Enterprise software company C3.ai(NYSE: AI) has benefited from the recent attention around artificial intelligence (AI). Shares are up 80% over the past three months, but is the hype justified?
C3.ai is a young company with a lot of work ahead of it to become a sustainable business. Investors should understand the long road ahead before chasing shares for their portfolios, especially after its recent run. Here are three red flags that investors must know before buying.
1. C3.ai has a complicated business model
C3.ai builds software tools and turn-key applications for enterprises. The company focuses on areas of artificial intelligence, including recognition as a Forrester Wave Leader for AI and machine learning platforms. For example, its software can use machine learning to detect money laundering. In oil and gas, C3.ai's software can monitor moving parts of a supply chain to keep operations running efficiently. But how do investors measure how much value C3.ai brings to enterprises?
At first glance, revenue growth doesn't tell a great story. The company's sales fell 4% year over year in the fiscal year 2023's third quarter (ending Jan. 31). Guided full-year revenue of $265 million represents just 5% growth. Management attributes the slow growth to a shift in billing to a usage-based model, and that growth will accelerate over time as enterprises use the software more. However, that's a double-edged sword. It could make the business more volatile, thriving during good times and hurting when customers tighten their wallets.
Investors shouldn't rush to give the company the benefit of the doubt. Its largest customer, Baker Hughes, still accounts for roughly 30% of revenue. Not only does that create concentration risk (Baker Hughes' contract runs out in 2025), but it's fair to question how much traction C3.ai's products have without a more established business portfolio. Currently, the company has just 236 customers.
Peter Lynch once spoke of simplicity in investing, stating: "If you can't explain to a 10-year-old in two minutes or less why you own a stock, you shouldn't own it." The company has so many moving parts that it's hard to grasp whether C3.ai is thriving or surviving.
2. When will C3.ai's business make money?
Many growing companies lose money -- it's normal. But ideally, you'll see a clear path to profitability. C3.ai has laid a path to see its operating margin turn positive at the end of the fiscal year 2024 (end of April 2024). Management expects the operating margin to trough at -36% six months prior, followed by a strong recovery. That's due to the expected ramp-up stages of its usage-based billing model.
But a positive operating margin doesn't necessarily mean the company is profitable. You can see below how the business is burning more cash than it's generating in revenue. Expenses have surged through three quarters of the fiscal 2023 year, led by research and development, increasing 54% to $161,000 year to date.
AI Research and Development Expense (Quarterly) data by YCharts
C3.ai's operating margin could turn positive, but investors could wait longer for positive free cash flow. Fortunately, the company does have some time. With roughly $790 million in liquid assets like cash and short-term investments, that's enough to fund nearly three years of operations at the pace C3.ai burned cash over the past four quarters.
Still, a company with a multi-year path to making money is a huge question mark. It's hard waiting for answers when the economic environment is shaky like it is right now. What if we enter a recession, and the company's usage-based billing works against it? Cash losses could worsen in such a scenario.
3. C3.ai has paid excessive stock-based compensation
The company's aggressive use of stock-based compensation is a big reason I'm concerned about the financials above. Paying employees with stock is a common way that growing businesses conserve cash. But too much stock-based comp can hurt shareholders by diluting their existing shares. Below, you'll see that the company has paid $204 million in stock-based compensation over the past year, an eye-watering 76% of revenue.
In other words, if the company paid full salaries to employees, cash losses would be much worse than they already are. It undermines the financials, in my view, because management is putting that cost on investors.
AI Stock-Based Compensation (TTM) data by YCharts
C3.ai looks like a company figuring out its sales strategy, spending a lot of money, and diluting investors with a flood of new stock -- all simultaneously. That's a lot going on, and not much is good for shareholders. Consider sitting this one out until C3.ai puts up much better numbers than today.
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Justin Pope has no position in any of the stocks mentioned. The Motley Fool recommends C3.ai. The Motley Fool has a disclosure policy.
