CS Disco: Restating Buy Rating As Q2 Growth Turns Positive (NYSE:LAW)

Summary

Readers may find my previous coverage via this link. My previous rating was a buy, as I believed CS Disco’s (NYSE:LAW) valuation did not reflect its intrinsic value, especially with the strong 1Q23 performance. I am reiterating my buy rating as I gain more confidence that LAW can grow revenue by more than 20% in the next 2 years.

Financials/Valuation

With revenue up 1.7% to $34.2 million in 2Q23, LAW showed signs of returning growth. Adjusted EBITDA came in at -$7.4m, which was better than the -$8.2m expected by the market due to increased revenues and more efficient spending. Balance sheet remains clean with no debt and ~$179 million in cash.

Based on my view of the business and management guidance, LAW should be able to continue growing just as I expected previously, especially with management guiding an acceleration in growth to the high teens in 4Q23. This makes 20% growth in FY24 very possible. More importantly, I am bullish on the pipeline activity, which bodes well for future near-term growth as well. Lastly, the impact of Cecilia should be gradually seen through FY24 and FY25, which should further support growth. For multiples, I assume it will stay at the current level, but I would note there is potential for it to inflect higher as consensus is only expecting high-teens growth for FY24/25.

Comments

The fact that LAW’s 2Q23 showed growth when the market expected a decline of 5% in revenue is a good sign that underlying performance is improving. In particular, growth resumed at 1.7% y/y on the strength of improved Review results after two consecutive quarters of sequential deceleration. When compared to the unchanged FY23 revenue guidance provided by management, this suggests a pick-up to a growth rate in the high teens for Q4. With continued customer growth following the 4Q22 low, I have no doubt that LAW will be able to meet this goal. Importantly, current pipeline activity provides optimism for 2H.

We’re really pleased by the performance of the pipeline, and I’ve talked about it on the past few earnings calls, looking at how well our new team members are ramping across each step of the funnel, from SDR and other kinds of lead generation through to our inside sales and field sales teams closing deals, and then our CSM team working to identify opportunities to expand existing customers.

Now the numbers we shared today, on a year-over-year basis, meetings were up 30% and near-term opportunities were up 20%, and we’re continuing to enjoy, despite that broader pipeline, the same elevated win rates that we’ve been enjoying since the time of the IPO. Source: 2Q23 earnings

At the end of 2Q23, the total number of customers was 1,431, an increase of 43 from the previous quarter. While the number of additions is a decrease from the previous quarter, it is partially offset by the fact that annualized average revenue per customer rose for the first time in four quarters, from $95,473 to $95,810. This trend reversal is further evidence in favor of my optimistic forecast for LAW’s future growth. Recall that average revenue per customer (on an annualized basis) once hit a high of $120k in 1Q22. If we assume LAW can achieve this peak over the next 5 quarters (the same timing duration since 4Q21), it implies a CAGR of 5%. 5% on top of mid-teen total customer growth (1Q23 grew 20% Y/Y and 2Q23 grew 14% Y/Y) equates to high-teen total revenue growth. Furthermore, management has observed that cost optimization pressures from major customers have remained constant. This bodes well for 3Q23, as management is providing this comment with around 6 weeks of insights into 3Q23.

As a final point, I highlight that the rollout of Cecilia is still on schedule, and I expect it to have a positive effect in the coming quarters (Cecilia’s features will be made generally available by the end of 2023). My positive outlook is due to the feedback that management has received so far. While access to Cecilia is still limited to a subset of customers, those who have used it have provided management with glowing reports of the time and cost they’ve saved thanks to the tool. Management has not yet decided how they will price Cecilia, so it is unclear what the exact impact will be. Management thinks a combination of a platform fee and a usage based fee may be optimal, but they are open to other suggestions. Given that the company intends to announce integrations with their Case Builder solution, I anticipate that the release of this functionality will lead to a rise in the utilization of other products. Overall, I expect the roll out of Cecilia to help drive LAW growth to 20%.

Risk & Conclusion

Naturally, the purpose of law firms is to litigate disputes; however, the number of practicing attorneys is far greater than the number of actual cases. My biggest concern is that law firms won’t make adopting the LAW solution a high priority, despite how effective it is, because they already have options that work just as well. Therefore, growth may be slower than anticipated.

In conclusion, I reiterate a buy rating for LAW as growth turned positive, reflecting improved underlying performance and management’s optimistic guidance. The prospect of over 20% revenue growth in the next two years should be achievable, supported by pipeline activity and the gradual impact of Cecilia.