Pagerduty Inc

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PagerDuty (PD) CFO: Striking that careful balance between growth and investment





Date Published:
Author: Tiernan Ray

 

Shares of PagerDuty (NYSE:PD), the next-generation digital operations management cloud software maker, rocketed following the company’s March 16th fiscal fourth-quarter report, and have risen by a third in the days following, at a recent $36.62.

The company’s chief financial officer, Howard Wilson, once again sat down with Capital Market Labs to discuss the results and outlook.

While PagerDuty has been an incredibly consistent performer relative to the forecasts that Wilson offers — twelve quarters in a row since coming public of solid top- and bottom-line beats, and outlook — Capital Market Labs drilled into some of the medium- and long-term targets for the company.

On the topic of growth, Wilson emphasized the company’s speed-up from 2020 to 2021, from 28% growth to 32%. However, CML asked whether, given that, the forecast for organic growth this year of a little over 28%, was not, in fact, a slowdown.

Howard replied by emphasizing his focus is on providing reliable forecasts rather than over-promising.

“It’s very unusual for a company at our scale, over $300 million of ARR, to actually be able to re-accelerate growth,” Wilson told CML.

Likewise, on profit metrics, Wilson emphasized that the company is continuing to “improve operating leverage,” with an operating margin of negative 8%, down slightly from the prior year.

Wilson emphasizes the goal is to be profitable on a non-GAAP basis next fiscal year.

But why not this year? Part of it is sensible caution, says Wilson.

“I’m very cautious of not wanting to create unrealistic expectations purely because the macro of environment gets, seems a little bit volatile.”

It’s also a matter of balance, Wilson tells CML. Maintaining R&D spend, which amounted to a quarter of revenue last year. Maintaining spend is also why the company has set a very modest longer-term goal of 10% profit margin.

Why not aim for more like a typical software company margin of 30%?

“We actually want try and preserve as much of the investment in R&D for the long term” as possible, he says.

“In my ideal world, I would love to see us increasing our investment in R&D, as a percentage of revenue, rather than reducing it as we get larger. “

Wilson offered his views on numerous other topics, including the way the company is using no-code/low-code to expand the products to non-developer teams within organizations, especially customer support types.

“Actually now, if you like, almost have two mechanisms,” said Wilson regarding how the products are used, “one that relies very heavily on how you think about service ownership within your company and the other, which is related to kind of how you organize your teams, from a business process flow.”

He was referring to devs, the appointed custodians of code, in the former case, and customer support in the latter case, where people rotate through their responsibility.

 

One-on-One with the CFO pf PagerDuty (PD):

 

Capital Market Labs: So, what things, Howard, first of all, would you say are most important for investors to take away from the results and outlook?

Howard Wilson (CFO PD): Well, I think we really are proud of our results.

We ended the year at 32% revenue growth for the quarter, and 32% growth for the year. And that was an acceleration from 28% growth the prior year.

And so, it’s very unusual for a company at our scale, over $300 million of ARR, to actually be able to re-accelerate growth.

And that’s really been a combination of really strong, consistent execution, now over at least six quarters, and good product innovation that I think is meeting the needs of our customers.

So, I think that’s kind of, for me, was a highlight that we managed to just, continually, we’ve had really good performance.

And I often look at some of the other metrics, like our dollar-base net retention. This was our fifth consecutive quarter of it being above 120.

So, it was a 124 for the quarter. And I think that, to me, is a really good sign of how we are expanding with our customers.

And we’ve spoken to the market a long time about the importance of the mid-market and the enterprise, to us, as a company.

Mid-market and the enterprise segments are 80%, or over 80%, of our annual recurring revenue.

And when I see how customers are expanding with us, we’ve got almost 600 customers spending more than a hundred thousand dollars [annually] with us. And that’s a reasonable investment.

And we actually saw growth in the number of customers who are now spending a million dollars with us. That’s grown by 65%.

So, we have 43 customers who spend over a million.

So, this shows to the value of our platform.

We’re not just some small little point solution. Companies are making significant investments in PagerDuty because we are helping them deliver on their promise to their customers.

And that’s really what we’re all about. Our customers trust us to help them build trust with their customers.

So, when we look at the year and at the quarter, there’s such strong momentum.

