PagerDuty Stock Q2: Encouraging Signs of an Inflection (NYSE:PD)

investment thesis

IT operations cloud software company PagerDuty (NYSE:PD) reported its Q2 FY25 earnings report, which showed some encouraging signs of trouble as the IT operations software business bottoms out.

The San Francisco, CA-based cloud software company has has undergone a difficult transition period, as has the larger cloud software environment, as CIOs and CSOs have allocated a larger portion of their IT budgets to GenAI while shedding software-focused projects in this process.

In addition, inflationary pressures and high interest rate environments have also reduced IT budgets for SMB customers over the past 18-24 months, creating headwinds for PagerDuty as SMBs represented a major customer cohort for the software company.

This has hurt PagerDuty stock as it continues to underperform major indices and benchmarks.

However, stabilizing its customer values, along with an increase in ARR and deferred revenue, support the medium-term case for PagerDuty.

I am updating my company rating to a hold for now.

Q2 Recap: Rising ARR, Deferred Revenue May Revitalize Growth

The last time we covered PagerDuty, we recommended a sell rating on this company and noted that the decline in the company’s customer base has been alarming. Management made attempts to recalibrate and reduce reliance on its SME customers, its core customer base at the time. However, PagerDuty customers with >$100,000 ARR were also quickly churned out.

Since my sell rating, PagerDuty is down ~23%.

However, PagerDuty’s Q2 FY25 revenue report showed some solid signs of stabilization in customer volume as well as revenue value.

Starting with PagerDuty’s customer base, the company’s total paid customers hovered around 15,000, flat from a year ago. This looked much better than the shrinkage I had seen last year. Customers with >$100,000 in ARR decelerated at a slower pace, growing 6% y/y to 820, as shown in Exhibit B.

For the first time, management disclosed that customers with >$500,000 in ARR grew 20% year over year, indicating high levels of penetration in the enterprise’s target market. I would have preferred the company to demonstrate an increase in their DBNR (net retention based on dollars)which landed at 106% in Q2, down from 114% seen in the same quarter last year, but flat on a sequential basis. Management said it expects DBNR to return to 107% by the end of the year.

The improvement in customer values ​​over the year has also translated into revenue trends that are now normalizing and appear to be at an inflection point. PagerDuty reported second-quarter revenue of $116 million, up 7.8% y/y, in line with management’s previous guidance, but missing consensus estimates by half a million.

Management attributed the marginal revenue loss CrowdStrikeThe company’s (CRWD) shutdown on July 19, as well as seasonal changes in their business, due to the company’s increased focus on selling to enterprise customers. Management also noted that due to the gradual shift in its customer base, with enterprise customers accounting for a larger portion of its revenue, the company now expects the fourth quarter of the fiscal year to be its strongest quarter going forward than second or third. quarter.

Still, PagerDuty, which makes cloud IT incident management software, is largely on track to deliver 10% ARR growth for the year, pointing to expansion in the second half of this year. This was reiterated several times during the conference call to discuss Q2 earnings.

Q2 ARR accelerated on a sequential basis to $474 million, up 10% y/y, better than the 6% growth demonstrated in the prior quarter. The company’s deferred revenue, the uncollected revenue that the company has collected from customers but will recognize in the next twelve months, has already moved higher in the first quarter of this year, supporting management’s back-half re-acceleration theory of next year. . On the call, management said that “ARR growth is expected to improve throughout the year, as is DBNR.”

In Q3, management expects revenue to grow to $115.5-117.5 million, representing ~7% year-over-year growth, while full-year revenue is also expected to be $463-467 million, implying a growth of 9% in Q4 FY25.

Management is making improvements to operating leverage

In Q2, PagerDuty posted earnings per share of 21 cents, beating consensus estimates by 4 cents.

During the quarter, management demonstrated efficiency in containing its S&M expenses, which rose just 2.5% y/y, while administrative expenses contracted 7% y/y. The cost control demonstrated by management allowed the company to expand its operating margins by 400 bp in the quarter on an adjusted basis. While adjusted operating margins expanded to 17.3% in Q2, GAAP operating margins also showed improvement, as shown in Exhibit D below.

Management said they continue to control components of their sales, marketing and overhead structure, which should help the company expand margins further in the back half of the year.

PagerDuty’s capital structure remains fairly stable, with balance sheet debt remaining relatively flat at $461 million, while cash and equivalents increased marginally to $385 million and ST investments to $214 million.

PagerDuty review now looks more attractive than before

PagerDuty now expects FY25 revenue to grow ~7.5% y/y this year, below the 8% y/y growth initially expected by management. Part of management’s reason for reducing its guidance is based on high levels of seasonality resulting from CrowdStrikeits discontinuation in July. I think there are some heightened levels of conservatism as management doesn’t want to repeat the string of downgraded outlooks it was forced to issue last year, which caused it to lose some credibility. In my view, customer metrics, ARR and deferred revenue growth all point to PagerDuty’s business stabilizing, as opposed to the bearish outlook I had earlier.

Management still expects 13.5% adjusted operating margins, while projecting equity dilution of about 3.8%, slightly less than the 4% I expected. This translates to ~11.5% earnings growth on an adjusted basis, implying a forward earnings multiple of ~24x.

Based on the forward multiple of ~24x, we estimate PagerDuty’s price per share to be ~$15.8, implying a 13.4% decline from the September 3 close, or an additional 1.2% decline from the moves the exchange where the PagerDuty price was set at $16.

At these price levels, I think the worst could be priced in for the PagerDuty, and at worst, stock may remain limited to the range. If the turnaround story plays out, PagerDuty could be well positioned to grow next year.

Risks and other factors to look for

When commenting on the challenging environment for cloud software companies to do business, management noted that this is now the norm for them. They said they will continue to see lengthened sales cycles, especially in their target market, which now includes enterprise customers who typically have more red tape and end-to-end sales hoops for PagerDuty’s sales teams to navigate. Any relative change from here on in the current business environment for PagerDuty will cause more headwinds for the company.

Conversely, any improvement in the business environment could also boost the outlook for PagerDuty as factors such as interest rates and improving IT budget expansion will improve sales dynamics for the company. At all times, investors would do well to listen to management’s stance on their business environment while paying close attention to the company’s deferred revenue, ARR and DBNR for clues about its outlook.

Take away

I certainly feel more encouraged by the improvements PagerDuty’s management has shown over the past two quarters since I issued a sell rating on the company earlier this year.

Deferred revenue, DBNR stabilization and a much brighter customer mix and base now positions the company to benefit from the business expansion ahead for incident management IT operations.

I have upgraded my ratings on PagerDuty to a hold and remain bullish on the company’s management turnaround.