C3.Ai Q1 2025 Preview: Seeking Clarity on Their Fed Business (NYSE:AI)

Investment Thesis

Enterprise cloud software solutions company C3.ai (NYSE:NYSE:AI) is scheduled to report the first quarter of their FY25 earnings cycle next week, Wednesday, September 4, after markets close.

C3 found it hard to recover from short sellers, Kerrisdale Capital and Spruce Point Managementthey published their reports alleging misreporting in the company’s sales figures.

Complicating matters for the company was also the state of transition C3 was in, after growth didn’t take off as expected given the AI ​​tailwinds that management has touted since the launch of ChatGPT.

The company has increasingly sought to take a share of the US federal government’s IT budget, and C3’s Q4 FY24 earnings report in May this year provided some hints of progress.

Unfortunately, C3’s leadership continues to be disappointing in terms of sustainable growth, leaving me on the sidelines. I see moderate levels of pessimism in its valuation and for these reasons I will recommend staying neutral on C3 before taking the gains.

Booking growth, critical to growing revenue, needs more clarity

My previous coverage of C3 looked at the company’s staggering customer acquisition costs, which showed that it must spend every dollar of revenue earned on SG&A to acquire future customers. I was not impressed with the efficiency of management or the fundamental strength of its business model and rated the company a sell, while valuing the company at ~$23 per share. My thesis so far has been with C3 trading at the value per share I thought was fair.

Since then, C3 ended FY24 with an earnings report that initially impressed the markets, but eventually the momentum faded as C3 moved closer to the ~$23 price range. Full-year revenue was $310.6 million, $2.2 million above consensus estimates. At the same time, management guided the company to raise FY25 revenue to a target range of $370-395 million, well above expectations of $368 million. Hence, with these forecasts, the company’s growth rate in FY25 is expected to exceed the revenue rate in FY24.

The basis for management’s projections was the performance of the company’s bookings metric, pilots. The C3 pilot measures the number of customers the company was able to sign up for a 6-month paid trial period. During the trial period, the customer has developer access to the C3 AI platform, its COE services, and any C3 AI or C3 Generative AI applications. After the trial period ends, the customer makes a subscription-like commitment, with consumer credits loaded over the commitment. Most high street sell analysts found the company’s pilot customer volume, C3’s measure of their business bookings, to be encouraging.

If an investor takes the past performance of this pilot metric at face value, strong growth for the company can easily be assumed. C3 closed 123 pilots in FY24, up 151% y/y, indicating that these customers are “either in their initial term of three to six months, or extended for a certain duration, or converted to a subscription or consumer contract, or are currently being negotiated for conversion to a subscription or consumer contract consumption.”

In my opinion, that leaves a lot of room for customers to drop out after the pilot tests are over, and if that comes to fruition, management would be forced to sharply scale back their outlook.

The other part of their business model is driving increased bookings by leveraging their partner’s network. Management disclosed only the number of reservation agreements signed, rather than the dollar value of those agreements.

In my opinion, this makes revenue projections difficult. As mentioned in my previous coverage, RPO is not usable because management expects this measure to decrease in the future due to the company’s transition to a consumer price-based revenue model. While C3 sells its products through the respective marketplaces of the Big Tech companies it partners with, the sales deals between C3’s other partners are not yet entirely clear. However, due to the distribution of its partner relationships, C3 has half of its bookings coming from various US federal departments, while a quarter of the remaining half is bookings from the oil and gas industry, as well as NE governments and local bodies

So far, management has attended just one conference call since their previous earnings report, where they talked about the strength of their federal business without disclosing specific metrics. I still expect management to be more clear about their growth metrics, as are many of their peers.

Well capitalized books but margin deterioration expected

I agree that C3 looks well capitalized, with only $59 million in debt and liabilities while holding $167 million in cash. C3 is trading at 3.4 times its book value ahead of next week’s earnings, making this an attractive prospect given that it’s a fast-growing technology company.

But the company’s margin story needs to improve fundamentally for me to be impressed by that multiple of book value, as management will be forced to use its cash reserves if growth slows sharply, diminishing the appeal of that multiple of book value.

On the Q4 earnings call, management disclosed that it expects gross margins to be pressured by a higher mix of drivers driving higher revenue. C3’s gross margins are now 58% and have declined every year since 2021.

In addition, the company also expects its operating margins to deteriorate as a result “additional investment” to be done in their business, “including our sales force, R&D and marketing expenses.”

I also noted this in my previous coverage, where I expressed dismay at the company’s high customer acquisition costs.

Expect the company to maintain the same margin guidance for the earnings call next week.

However, the mathematical evaluation indicates some advantages

In my previous coverage, I explained how we thought the company could grow revenue in the double-digit range closer to tweens. Given management’s improved growth outlook, we estimate C3’s growth rate to be 22-23% CAGR over the next two years. I will still use a sales forecast as there is no room for margin improvement in the near future for the C3.

In my base case, I value C3’s forward sales at 8-9x sales, implying a ~10% premium when comparing C3’s earnings growth to the long-term earnings growth of the S&P 500. Some investors may be more bullish and willing to apply a higher sales multiple. I’ve attached my target prices in the optimistic scenario as well, but I’m not entirely confident that the C3 will warrant these sales multiples.

My model assumes a discount rate of 8% and a stock dilution rate of 5%. I increased my share dilution ratios after noting that share dilution increased by 8.6% in FY24.

What to look for in C3’s Q1 earnings report

Q1 Estimates: Analysts are calling for C3 to report a loss of 13 cents per share on revenue up 20% to ~$87 million, in the middle of management’s Q1 guidance range of $84-89 million. I don’t expect any surprises here.

Forward guidance for Q2 and FY25: This is where it gets interesting. Markets expect growth to accelerate sequentially to $91 million, implying ~25% YoY growth, while losses are expected to be 13 cents per share in Q2 FY25 as well. Expect serious repercussions if management fails to guide beyond expectations. Full-year revenue for FY25 is expected to be $383 million, in the target range of $370-395 million.

Business Comment: I strongly believe that providing feedback on proven business metrics such as bookings, invoices, deferred revenue and ARR would improve my impression of C3 management, but I don’t expect it to. So the key in next week’s Q1 earnings call will be to see how their pilot growth has fared and if growth has slowed.

Take away

I am not too optimistic about C3 with the business transparency that the management provides to the investors. The operational metrics that management provides do not provide a clear and precise operating environment for me to evaluate. Investors were left with anecdotal evidence of business metrics that could provide short-term growth spurts, but nothing to point to secular growth for C3. I don’t expect any of this to change yet in the next Q1 earnings call.

However, my valuation models based on the sales forecast for C3 suggest that there is a marginal upside to the company’s stock in a base case valuation.

Given the risks that still exist on the earnings call, I recommend staying neutral on C3 and watching for more formidable signs of business strength.