Shutthiphong Chandaeng
What do bots say about Path’s consistent growth?
As many have observed, the last two years in the market have been a period in which stocks fell consistently for months, and then rose quite sharply, albeit not in a straight line. Depending on what ETF a reader might look at, the change over 2 years has been small, with the QQQ and the IGV ETFs up about 10% due to the weighting of the magnificent seven, while the Wisdom Tree Cloud ETF (WCLD) is still down more than 30% from its level at the start of 2022. The SPDR ETF is almost exactly unchanged over the same span.
There are plenty of bold individuals who make guesses as to what is next-in politics, style and of course the market. Sometimes the guesses are right; often time’s forecasts go seriously awry. This is not an article trying to call the market for 2024. It is an article updating my last article regarding UiPath that was published on SA in April 2023. The shares have risen more than 35% since then, quite a bit more than the market as a while, mainly in the wake of what might be considered to have been a break-out quarter. That said, like the shares of many other high growth IT, the shares remain almost 40% below their levels of 2 years ago.
Have Path shares run too fast and too far? The temptation is there to believe that thesis. Many observers have written much about the extraordinary rally of the last two months. I have no specific idea if the rally continues or consolidates. For the most part, the rally was based on waning inflation and lower interest rates. Currently there is a debate between those who believe that there will be 6 rate cuts, i.e. rates going from about 5% to 3.5% this year, and those who think the terminal rate will be 4.25%. In turn that evolution will be primarily decided on how the overall economy grows and how employment metrics progress. I don’t have that kind of crystal ball; for the record my favorite economist, Ian Shepherdson, who runs Pantheon Macroeconomics, is forecasting a greater than anticipated rise in unemployment and consequently more rather than fewer rate cuts. His track record on such calls, while not perfect, is better than that of most other economists.
Just based on the velocity of the rally in last weeks of 2023, I would guess PATH shares, along with most else high-growth IT, will consolidate for a time until there is some additional validation of the soft landing thesis or more likely the thesis of Mr. Shepherdson. I don’t really expect some short-term out-performance from high growth IT shares, and that includes UiPath (NYSE:PATH) shares. Some technical analysis suggest there will be a short term sell-off in the shares of the magnificent 7: if that happens, PATH shares will go along.
As it happens, some of the consolidation that I have expected has finally arrived with the New Year. Path shares have fallen by 11.5% in just the last 3 trading sessions, and have perhaps provided investors with a better opportunity to enter a position. But I am certainly not trying to forecast any macro headlines which will have a significant impact on the share price of PATH over the next few weeks.
But this is an article about the operational performance and the valuation of PATH over the next 12 months. This is not a trading call, or an attempt to forecast how markets, and UiPath shares might trade in the next couple of weeks. If you want that, consult your local necromancer. Part of the valuation of UiPath shares will be determined by how the market plays out in 2024 and exactly how the market for high growth IT shares will evolve as the year progresses. It would be naïve to imagine that Path shares can achieve significant appreciation without at least a benign market environment for high growth IT shares.
That said, UI Path will chart its own course with regards to its growth which I expect to exceed current consensus forecasts for reasons outlined in this article. Just as last quarter was a breakout period for PATH, I expect that many of the positive trends seen then to reprised in the quarter next to be reported (est. reporting date will be 3/15/24).
But the question really is can Path continue to achieve accelerating revenue growth and maintain strong improvements in profitability even if the economy starts to decelerate. This article explores that in depth with a conclusion that the likelihood is that growth expectations will increase throughout the year. Based on that expectation, this is article reaffirming my prior purchase recommendation for Path shares at this time and at this price.
Last quarter, Path’s revenue growth and the year on year growth of the ARR balance reached 24%. Net new ARR grew by 15% sequentially. The company’s free cash flow margin was about 13%. The company increased its expected year end ARR noticeably, and also increased its forecast for non-GAAP operating income. That said, the 1st Call consensus for 2024 revenue growth is below 20%, implying a growth slowdown from the levels expected for this current quarter. The company’s backlog (RPO balance) grew nearly 30% which self-evidently is a contradictory indicator with regards to Path’s actual growth momentum.
