PagerDuty (PD) Stock Analysis

In this post, I examine PagerDuty (PD). Based on my characteristics of successful software stack investments, PagerDuty meets some but not all of my criteria for recommendation. While their core product offering of on-call management has been a staple for DevOps teams since the company’s founding, a clear path to a much larger product expansion that provides necessary value to digital enterprises is harder to discern. Competitive positioning will also be a challenge, as established IT service providers are now encroaching on PagerDuty’s territory through acquisitions. In this post, I will examine the company’s financials, product offering, addressable market, competitive positioning and leadership team. This will set a foundation and investment framework which investors can use to monitor PagerDuty’s progress going forward.

History

PagerDuty was founded in 2009 in Toronto by three graduates of the University of Waterloo, a well-known Canadian university with a strong computer science program. The company raised about $170 million over the following 10 years, until going public in April 2019. They hired Jennifer Tejada to be CEO in July 2016. She was previously CEO of Keynote Systems, which provided web site performance measurement services and merged with Dynatrace (DT) in 2015.

I first experienced the PagerDuty product in 2010 when I was VP of Engineering at a large online dating service (Zoosk). Our DevOps team utilized PagerDuty for on-call management. This meant that each operations engineer would enter their contact information and availability schedule into the PagerDuty system. Any time one of our other system/service monitors (Pingdom, New Relic, Nagios) would issue a critical alert, PagerDuty would register the alert and notify the primary on-call person, usually via SMS or automated voice call. The operations engineer could read a short version of the alert description with a link to the associated performance dashboard of the alerting system. If the primary on-call operations engineer wasn’t reachable, the PagerDuty service would intelligently move on to the next ops engineer in the call tree. Preferences for notification method, frequency and escalation trees could all be customized. PagerDuty charged a monthly fee for this service.

As a product for managing an on-call rotation, PagerDuty was indispensable. They provided an intuitive, reliable and reasonably priced solution to a common issue for DevOps teams at internet-first companies. PagerDuty was pretty much the standard for managing incident response notification trees at the time.

Since that initial use case, PagerDuty has expanded their offering and target enterprise audience substantially. This was driven by both the recognition that digital operations for any company must be continuous and likely internal investor pressure to grow PagerDuty revenue streams. While the core service is useful, the big question for investors will be whether PagerDuty can evolve substantially beyond their roots in incident management to create and capture a much larger market opportunity.

Financial Overview

PagerDuty went public in April 2019. They priced the IPO at $24 a share. On its first day of trading, like many IPOs in early 2019, share price jumped to $38.25 at close. PD share price continued to ascend and peaked near $60 in the summer of 2019, only to slowly drift to the mid-20’s currently. This was attributable to a couple of marginal earnings reports and the general malaise associated with high multiple cloud stocks in 2H2019. PD stock has recovered somewhat as we have entered 2020, but is still substantially below its ATH price.

PagerDuty announced their most recent quarterly results on December 5, 2019 (Q3 FY20 ended 10/31/2019). The results were followed by a 12.7% drop in stock price the following day to close at $21.81. These results included the following highlights:

• Revenue growth of 37% year/year to $42.8M. Analysts had estimated $42.1M, so a beat. This annual growth rate represented a decrease from 45% in Q2 and 49% growth in Q1 FY 2020. This rapid decline in yearly revenue growth on such a small base is concerning.
• Gross margins of 85.2%, compared to 85.5% the prior year. Reassuring to see gross margins stabilizing at a relatively high level.
• Total of 12,000 customers, representing growth of 15% year/year. New customer pick-ups have been consistent over several years.
• Accounts with $100k or more ARR grew 49%. This usually represents traction in the enterprise.
• Non-GAAP operating loss of $9.3 million, with non-GAAP operating margin of negative 21.9%. This compared to a $5.8 million loss, or non-GAAP operating margin of negative 18.5%, in the third quarter of fiscal 2019. The decrease in non-GAAP operating margin is concerning.
• Free cash flow was positive $2.3 million, or 5.3% of revenue, compared to positive $0.2 million, or 0.5% of revenue, in the third quarter of fiscal 2019. FCF is growing.
• Cash and Cash Equivalents were $346.1 million as of October 31, 2019. So, likely won’t require additional capital raise in the near term.
• Estimated the next quarter (Q4 FY20) revenue in the range of $44.5 million – $45.5 million, representing a growth rate of 32% – 34% year-over-year. At the mid-point, this was slightly above consensus revenue of $43.8M, but again, a further deceleration year/year, even assuming a slight beat.