Our product innovation, each quarter, we’re releasing new product innovation that puts greater distance between us and anyone who may be framed as our competition.

There’s no one that has the breadth of the detection, all the way through to auto-remediation, that we have, in terms of our ability to manage that unstructured, unplanned critical work. So yeah, I mean, it was really, it was a great year.

And then, if I look at the bottom line, obviously, in this environment, people are more concerned about what’s happening with profitability.

We continue to demonstrate that we’re improving operating leverage.

We ended up with a[n] operating margin of negative 8%. Our gross margins were still within our target range of 84% to 86%.

And we demonstrated improvement, and we beat our guidance, at that top line and bottom line. So that’s always a good place to be.

And we did share with folks that we’re on a clear path to profitability.

So, the guidance that we’ve given for next year shows improvement in operating margin.

We’ve guided to operating margin being in a range of negative four to negative six, so that would be 200 to 400 basis points improvements.

And we’re expecting that through the course of this next year — the first half of the year always tends to be heavily weighted with expenses that are related to payroll taxes and merit increases, bonuses, those sorts of things — that we expect to see an improvement, significant improvement in the back half the year with the fourth quarter being profitable.

And we put out there that FY24 is a year that we would see us being profitable for the year, not profitable every quarter but profitable for the year, on a non-GAAP basis.

 

CML: Anything else?

HW: Should qualify the non-GAAP. I always get reminded by our legal people, qualify that you’re talking about non-GAAP!

 

CML: With the largest tech companies, switching to a GAAP report became a thing a decade ago or more. But I remember reporting in the 1990s, and no one did GAAP ever. It was, like, crazy.

HW: Yeah. And I guess, especially within the software environment, there are elements that have a… there are non-cash elements.

I’m not saying they’re not important, from an accounting perspective, but we try and look at the underlying performance of the business.

Taking things out, like stock-based compensation and some elements of amortization, give you a much better view on the profile of the business.

So that’s why we follow a practice that’s common amongst our peers to use non-GAAP operating margin because it helps just reduce some of that, I wouldn’t call it noise, but just some of those metrics that kind of can distort what’s the actual performance of the business.

 

CML: I understand. And you’re certainly not alone in that, amongst companies that are young as you are and fast growing.

So, to make non-GAAP operating profit, it sounds like an objective in next fiscal year, which would be fiscal ‘24?

HW: Yes.

 

CML: Right, because we’re in fiscal 23.

HW: That’s right.

 

CML: Some investors, I think have asked why not push to make it happen now?

Because this year it feels like, for software investors, suddenly they’ve said that they’re more concerned with profitability because they’re anxious about valuations.

HW: Yeah. And I think, for us, what we’ve shared with investors and analysts is we have a clear path to profitability that we’ve been executing on.

And obviously, we’re keen to see if we can reasonably accelerate that without reducing investment in key areas that will support long-term growth.

So, it’s always this balance.

How do you make sure that you are investing for long term growth, but also making progress?

And frankly, when I look at a negative 8% non-GAAP operating margin, it’s not a big gap for us to get to profitability.

And so, I think the piece for us, like being able to make further improvement this year and then be profitable the following year, I think will resonate well with the investors. I’m going to get some real time feedback from them today.

But I do think that we’ve been doing what we said we would do.

Like we said, we’ve been remarkably consistent, in terms of providing guidance and being able to make sure that we meet or beat that guidance and have built a good reputation of reliability and consistency.

And we want to continue to do that.

So, I’m also very cautious of not wanting to create unrealistic expectations purely because the macro of environment gets, seems a little bit volatile.

We feel that we need to take that into account and take defensive measures where necessary.

But at the same time, we can see that it’s in the interest of our customers to continue to invest in our products, to invest in our platform, to improve our routes to market, so that we can increase our customer base and increase the number of companies that are getting value from the product.

So, we’re very intentional around how we think about investment.

 

CML: Okay, fair enough. The 28% growth, I guess, it sounds like organic growth has been 28.7% is the… When taking out a point, a percentage point of acquisition growth that would be layered on top, this is, I think, for fiscal ‘23, is that correct?