In some ways, the most encouraging part of Path’s performance was the sequential growth in ARR additions. It is, to be sure, a second order number, but I often look at it as an indication of the changes in health in terms of go-to-market efficiency. When asked about Q4 guidance which calls for revenue growth of 24%, the CFO indicated explicitly that the forecast was based on putting adequate prudence and macro-economic concerns into the projection. The company’s forecast also was said to reflect macro headwinds at the lower end of the company’s market; the company’s go to market focus remains on acquiring larger customers with a higher propensity to grow. This focus was partly responsible for a constant currency, dollar based net expansion rate of 123% in the quarter.
Ashim Gupta
Yes, I would just say, Mark, we’re really pleased with our performance and the team’s execution. We are focused on closing out a good year-end here. And the teams are really focused on that. And we look at our fourth quarter guidance just putting the right prudence and the right macroeconomic variability included in our guidance, and we’ll update as we get closer to next year.
In this very uncertain environment, the company has taken an appropriately conservative path with regards to guidance; if the macro environment improves for enterprise IT spend as the most recent surveys have been suggesting, then current guidance and expectations are likely to see noticeable upward revisions. Some analysts on SA who have downgraded their rating of the shares have done so without considering the messaging here, which is not to be too literal in using the guided numbers as the most likely forecast.
Just for the record, the company is now forecasting Q4 revenues of $383 million; that compares to a prior revenue forecast of $380 million. Ending ARR is now forecast to be $1.455 billion; the prior forecast for ending ARR was $1.435 billion. For a company like this, ARR and ARR growth are the most important metrics to consider in evaluating sales growth. The company increased its forecast for Q4 non-GAAP operating income to $78 million; the prior forecast for that metric had been $63 million.
Recently, 3rd party surveys for IT spending growth have begun to tick upwards. While surveys aren’t always accurate, there seems to be a theme that last year’s anemic revenue growth for the space represented an aberration in IT spending growth. I am inclined to agree with that theme. The most recent surveys also point to a growth acceleration in the process automation space specifically, the space in which PATH enjoys a market leading position.
When it comes to Path, in particular, it has been able to develop products that users view as an important component of an AI strategy. I will discuss the product strategy in greater detail below, but the concept that automation using bots + AI are better together seems to be resonating with large enterprises.
Why PATH’s growth is showing signs of acceleration
UiPath is the leading company in what is called the Robotic Process Automation space. This technology makes it easy for developers to build, deploy and manage software robots (most usually abbreviated as bots). The bots can be taught to emulate human actions such as understanding what is on a screen, completing the right keystrokes and perform a wide range of defined actions-basically repetitive tasks, and to do so far faster and more accurately than the comparable human actions can achieve. I have linked to a white paper by PATH’s marketing function that does a deeper dive into what RPA is all about.
It is hardly any secret that users want to invest, and invest heavily in generative AI solutions. That investment will be a rising tide for many boats-and so far as it goes, many investors. But perhaps, not all boats. Initially, when the AI craze struck market participants with full force last spring, one issue that arose for PATH-or at least PATH shares, was whether the deployment of generative AI would mean less need for the process automation bots that are the heart of what this company sells. The underpinning of that thesis is linked here
Despite the provocative headline, in the context of PATH’s operating performance, the thesis couldn’t be more wrong. In point of fact, AI works better with process automation bots. Indeed, that is why I wrote my last article on PATH shares last spring.
A few months ago, PATH introduced a new sales tool, NorthStar, which has apparently has had a significant impact on the company’s sales efficiency. I am not going to try to provide a deep dive into NorthStar; it provides PATH sales people with a road-map to present to users showing them ROI for various steps on their automation journey. The use of NorthStar is an iterative process and is having a more substantial impact on driving the increase in ARR than might be appreciated. In addition, the company’s relatively new partnerships with SAP (SAP) and with Deloitte are starting to produce some significant transactions.