On a “Rule of 40” basis, PD would score 37 (Revenue growth) + 5 (FCF margin) = 42. On a forward basis, this might drop below 40.

My primary concerns with these performance metrics are 1) the rapidly slowing year/year revenue growth rates and 2) operating margin trajectory. Also, given that the company IPO’ed recently, we would expect larger beats for the first couple of quarters, which we normally see in other growth stocks. This issue is magnified by the small revenue amounts, with a FY2020 target of about $165M. The inverse of the “law of large numbers” should be favoring the company at this point.

Analysts have projected revenue growth of 27% and 26% in the following two years. This is coupled with gradually improving non-GAAP income and EBITDA margins.

Finally, analyst recommendations are mixed for PD. There are currently 9 Buy or Strong Buy ratings and 4 Hold ratings. The majority of the Buy ratings were set before the 12/5 quarterly release and ratings since have been more neutral.

In terms of valuation, PD currently has an Enterprise Value of $1.45B, with an EV/Revenue ratio of 9.4. If we project out a quarter to end of FY 2020 (calendar year 2019), EV/Revenue ratio is 8.8. Projecting out two more years using analyst revenue estimates, we get 6.9 in FY 2021 (roughly calendar year 2020) and 5.5 in FY 2022 (doesn’t take dilution into account). For revenue growth in the high-20 percent range and a path to profitability with positive FCF, these valuation numbers are reasonable. We could expect a comparable EV/Revenue ratio at peer companies with similar profile to be 8, so investors could see about 45% growth in value over the next 2 years, if everything goes well.

Product Overview

PagerDuty’s products include on-call management, incident response and event intelligence. These are used by engineering, security, customer service and business operations teams to respond to service issues in a coordinated and efficient way.

As I mentioned previously, PagerDuty started with an on-call management solution. As they gained experience and users, and watched digital transformation initiatives emerge, they pursued other areas of product expansion.

This period coincided with the emergence of several powerful trends, that are providing secular tailwinds for most software stack companies:

• Every enterprise across all industries is realizing that they must “become a software company”. Really, this means increased investment in custom software development as a means to differentiate their service offerings from competitors.
• As the internet and mobile usage become commonplace, customer expectations for digital experiences go up significantly in terms of reliability, responsiveness and innovation.
• The DevOps trends in managing the operations side of building digital experiences becomes mainstream.
• Custom software applications migrate to the cloud and rely on a web of third-party SaaS applications to support them.

As enterprises address these trends, they increasingly struggle to manage their digital operations from a single view. High customer expectations and ultra-low tolerance for outages causes over-correction on incident response, tying up many resources that could otherwise be focused on building new experiences. Orchestrating activities across teams and communicating status of issues also becomes more difficult as digital support organizations expand. Enterprises resort to inefficient, manual process fixes, like “war rooms” and “pull in everybody” conference calls.

PagerDuty’s product evolution attempts to address these issues by providing companies with a mechanism to manage all inputs and coordinated response in a single system.

PagerDuty has also expanded its relevance to a broader set of teams within the enterprise. In the beginning, users were primarily technical operations personnel and developers themselves, essentially the realm of the engineering group. However, as business continuity began to encompass security incident response, the security operations team was brought into the user audience. Further, since continuity incidents generate inquiries from customers, the customer support team needed awareness. Finally, business operations managers similarly require visibility into service performance and availability issues that might impact business KPIs.

