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DocuSign - A Case for Real Free Cash Flow

John Chapter 3 verse 16 states, "For God so loved the world that he gave his one and only Son, that whoever believes in him shall not perish but have eternal life."


John 3:16 for some, is relatable to the signs seen at sporting events, notably the National Football League, NFL. However, it is a core Bible verse as it relates to every person on the face of the earth. God's love for every single person ever created in His image transcends time. The choice to pursue a living relationship with God through Jesus Christ is available for all and any who choose to accept it.


One of the core benefits I get from reading the Bible every day, is that it sets defined parameters for me to live my life by. I recognize that not all people live by a set of rules (with some eager to break any "restriction" in their way), but for me, this makes life more manageable and straight forward. It doesn't eliminate life's challenges and trials, and certainly doesn't eliminate my imperfections, but it allows for peace and confidence that God will always be in control.


For investing, this fits very nicely into the topic at hand. I have developed a very precise way to analyze the fundamentals for any and every public company. While this transcends the thousands of public companies across the globe, I primarily focus on those listed as U.S. equities.


The two core metrics that lead to long-term investment returns are driven by Revenue growth and corresponding Cash Flow performance, notably Operating and Free Cash Flow, OCF/FCF. While mainstream media and Wallstreeet has pushed retail investors and the public to focus on measures like Net Income/Profits, P/E ratios, and EBITDA, I take a holistic perspective on OCF/FCF per share. Today, I'm going to illustrate how FCF is deconstructed the right way, and show why DocuSign, Inc. (DOCU) has a negative return on investment for shareholders.


How to Deconstruct Free Cash Flow

I'll provide an overview here as succinctly as possible, while trying to explain OCF and FCF well for those who haven't reviewed these items before.


Hierarchy of Financial Analysis

The first part of financial analysis is understanding the hierarchy of financial statements as shown below:

  • Balance Sheet, B/S

  • Statement of Cash Flows, CFs

  • Statement of Income

The B/S is the most important financial statement as it provides the snapshot of every company's financial well being. The B/S provides the following key attributes:

  • Net Cash or Debt position: This shows the core way that the company has capitalized itself to grow.

  • Receivables/Inventory: This shows the value of contracts and supplies to generate Revenue.

  • Operating Right-of-Use/Lease Liabilities: This shows the lease asset values that correspond to lease operating expenses.

  • Property/Equipment: This shows how much value has been invested into operating needs.

  • Goodwill/Intangibles: This shows how much the business has been built using acquisitions.

  • Payables/Accruals: This shows the costs to operate internally/externally.

  • Deferred Revenue: This shows contractual liabilities that lead to generating Revenue

  • Debt/Equity: This shows a company's capital structure.

The above reflect a high-level review of major B/S items, but there are many others depending on a particular company. At the same time, investors should note that the CF and Income statements are critical in providing Revenue performance and the core changes that will impact the B/S.


The Statement of CFs is only second as it is the core financial statement that accounts for all flows that adjust the B/S every quarter. Key attributes are as follows:

  • OCF: OCF serves two purposes. First, it reconciles the Net Income line item from the Statement of Income, second, it accounts for the changes in working capital reflecting many of the attributes listed above on the B/S.

  • Financing Activities: This shows the changes in a company's cash and marketable securities, includes Capital Expenditures, CAPEX, acquisitions, other investments, and other purchases of assets and intangibles.

  • Financing Activities: This shows borrowing/payments through debt, payment of leases, dividend payments, proceeds from stock plans, options and warrants or units, payments for tax withholdings, among many others.

The Statement of CFs is the real meat of fundamental financial analysis as it essentially accounts for all items impacting the B/S. This is why it is more important to focus on CFs, than simply considering elements and/or derivatives of the Statement of Income. Unfortunately, Wallstreet and mainstream media have pushed the latter to muddy retail investors and the public. Every investment in a business is based on the cash that can be generated as a return on investment.


The Statement of Income is not the meat, aside from Revenue performance, but it still is very important. Key attributes are as follows:

  • Revenue: This is straight forward, Revenue is the most important facet of how the company's future prospects will be measured, depending on expected growth rates.

  • Gross Profit/Margin: This shows the profit/margin that is attained by a company after accounting for all the costs of goods/services to generate Revenue.

  • Operating Income: This shows the income after accounting for all operating expense. Operating expense typically include Research & Develop, R&D, or Technology, Sales & Marketing, and General & Administrative.

  • Interest Expenses: This shows the cost of debt to grow and operate the business.

  • Tax Expenses: This shows the tax impacts from how profitable the business is.

  • Net Income: This shows the margin of profit from the Revenue generated on the Statement of Income.

While pundits focus on the Net Income/Profit, EPS, P/E ratios, EBITDA, etc., Net Income needs to be reconciled, with working capital changes added back in to obtain OCF. It is only one line item of many that truly show the return an investor is obtaining from any company.


Real Free Cash Flow

Many are familiar with the term FCF. The high-level traditional version of FCF is a simple equation.


OCF - CAPEX = FCF


However, this masks what real FCF is. As highlighted above, CAPEX comes from the Investing Activities section from the Statement of CFs. but this line item is not the only one that should be considered.