HW: So I think it might have been — I made a comment around we did an acquisition on the end of March or thereabouts —

 

CML: Catalytic —

HW: Catalytic, that’s correct. Yeah.

So, there was a question around what did we see as being their contribution? Catalytic was a startup, not profitable.

And the contribution to revenue that we expect, we think will be less than $5 million.

And so, it’s probably right about a point of our, at 1% of our revenue for the full year.

So, the guidance that we’ve given is a range of $360 million to $366 million.

We think it’s, their revenues may come in four to five million because obviously, it’s a very new acquisition.

So, we had to kind of just assess that a little bit.

So, it’s maybe 1% of our revenues. And so, it probably represents less than that, in terms of percentage of growth.

 

CML: Okay. So, the question there becomes is there… Because I think my editor looked at this and said, “Well, that sounds like, it sounds like organic growth is then 28.7% at the midpoint of fiscal ’23, is that a step back from the pace that we saw in fiscal ‘22, relative to fiscal ‘21?

Let’s assume there’s speed up, and now it’s stepping back.

HW: Yeah, so, I think our approach to guidance hasn’t changed, in that it’s early in the year.

So, when we give the full year guide, we’re sort of providing a range that we see of 28% to 30% is where we see us landing.

My expectation is that as we get greater certainty, as we go through the year, we adjust that guidance relative to that.

If we were to think, given what we see today, you would say that Catalytic represents potentially 1%, then yes, you would say, “Okay, there’s 29% that’s associated with PagerDuty growth on its own.

But I don’t think that’s really the, I don’t think that’s necessarily representative because we’re providing — this is the first guidance for the year.

And so relative to that, we’re just saying the Catalytic contribution would be a small percentage of the growth.

 

CML: Okay, sounds like —

HW: Almost immaterial, I would say. I mean, Catalytic is a great acquisition for us, from a technology perspective, but in terms of revenue contribution, it’s immaterial.

 

CML: Okay. That’s fine. What is Catalytic? I didn’t, I apologize, forgive my ignorance, I didn’t look at the —

HW: No, happy to tell you.

So, Catalytic is essentially a platform that was developed to be able to provide non-tech workers, in many instances, the ability to create workflows.

And so, it’s, essentially, it’s a no-code, low-code workflow builder that helps accelerate the work that we’re doing within our platform around flexible workflows to support other use cases.

So, today, Catalytic, with their customers, often helps drive workflows that are unstructured workflows that need to be built fairly rapidly and dynamically.

And that fits in… And they service customers in areas like pharma and financial services and individuals within other functions, like finance and legal, where we have some footprint today, but it’s not where the majority of our effort is.

And part of our view on how we continue to evolve, as the operations cloud for the modern enterprise, means that we need to be serving more than developers and IT workers and security and customer service operations.

So, this helps accelerate our roadmap to support the workflows of people across the business, who are dealing with unstructured, unplanned time critical work.

 

CML: Wow. Okay. So, even a journalist could use it?

HW: Yes. I mean, that is exactly the idea is that we will… What we’re going to do is take that technology and integrate it into the PagerDuty platform.

So, it lines up with items we already have on our roadmap but accelerates our opportunity to do so.

So, I think it creates a… I’m very excited about this because I’ve been passionate about how you can use PagerDuty in non-developer, non-IT use cases.

And I’ve championed that within our company, so that we actually use PagerDuty internally for any number of things.

Like, how do you orchestrate a sales team around a deal that’s closed to make sure the order gets booked in a timely fashion?

Or how do you make sure that there’s a contractor — when a contractor needs to be off-boarded in this modern age of SOC controls and security requirements, you need to make sure that you can operate on that pretty rapidly and do that effectively.

So, we use PagerDuty for contractor off-boarding.

And so, there are these other use cases, and I think there’s a large opportunity for PagerDuty to be able to have everyone, connect everyone within an environment so that they’re using PagerDuty, in some shape or form.

 

CML: Was that an uphill battle for you to evangelize that to the company, internally?

HW: I think it could be.

 

CML: Did they say, “Oh, that’s a dumb idea?”

HW: I wouldn’t say they do that, but I think our company has such a strong developer orientation. We were built by engineers for engineers.

And so, that’s so much part of our DNA. So, sometimes it’s almost by — it’s serendipitous when people do start using these other use cases.