The value proposition also evolved for the PagerDuty solution over time. Initially, it consisted of simply adding efficiency to the management of an on-call rotation among technical operations engineers. As more teams became involved in incident response and the leadership over-correction created a lot of resource inefficiency, the value proposition expanded to include:

• Resource utilization efficiency – Intelligently alert only the personnel needed to resolve a particular issue, versus the prior practice of pulling everyone possible into a response call.
• Reduce communication overhead – Half of the time spent in incident response is often writing one-off status updates and distributing to various layers of the organization.
• Minimize business disruption – This is the base case of ensuring that incident notification and response is as rapid as possible.

With this product overview, let’s take a brief look at each of the individual PagerDuty product offerings.

On-call Management

This product allows DevOps teams to set up and manage their on-call schedule. The on-call designation represents a commitment by a member of a team to be available during a time window (usually for a week) to respond to an issue that occurs (usually after-hours). On-call schedules represent assigning primary and secondary roles for notification, as well as management escalation. Once an issue occurs, the notification can be distributed to the designated personnel through their desired contact method (SMS, voice recording, push notification, email, etc.). Also, timers can be set for acknowledgement and type of issue that determines escalating updates to management levels. Schedules, incident status and other data can be viewed through web or mobile interfaces. PagerDuty provides a customer testimonial from DataDog (DDOG) on their site. This is interesting, as it represents the fact that PagerDuty occupies a niche in this product that even other APM and log management companies rely upon.

Modern Incident Response

Incident response represents the process and communications that occur after incident notification to ensure that the event is addressed, all personnel are aware and historical data is captured.

The incident response tool provides the ability to engage other responders, depending on the scope of the issue. It also delivers real-time updates to stakeholders as the issue is triaged and addressed, which allows the responders to focus on fixing the issue and not having to communicate status repeatedly. The response data can also be ported to other ITSM (IT Service Management) tools like ServiceNow and communications can be forwarded (both ways) to collaboration tools like Slack. As incidents are addressed, events are recorded in a history that can be referenced in the future. This historical log also allows for notations to be added manually to provide context.

Event Intelligence

As an enterprise accumulates a history of past incidents and responses, event intelligence represents the ability to achieve continuous improvement going forward. This is accomplished through event handling automation scripts, relating current incidents to past history, grouping alerts and suppressing lower priority items. This is accomplished using algorithms and machine learning that examine past event circumstances, identify common patterns and then apply those to add context to new incidents. The goal is to allow the incident response team to handle more incidents without requiring proportionally more staff. There is also an implication that resolution for common issues could be automated, although I wouldn’t necessarily take it that far.

Analytics

The Analytics tool set gathers raw incident response data and aggregates it into insights that can help improve team performance. It provides a set of standard metrics, KPIs and dashboards for leaders to review. Incident response data can be tied to actual business performance data as well to provide a full picture of business impact of incidents. Metrics and KPIs can be compared to industry and peer benchmarks, which provides useful insight for leaders to understand how their teams are performing relative to others. This is possible due to PagerDuty’s coverage across many companies and industries.

Visibility

The Visibility product provides a top-level view of all incident activity. This can be used by both technical and business stakeholders to understand how technical incidents are impacting digital experiences in real-time. It allows customer facing teams to craft appropriate responses, like communications, service discounts, or capitalizing on a marketing opportunity. Visibility primary consists of a series of “consoles”, which resemble consolidated dashboards of ongoing incidents, their status and business impact. These would be consumed by top-level leaders for situational awareness.

Pricing

PagerDuty generates revenue primarily through subscriptions to their service offerings. They offer four subscription pricing levels – Starter, Team, Business and Digital Operations (which is the enterprise offering). Customers are able to add on products, including Analytics, Visibility, Event Intelligence and Modern Incident Response to the Team and Business levels, or get them all as part of the Digital Operations package.

This subscription pricing model is desirable from a recurring revenue perspective, like all SaaS companies. Additionally, I can see how a streamlined user addition process could quickly drive up revenue within a customer company as more employees want access to the system. This likely explains PagerDuty’s above average DBNER over 130%.

