P 500 is quite exaggerated in my opinion and leaves no more room for further expansion. This is one important risk factor to consider when investing into the shares.

Another important risk factor is the larger-than-usual volatility in the company’s revenues, which comes mostly from the volatility of the Review business. During 2022, investors could witness how this can impact top line growth to a material extent, and there is no guarantee that this would change anytime soon. Of course, a positive divergence cannot be ruled out as well.

A further important risk factor to consider is the strong competition in the e-Discovery space, where hundreds of companies conduct their business. Looking at revenue figures of recent quarters, Disco’s e-Discovery business seems to be stagnating. Management blames this on cost reduction efforts by customers, but one cannot be sure that there are no competitive dynamics also behind this.

Finally, an important risk factor to consider is the low level of transparency from management, which has been the most prominent during 2022, when revenue growth diminished. I think they provided insufficient information on fundamental trends happening in the background, which led to a loss in investor confidence. It will take time until this wound heals.

Conclusion

The Q2 earnings release of CS Disco, Inc. provided much-needed evidence that a positive turnaround in company fundamentals is on the way. However, there are still many uncertainties surrounding the company, which is combined with a stretched valuation after the post-earnings surge in shares. I believe the best strategy is moving to the sidelines for now.