And I think the thing that’s been most fascinating, to me, since I joined PagerDuty, is that our customers have been coming to us to tell us, “Oh, we’re also using PagerDuty for this, or we’re using PagerDuty for that.”

So, I visited a customer in Atlanta a few years ago, and I was chatting to them about, we were looking for office space at the time.

And I said, “Oh, do you know PagerDuty?” And he said, “Yes, we’re a PagerDuty customer.” And I said, “And have you used it?”

He said, “Of course, I run facilities. I use PagerDuty because facilities, when there are critical issues within an office environment, people want them fixed straight away. So, we’ve got to orchestrate the right people at the right time.”

It’s like, “Fantastic. Glad to hear that.”

And in fact, the development of our customer service ops offering was customer driven.

We actually, we noticed that, hey, this is quite interesting, we’ve got these other job titles using PagerDuty. Like, what’s going on here?

And our customers had seen the value of using us in other adjacent spaces.

So that’s why I feel so confident in the business and our performance because unplanned, unstructured work is not reducing.

Everybody’s life is being faced with more things that are time critical, that need to be dealt with in the moment, that need to be managed in a way that brings in other people.

It’s not just up to a single individual. And our platform allows companies to do that.

 

CML: Okay. Very good. I like that you’re that hands-on! So, the long term is a 10% operating, positive 10% non-GAAP operating margin, correct?

HW: That’s right. So, we presented at our analyst day, we said that by the time we were a billion [dollars] in revenue, we expect it to be at least at an operating margin of 10%.

So, because our view is that we’re still going to be growing at a healthy rate at a billion dollars.

And I think some of the discussions are when people see, oh you have ARR of $326 million, as of the end of this last year, oh, we can see $500 million is in sight.

And we said, “Look, by the time we’re at 500 million, we expect to be profitable probably in the range of least 5% operating margin.”

And that’s what we told folks at our investor day, and we are plotting that path.

 

CML: And so, some people… So long term is always relative.

And so, one could say if half a billion is within sight, then a billion dollars is long term.

But then, some people say, “Well, I’m thinking long term is when I start to think about terminal cash flows. And so, wouldn’t you have EBITDA margins, let’s say, adjusted EBITDA margins in excess of 30%, in what’s really long term?

HW: Yes. So, I mean, we’ve provided the long-term model for folks, as I guess a discussion point, like an initial guide around how we’re thinking about things because what we are keen to demonstrate is that we can see our way to continue a very high investment level in R&D.

And often, what you’ll find is that, for a lot of companies, as they start getting to that scale, they often dramatically scale down the investment in R&D, and there’s a lot more going into sales and marketing.

We actually want try and preserve as much of the investment in R&D for the long term.

In my ideal world, I would love to see us increasing our investment in R&D, as a percentage of revenue, rather than reducing it as we get larger.

And I would love to see us being able to continue to drive efficiencies in sales and marketing because I think we already have this product led sales motion, which we continue to evolve and mature.

And then, from a G&A perspective, there’s always opportunity to get more efficient there, and we continue to drive down that path.

So, we put those numbers out there. We will revise those, as we go along. Sometimes, when you talk about a long-term model, it’s a general model, in some respects, as opposed to very finite concrete numbers, but that’s a little bit to get folks the way in which we’re orienting our thinking.

We still want to have industry best practice gross margins.

We think we can still deliver gross margins in the 84% to 86% range, even as we approach a billion dollars. That’s unusual.

There are not many companies that can do that. And so, that’s really created, if you like, the format for us to engage or have a conversation.

 

CML: And there are probably, I guess, to your knowledge — I would’ve to go back and review, but there are companies that generate more than a billion dollars in annual revenue that over many years have been able to maintain an R&D profile.

And then, the conversation with the street becomes one about at scale, maintaining R&D and having an operating profit margin that also is to their liking, I guess.

Because everyone thinks, to my earlier point, everyone thinks that any enterprise software company that reaches terminal cash flow valuation has a 30% EBITDA margin.

Probably somewhere in between there, they’ve reached a billion dollars, which is a big, important threshold. And then, they have some path forward that, as you say, has to balance increasing profitability but also R&D.