Product Evolution

The order of the products listed above correlates to their release timeline by PagerDuty and progression of steps in the incident response process. This started with basic notification and evolved to summary data and predictability. From my perspective, On-call Management and Incident Response represent tangible product applications with clear use cases for modern DevOps and Support teams. The newer product offerings of Event Intelligence, Analytics and Visibility are more visionary, and seem to be nice-to-have add-ons that go beyond the core use cases.

If PagerDuty can establish themselves as the “central brain” of digital operations and enterprises truly value the incremental cost of this, then I think PD will have a big opportunity. However, if this central brain function either isn’t achieved or isn’t worth the investment by enterprises (nice to have, versus must have), then PagerDuty will have less growth opportunity going forward.

It is also worth considering that the PagerDuty service represents budget that CTOs/CIOs wish they didn’t have to spend. They naturally skew spend towards areas that grow the business (have clear ROI) versus functions that reduce risk. I made a similar argument around investment in security companies and consider PD in the same way.

Total Addressable Market

PagerDuty leadership estimates that the addressable market for their core product offerings around incident management represents a $25B opportunity. Further, by expanding out to encompass real-time operations, they see another $75B of market opportunity. This provides a total addressable market of $100B. Given that the current year revenue estimate is about $165M for PagerDuty, they have captured a very small percentage of this overall market opportunity.

In the footnotes, leadership derived these estimates by taking the total per user annual fee for existing products and multiplying by the number of employees worldwide who could potentially use their products.

• 22.3 million global software developers
• 18 million information and communications technology skilled workers
• 43.7 million customer support and success workers
• 1.2 million security operations workers

To calculate their total addressable market of $25B, they multiply the estimate of 85 million potential users by the average revenue per user for the financial year ended January 31, 2019.

As you can see in the left hand column, this includes many different teams within an enterprise and some categories, like “business” are broad. Overall, I think these estimates are very optimistic. It is hard to imagine that all of the user types listed above will need a license.

Finding an outside estimate to corroborate this data doesn’t provide a direct comparison. Marketsandmarkets published an estimate of the “incident response” addressable market: “The incident response market is expected to grow from USD 13.38 billion in 2018 to USD 33.76 billion by 2023, at a Compound Annual Growth Rate (CAGR) of 20.3% during the forecast period.” However, this is associated with security incidents.

There is likely not a great source of addressable market estimates for this space, particularly as it is evolving. I think it’s fair to assume there is a large (> $5B) market for the services that PagerDuty provides, but think the methodology used by PagerDuty is a stretch. As the user count within an enterprise expanded to include all the teams PagerDuty targets, I think the total cost would quickly exceed what a CIO/CTO would like to spend on this type of solution relative to their overall budget.

Competition

There are a number of players around of the periphery of IT service management, observability (APM, log analysis, security events) and incident response. In their September 2019 investor session, PagerDuty management divided up the competitive space as follows. I would also include ServiceNow (NOW) in this, as well as the major cloud providers.

For PagerDuty’s core market of on-call and incident response management, the two competitors that I see referenced most often are VictorOps and Opsgenie.

VictorOps

Splunk (SPLK) acquired VictorOps in June 2018. This acquisition made a lot of sense for Splunk, which is already deep in the log analysis space and deals with most IT operations within enterprises as a result. Extending into incident response is the next logical progression of their product offering, as system log entries often provide the source for an alert. Splunk is also applying AI and ML to process volumes of operational data to drive insights and automation. This “intelligence” would enhance the VictorOps offering and represents similar positioning that PagerDuty is promoting.

Reviewing the product offering on the VictorOps web site, there is a lot of overlap to the PagerDuty offering. Their current focus is more on the core use cases of on-call and incident response management, with a little less focus on the broader visibility use case and expanded team that PagerDuty promotes.

VictorOps’ customer highlights appear reasonable and they share most of the third-party system integrations that PagerDuty includes. Having the Splunk salesforce promoting this product will give it a lot of visibility with enterprise customers.