Some companies even include line items that technically should be in the reconciliation to Net Income or working capital changes sections for OCF. Others to consider include intangible assets or other assets acquired, equity or equity method investments. If cash and marketable securities are clearly spelled out, even an other category may be included.


At the same token, there are even items which need to be considered from the Financing Activities section from the Statement of CFs. I have even seen working capital changes listed in this section for some companies. Other attributes may include financing/operating lease payments, proceeds from stock plans, options and warrants or units, payments for tax withholdings, or other category, among others.


A good way to think about what isn't included is as follows. For Investing Activities anything showing changes in cash and marketable securities and acquisitions should be excluded. For Financing Activities, anything showing changes in borrowing/payments for debt, dividend payments, or stock repurchases should be excluded.


An adjusted real FCF formula might look like:


OCF - ( (CAPEX + Intangible Assets + Equity Method Investments + Other) + (Operating Lease Payments + Compensation of Stock Options + Payment for Tax Withholding + Other) )


Essentially, real FCF represents anything that should be reduced from OCF, which occurs on a regular basis and falls outside of the items excluded above. Companies publicly rely on the high-level version as a gauge. But serious investors need to fully understand real FCF, as well as how to relate all these line items across financial statements.


DocuSign Free Cash Flow

Many are familiar with DocuSign, but for those who are not, DocuSign helps organizations do business faster with less risk, lower costs, and better experiences for customers and employees. The company does this by transforming the foundational element of business: the agreement.


The DocuSign Agreement Cloud is the cloud software suite for automating and connecting the entire agreement process. It includes DocuSign eSignature, the world’s #1 electronic signature solution. The Agreement Cloud also includes several other applications for automating pre- and post-signature processes—for example, automatically generating an agreement from data in other systems, supporting negotiation workflow, collecting payment after signatures, and using artificial intelligence ("AI") to analyze a collection of agreements for risks and opportunities. Finally, the Agreement Cloud includes hundreds of integrations to other systems, so agreement processes can integrate with larger business processes and data.


Let's do a quick snapshot of DocuSign:

  • Net Cash Position: $190 million

  • Revenues: $1.3 billion

  • Gross Margin, GM: 74.5%

  • Operating Cash Flow, OCF / Margin: $280 million / 22%

  • Free Cash Flow, FCF / Margin: ($48) million / (4%)

  • Shares Outstanding 187 million

  • Subscription Revenue: $1.2 billion

  • Professional Services & Other Revenue: $68 million

  • Billings: $1.6 billion

To the point above, DocuSign has a 22% OCF margin, but a FCF margin at (4%) as of the most recent quarter. This hasn't always been the case. During 2018, DocuSign witnessed Revenue growth at 35% and held a FCF margin at 10%.


Revenue growth has been robust in 2019 and accelerated to 40% during 2020 and is projected to achieve 46% for 2021, however, FCF has turned negative since 2018. Specifically, DocuSign only has three line items to account for after OCF:

  • Purchases of property and equipment

  • Payment of Tax Withholding Obligation on RSU Settlement

  • Proceeds from Exercise of Stock Options

  • Proceeds from Employee Stock Purchase Plan

Accounting for these additional items, that occur every quarter, is what has led to the (4%) margin for FCF, notably the tax withholding payments. This is the key element driving DocuSign's FCF negative. Note 12 Stockholder's Equity gives us a clue as to how this will track over the near-term.


In this note, the following statement is provided, "As of October 31, 2020, our total unrecognized compensation cost related to RSUs was $708.2 million. We expect to recognize this expense over the remaining weighted-average period of approximately 2.4 years."


That's average annualized cost of $300 million. For 2019, 2020 and the LTM for 2021, this cost reflected $215, $167, and $289 million respectively. For 2021 based on the LTM, DocuSign generated $280 million for OCF.


Since 2018, DocuSign has burned $200 million, while making $400 million in acquisitions. For the B/S, cash has been spent down by $250 million, and debt has increased for a zero balance to nearly $500 million. With only $190 million remaining from a Net Cash position, DocuSign will likely need to raise more capital via debt, likely, around $500 million.


Conclusion

DocuSign is a core holding within the portfolio ranking 13th, and reflecting 2.3% of the total. By no means will I be selling next week. However, this overview and illustration is a great example of how to deconstruct FCF and to assess a company's prospects.


For me, I don't like holding high-growth companies that depend on debt to grow the business. DocuSign is approaching a tipping point where the company may end up switching from a Net Cash to Net Debt position. The other important fact to consider is that currently and for the foreseeable future, DocuSign is likely to maintain a negative return on investment for FCF.


This means that the company is going to need to see an expansion generated from the OCF margin as Revenues scale. I doubt that the RSU Settlement payments will go away. It isn't uncommon for technology-based companies to have this mechanism. ServiceNow, Inc. (NOW) is another example of this, but ServiceNow has 40% and 22% OCF/FCF margins respectively.


Only the future will tell whether DocuSign can expand OCF margin towards 30% (a likely target to get positive FCF). But at least this exercise now provides a clear way to measure whether the company's scale will afford it a positive return on investment for shareholders.

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