Daniel Dines
Well, I think that direction in the market that we are seeing right now, around autonomous agents prove a bit — our approach that always said that AI plus automation is the thing that drives the biggest outcomes for our customers. Actually, this is what we are seeing a lot of our customers after the initial, a little bit of a pause around how AI is going to help me with my automation, they realize that they need powerful automation platform in order to harvest the power of AI. And going forward on a longer term basis with UiPath are in one of the best positions to build the next generation foundational models that understand processes, tasks, screens and documents, the type of multimodal that is built in, in order to drive automation. So it’s — to me, it’s clear that the world is going into that direction. And again, we are really in a very good position to take advantage of it.
(For those unfamiliar with the term, and that most surely includes this writer until I looked it up, an autonomous agent is a system situated within and part of an environment that senses that environment and acts on it, over time in pursuit of its own objectives. According to the link above, the deployment of autonomous agents is supposed to be the next AI wave after Chat GPT. There is some uneasiness about this trend, which I confess I share, but which is not a factor in evaluating PATH shares-the only subject at hand).
I think the above quote from the founder/co-CEO is really the heart of what is happening. Generative AI + automation simply produces an overall better results for users, and PATH’s selling motion NorthStar is proving that effectively to users. It is one of the key reasons why sales growth as measured by net new ARR is showing strong gains and I anticipate that this is a long lived trend that will provide allow percentage revenue growth to continue to accelerate.
Another issue that in the past had been called out as inhibiting sales growth has been the lengthy deployment time for the average bot. While it is only supposed to take a few weeks to create an intelligent bot, getting a bot deployed across a business vertical takes 6-12 months, of course an unacceptable period. The issue has been creating a reasonable knowledge base that allows a specific new chatbot to achieve satisfactory performance.
The company recently launched a product called UiPath AutoPilot: essentially all generative AI products simply must have “pilot” of some version of pilot in their names. In any event this pilot, which is in beta, is apparently already seeing some definitive and positive results in terms of shortening the deployment cycle for bots.
Already in production and in use at some PATH clients is something called Document Understanding and Communication Mining models as explained here by the co-CEO.
Daniel Dines
This is always one of our major product focus on how can we shorten the adoption curve for our customers. And we are already seeing with our autopilot family that is in private preview some really good results with the initial set of few hundreds of customers that are testing the product. So, yes, I would say that this is going to be a significant driver for adoption. And both for advanced developers, where they will get to really increase the productivity to also citizen developers that will get started faster.
And also, I would like to mention that training our specialized Document Understanding and Communication Mining models using Gen AI, it has already proven this is actually in production already. And it’s been proven to accelerate the deployment quite a bit.
Overall, I believe that the reasons UiPath achieved what might be described as a break-through growth quarter when it last reported are fairly straightforward. Users are getting better results in terms of their automation journeys by using bots and generative AI as part of a unified strategy. PATH solutions are designed to help developers build next generation models that understand processes, tasks, screens and documents as part of an enterprise AI strategy. The company has an effective sales tool called NorthStar that is helping its sales people document a road map and expected ROI. And it is developing tools to speed up the deployment of intelligent bots.
I don’t want to suggest that I have some particular crystal ball when it comes to handicapping the company’s growth both for the company soon to be reported and for its 2024 forecast. But I think from a qualitative point of view, what was reported was a break-out quarter whose foundation is based on multiple pillars that should support growth significantly above the current 1st Call consensus revenue growth forecast of less than 20% for this year.
UiPath Competition
UiPath is the leader in the Robotic Process Automation (RPA) space. 3rd party analysts suggest that RPA has one of the higher CAGRs of any IT space. The study linked here suggests that the market in 2022 had a value of about $4 billion and will have a CAGR of nearly 37% over the next 10 years. That gets the market to a value of $82 billion. I am not sure how realistic a 37% CAGR projection might be. That said, the study is just 90 days old at this point. Like most of these kinds of studies, the devil is in both the details, but particularly in the definitions. In this report, much of the growth being forecast is coming from those autonomous agents about which I commented earlier in this article. Autonomous agents are part of the process of implementing generative AI solutions, so perhaps there is a foundation for the high growth forecast.
UiPath, as can be seen in this most recent study by Gartner, dwarfs its competitors with a market share of around 36%. According to Gartner:
UiPath is a dominant player owing to its strong performance, global brand recognition, a customer and partner ecosystem of more than 2.5 million members, and its market-influencing narrative about AI-powered automation.