Finally, it is interesting that I received a promotional ad from VictorOps Sales offering a 50% pricing discount. This is probably indicative of the potential commoditization in this space, particularly if Splunk views the VictorOps offering as a simple add-on or loss leader for their core log analytics sale.

Opsgenie

Atlassian (TEAM) acquired Opsgenie in September 2018. Like PagerDuty and VictorOps, Opsgenie started with on-call management and alerting over multiple channels (email, SMS, voice calls, and mobile push). From those roots, it evolved into a platform empowering teams to prepare for incidents, collaborate on solutions, and conduct retrospection. The product offers on-call management and escalations, alerting and analytics. They provide integrations with over 200 third-party tools.

Opsgenie is promoted as one of Atlassian’s core products, along with its issue tracking, service desk, agile planning and incident communication offerings. Because of Atlassian’s broad penetration into engineering and operations teams, they can offer Opsgenie as an add-on to a core product. Interestingly, the pricing structure for Opsgenie appears similar to that of PagerDuty.

PagerDuty’s Perspective

PagerDuty provided a list of the items they felt differentiate their solution from competitors in their S-1 filing in March 2019.

• Built for real time. PagerDuty emphasizes the fact that all signals and responses are processed in real-time without creating work queues or latency.
• 10 years’ and over 10,000 customers’ worth of data. As a result of their long operational run in this space, PagerDuty has accumulated a large amount of historical event data and subsequent human responses. This data has been mined and is leveraged to provide contextual insights to teams, share analytics and provide industry benchmarks.
• Over 300 integrations across the technology ecosystem. PagerDuty has created over 300 integrations with third-party services, allowing them to send data both ways. Most integrations are with companies in the observability space, including AWS, Datadog, HashiCorp, New Relic, and Splunk, and bi-directional integrations into Atlassian, Salesforce, ServiceNow, and Slack.
• Breadth of functionality. The PagerDuty platform spans digital operations management from end-to-end. It can collect digital data, make sense of it, alert and engage teams, and analyze outcomes to learn from a team’s actions. PagerDuty has embedded machine learning, automation, insights, and best practices across their products.
• Proactive. PagerDuty has made a shift from efficient response to proactive and predictive action to help teams prevent incidents from occurring.
• Secure, resilient, and scalable. PagerDuty infrastructure is designed for high availability and resiliency. The infrastructure includes multiple redundancies and has maintained over 99.99% uptime. Finally, security is embedded throughout.
• Designed for the user. PagerDuty software is intuitive and easy to learn. It includes a simple, self-service on-boarding experience so teams can be up and running in minutes. Products are mobile-first. Customers can easily extend the platform across teams and multiple use cases within an organization.

Customer Adoption

Due to their long time market presence with the core incident response management products, PagerDuty has established pretty broad and deep penetration into its target market. Customers span multiple verticals and range in size from smaller start-ups to large enterprises.

The majority of their customer engagements still involve sales of the core on-call management and incident response products. However, at the recent Investor Session in September 2019, leadership spoke extensively about expansion of enterprise customers in particular into broader roll-out and use of newer visibility and analytics products.

In PagerDuty’s S-1 filing, they provide some other interesting customer examples (copied verbatim):

• Box uses PagerDuty to help ensure that its services are always available to its customers, leveraging PagerDuty Modern Incident Response to run automated response plays that enable teams to mobilize faster and take action in real time.
• GoodEggs uses PagerDuty to enable warehouse operations and development teams to analyze signals from refrigeration units to ensure food stays fresh for deliveries.
• Okta uses PagerDuty for its digital operations to remove friction from the incident response process so that teams can identify, escalate, and resolve incidents, while mitigating customer impact.
• Slack leverages the PagerDuty platform to orchestrate real-time response across teams to maintain high availability and reliability for its millions of users across the world.

Like other software stack companies with a subscription model, PagerDuty offers a low friction on-boarding process for new customers. Individuals or small teams at enterprises can begin utilizing a product through a free trial in a self-service motion. Then, expansion is driven by an easy upgrade path and inside/field sales personnel.