HW: That’s right. And I think when people start looking at some of the free cash flow modeling, there’s sometimes a little bit of a disconnect between the operating margin performance and free cash flow.

So, I think there’s an increasing interest in analysts, in terms of how quickly or rapidly can you generate free cash flow.

So, we’ve been at a point where we’ve been, in some years, we’ve been breakeven or positive on free cash flow.

We have some quarters where we’re positive this year, slightly negative for the year.

But certainly, it starts getting into the realms of possibility that long before you get to that point, that you’re generating positive, free cashflow. And I think that’s often a consideration for investors.

 

CML: Interesting. Okay.

HW: And that’s also a function of we have high gross retention rate.

So, there’s stability in our customer base.

And so, you don’t have this thing of going to sell everything new every year. The recurring revenue component of our business is so high.

 

CML: Right. And the structure of cloud is different in that respect too. I mean, selling every year, I think of as more as a license business, traditionally.

HW: Yeah, exactly.

 

CML: In some sense, we’d spoken about use cases before, and it seemed like, last night, there wasn’t as extensive a discussion perhaps about the new incremental use cases.

Is there other, I guess, optionality, in terms of the business, where you’re seeing these other new use cases?

HW: Yeah, so, I think there are two dimensions.

We chose on the call yesterday to focus on the multi-product dimension of our product, of our platform.

And part of that is really just to give people confidence that we’re not just selling one single solution, but we in fact have four separate products that customers could buy.

And when we look at our annual recurring revenue, over half of our annual recurring revenue is coming from customers that have got two or more products.

So that at least speaks to how customers are using the breadth of our solution, which we think is really, really positive.

On the use case side of things, we chose to sort of just reference some of the enhancements that have actually, are geared towards servicing some of the other use cases.

So, the round robin scheduling, which is part of our most recent release, is really a function that can be used across any part of the business, but is particularly important to customer service operations.

So, customer service operations have a slightly different mode of how they organize their team.

So, if you’re a developer team, following a dev ops approach, you typically have the people who wrote the code on call for the code.

When you’re in a customer service operations environment, you may have centralized or decentralized teams.

And then, the nature of — you can’t have people on call for a customer incident or a customer call, but you need to have a different mode of being able to schedule people in and bring in the right people at the right time.

So, the round robin scheduling was specifically to support that use case.

And I think that’s going to have broad applicability across the other use cases.

So, when I look, even internally, the work that we do around using PagerDuty in non-dev use cases, whether it’s in finance or HR, round robin scheduling is going to make sense to us too because it’s not as though there’s always going to be like one specific named individual who owns that piece of code.

Because now you’re talking about a process, and you need to be able to say, “How do I direct this particular issue to whoever is the most appropriate person at this time through a round robin scheduling mechanism, as opposed to the other mechanisms that we use in the DevOps approach.”

 

CML: It’s very specific, in other words. It becomes specific to the flow of responsibility?

HW: That’s right. So, we, actually now, if you like, almost have two mechanisms, one that relies very heavily on how you think about service ownership within your company and the other, which is related to kind of how you organize your teams, from a business process flow.

 

CML: I like it. Okay. Well, I’m just about out of time, Howard. Anything you wanted to add that we didn’t mention?

HW: No. I mean, I think I’ve covered the things that — Obviously, I was very excited about — you’ve seen my growing excitement over the quarters with our performance.

And I really feel really proud of the results that we were able to post this last quarter, in this last year, and feeling very confident about the momentum that we are seeing in the business.

Obviously, we’ve also looked at the macro very, very carefully.

I think the conflict within Ukraine and the potential impacts of that on Europe is something that we are very sensitive to and aware of.

Inflation, of course, is an item that I think every CFO is sort of trying to model and think about what are the impacts.

But even within that framework, we’re seeing strong demand from our customers.

And I feel humbled every time I look at an experience of our customers using our product and the kind of return that they’re getting and how much they appreciate what we’re doing.

And I feel we’re really honored that they trust us the way that they do.

And that’s something that we appreciate that we have earned that trust and want to continue to build it.

 

CML: That’s great. Keep up the good work. It seems like it’s going well.

HW: Yeah, thank you, and, of course, always great to catch up with you.

 

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Thanks for reading, friends.

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