The Gartner study contained commentary from Wayne Butterfield, who is the Global Lead for Augmented Intelligence at ISG. Even though this sounds like a commercial, it really isn’t. It is obviously far more authoritative than anything else I am likely to find.
Many prominent RPA practitioners and thought leaders will agree with this sentiment. That includes Wayne Butterfield, Global Lead for Augmented Intelligence at ISG, who exclusively shares his perspectives on the market share research below.
An Analyst’s Perspective
Butterfield believes the suite of complementary capabilities that UiPath couples with its “solid” RPA product drives the vendor’s market leadership.
These capabilities widen the scope for automation, “ensuring the ceiling that many end clients hit with RPA alone lifted further,” he suggests.
To achieve this, UiPath delved deep into adjacent fields, such as Optical Character Recognition (OCR) and Process Mining, opening up many new opportunities for customers.
Alongside this, the provider has more than 5,000 partners and resellers globally. Underlining the significance of this ecosystem, Butterfield says:
They have a much broader reach than the other RPA vendors, getting into clients that others may have struggled with.
Finally, Butterfield notes that UiPath has become the analysts’ preferred RPA provider for the past three or four years. That timespan corresponds with how long the provider has led the RPA space, in terms of market share, as per the Gartner report.
I really don’t see that I can add much to what has been said here. RPA is growing rapidly, because it is really part of a holistic AI solution. I think it is the growth in bots that are described as autonomous agents that is leading to this very strong forecast. The analysis linked below contrasts the functionality of Path with the #2 competitor, Automation Anywhere This is how that product is said to compare to UiPath’s RPA suite.
Reviewers rated RPA Suite higher than Automation Success Platform in the following categories
- Better at service and support
- Easier to integrate and deploy
- Better evaluation and contracting
Based on what I have read, PATH is more likely than not to continue to enjoy market dominance for the foreseeable future, and dominating this market should be a lucrative position. Gaining market share as has been the case for UiPath for some time now ought to set the company for years of growth greater than 30% suggesting a continued path to higher percentage growth that is clearly not what the consensus is currently reflecting.
The UiPath Business model
UiPath’s business model has seen significant improvement over the past several quarters. This is a function of better expense management, some improvement in non-GAAP gross margins, and of course leverage at scale. Last quarter non-GAAP gross margins rose slightly to 87% of revenues compared to 86% in the preceding year. They also rose by 100 bps sequentially. The company has a rather substantial set of new products that are moving into GA; this might produce a minor headwind on short term gross margins.
The non-GAAP sales and marketing expense ratio last quarter was 47% compared to 47% in the year earlier quarter. Sequentially, non-GAAP sales and marketing expense rose by 19%. To an extent, this kind of increase was a catchup from the prior quarter during which non-GAAP sales and marketing expense actually declined year on year, an unsustainable cadence. Of more significance was a reclassification of expenses between general and administrative and sales and marketing which is expected to reverse in this current quarter. Over the first 9 months of this current fiscal year, non-GAAP sales and marketing expense fell to 45% of revenue down from 53% of revenues in the comparable year-ago period. Basically, sales and marketing expense declined year on year through the first 6 months of the year and then rose as indicated, partially a function of reclassifying some expense, but also accelerated sales hiring.
The company, I believe, is going to attempt to achieve 30%+ revenue growth next year in a difficult software sales environment. To achieve such a goal, the company will need adequate sales capacity in-place and reasonably trained at the start of the fiscal year.
The research and development spend ratio was a comparatively modest 16% of revenue last quarter, essentially unchanged from the year earlier period. Non-GAAP research and development spend was essentially flat sequentially while sequential revenues rose by 13.5%.
The Non-GAAP general and administrative expense ratio, as mentioned, was severely depressed last quarter due to the classification of some expenses into the sales and marketing category. Reported non-GAAP general and administrative expense was down almost 15% year on year and was 10% of revenues compared to 16% of revenues in the year earlier period. It would be difficult to imagine running a company of this scale on a general and administrative expense ratio of 10% over the long term. Over the first 9 months of the year, reported general and administrative expense was also down by about 16% and it was down by 3% sequentially.