This “land and expand” motion has been strong, leading to fairly consistent growth in customer counts and revenue per customer. This motion has also provided the foundation for PagerDuty’s high DBNER over 130% for the past 2 years, although as noted previously, in recent quarters DBNER has been dropping.

Finally, PagerDuty has a strong and broad set of integration partners. These provide both input signals for generating alerts and output channels for communications. With over 350 integrations, PagerDuty has established more of these partnerships than other competitors.

Leadership

Jennifer Tejada is the CEO. She joined the company in July 2016, after serving as the CEO of Keynote Systems from 2013 – 2015. Keynote merged with Dynatrace (DT) in 2015, with the Dynatrace CEO maintaining the leadership role of the combined company. Prior to Keynote, Jennifer served in leadership roles on the strategy and marketing side at Mincom, an enterprise software provider. Early in her career, she held marketing roles at i2 Technologies and Proctor & Gamble. She is also on the boards of PuppetLabs and Estee Lauder. PuppetLabs is interesting, as they were an early provider of server configuration management software. Finally, she has a business management degree from University of Michigan.

Based on my characteristics for successful software stack investments, I prefer CEO’s who are technically-oriented founders. While Jennifer has strong leadership experience in the sector, she didn’t start PagerDuty and isn’t an engineer.

With that said, Alex Solomon is one of the co-founders of PagerDuty and still serves at CTO. He was the CEO for most of the early stages of the company. Prior to founding PagerDuty, he was a software engineer at Amazon. He has a software engineering degree from University of Waterloo.

Having a technical founder still involved in the overall leadership of the company is a good sign and will hopefully balance the CEO’s skew towards strategy and marketing.

Other members of the leadership team seem to have adequate experience for their roles.

Going Forward

PagerDuty (PD) poses an interesting quandary for investment. On one hand, its current growth rate of 37% with positive free cash flow is favorable. This isn’t reflected in PD’s current EV/revenue ratio of about 9, which drops to 8.8 for past year end (FY 2020 ended Jan 2020). Projecting revenue estimates out 2 years gives an EV/revenue ratio of about 5.5, which seems low for mid to high 20 percent growth, and gradually improving profitability.

The long term profitability model also is pretty strong, with high gross margin (already at target of 85% in the most recent quarter) and good operating margins of 20%.

PagerDuty leadership did not set a long term revenue growth target. As mentioned previously, year/year revenue growth was 37% in the most recent quarter. However, this has dropped from 45% and 49% in prior quarters, which represents large deceleration. Normally, I might not be worried if annual revenue were larger (law of large numbers), but with this past year’s revenue targeted to close around $165M, this represents a small base. If annual revenue growth further dips into the 20’s at such a small base, that is cause for concern around sustainability and overall market opportunity.

Investment Plan

Decelerating revenue growth and competitive offerings from two established players (Splunk and Atlassian) are challenges for my investing thesis. At this point, I am not comfortable recommending the initiation of a position in PD until I can observe performance for several more quarters. While the stock is trading about 60% off its all-time high of $59.82 established last summer, I don’t think there is a value play here. If PD begins to regain traction, then there should be plenty of upside for investors, even after the initial surge.

These are the items I will be examining as PagerDuty progresses:

• Revenue growth rates. Do these stabilize in the 30% range near term, or drop into the 20% range?
• New product penetration. Monitor sales of newer product offerings, like Analytics, Visibility and Event Intelligence. I think the core offering of on-call management and incident response will likely become commoditized, so higher level products will provide future growth drivers.
• DBNER is maintained. The high rate of DBNER (132% in last quarter, albeit down from 138% year/year) is encouraging. If this maintains a rate above 130% over more quarters, that will be a strong indicator of the up-sell motion in enterprises and for new product penetration.
• Progress on profitability. If free cash flow continues to be positive and operating margins improve, investors will know that PD can drive growth without overspending.

I plan to monitor PD stock for the time being and will provide further updates as PagerDuty executes on their vision over the next couple of years.