Overall, non-GAAP operating expenses for the 3rd quarter were 74% of revenue compared to 79.5% of revenue in the prior year. This put non-GAAP operating margins at 13% of revenue compared to 7% in the year earlier period. The company is forecasting that its non-GAAP operating margin will reach 20% of revenue in this current quarter. On the surface, that looks ambitious as it implies a decline in non-GAAP operating expense in the quarter. Presumably most of that will come out of the still very elevated non-GAAP sales and marketing expense ratio. The company has seen some significant seasonality in the past with a quarterly operating margin which was actually 22% in the year earlier period.
For the full year, the company CFO has forecast non-GAAP operating margins will be 13.7% compared to 6.1% in the year earlier time frame. The latest published 1st call consensus essentially calls for non-GAAP margins to fall noticeably in FY ‘25; I would suggest that is fairly unlikely. The company is quite focused on spending discipline, and it has achieved spending discipline and the results of the last year are indicative of that discipline. My guess is that the company will wind up continuing to grow non-GAAP operating margins for the year, and that current valuation metrics do not reflect a more likely margin improvement. Of course, the combination of reasonable spending discipline and resurging growth make it much easier for the company to achieve a path to stronger margins-no pun intended.
The company continued to generate cash; through 9 months its free cashflow margin was 17%; in the year earlier period the company burned cash. Unlike most other enterprise software companies, the growth in the deferred revenue balance was relatively strong last quarter.
The company does use stock based compensation, and stock based compensation expense was 28% of revenues last quarter, down from 36% of revenues in the year earlier period. Stock based comp. actually fell 6% sequentially. I look at actual dilution to factor in the real expense of stock based comp. Outstanding shares rose 3% year on year. I have forecast that 12 month forward outstanding shares will be 588 million, up 3.5% from the outstanding shares in the period most recently reported.
Wrapping Up: The case to buy UiPath shares
UiPath shares have seen a considerable run in the wake of a particularly strong quarterly earnings report that was well above prior forecasts. Guidance also was increased, although apparently not enough for some observers. The most impressive metric for me was that of the net new ARR metric which rose more than 15% sequentially. Based on the comments by the CFO as well as indications of stronger IT spend growth, I expect that the company is quite likely to exceed its Q4 revenue growth guidance.
Overall, the shares are up by more than 50% since their late October, 2023 lows, but down about 11% since their highs at the end of last year. The shares after doubling over the last 12 months, are still down over 40% over the last two years.
UiPath remains the leader in robotic process automation, and RPA growth has been accelerating as part of the overall enthusiasm for all things based on generative AI solutions. Generative AI + RPA demonstrably work better together, and some of the generative AI components that UiPath is deploying allow its solutions to be deployed more rapidly, typically a bottleneck for developers.
Just how fast can the RPA space grow? The 3rd party analysis linked in this article show a multi-year CAGR for the space in the mid 30% range. And 3rd party analysis also linked in the report show a highly favorable evaluation of the company’s competitive position suggesting further market share gains from an already market leading position.
I haven’t chosen to go all-in when forecasting a CAGR for this company-my valuation model is based on growth in the mid-20% range. My projection is that the EV/S for PATH is just greater than 7X and I have also projected a 4 quarter forward free cash flow margin of 17%. Despite the huge run the shares have had-on a relative basis, the shares are still valued below average for the mid-20% growth cohort, an indication of the strength of most high growth IT shares at the end of 2023.
I have commented that the kind of spike that high growth IT enjoyed the last two months of the year is extraordinary. While I believe that the current valuations are not excessive given greater growth, stronger profitability and a trend toward lower interest rates, as well as the base from which the spike started, I doubt that the kind of cadence seen in the last two months of 2023 can continue. And that applies to the short term outlook for PATH shares as well. I think it would be more than a bit surprising if the shares showed significant relative strength until they next report earnings which is likely not to be until mid-March. That said, I think the opportunity for the company and the shares over the next 12 months remains considerable, despite the recent rerating. I think the potential for positive alpha remains significant.
