Stock Idea: Can PagerDuty cross the chasm from niche to mainstream for outsized investor returns
Part 4 of 5 part series
In this five part series I provide an overview of my favorite investing theme currently - the cloud platform providers powering digital transformation and analyze what I think are the five best cloud platform stocks in this area. I will post my evaluation of each one every few weeks, culminating in my selection of the best of the bunch. Follow me on Twitter @OwlWealthy to read my analysis when it's fresh off the press.
The investment story of PagerDuty (NYSE: PD) is one of accelerating digital transformation, a company that grown up within the software based DevOps movement, and a stock that offers big potential investor gain if the company can cross the chasm from its current niche market into a more mainstream digital operations market.
The race to digitally transform or risk obsolesce has been underway for some time. Worldwide spending on the technologies enabling digital transformation is forecasted to reach $2.3 trillion in 2023, according to the International Data Corporation (IDC)Worldwide Semiannual Digital Transformation Spending Guide.
This data from IDC could now be under stated. The work from home and learn from home model, thrust upon us by the COVID-19 pandemic, has accelerated digital. The impact of COVID-19 on digital transformation is best summarized by Microsoft CEO Satya Nadella:
“We’ve seen two years’ worth of digital transformation in two months. - Satya Nadella, CEO, Microsoft
Digital transformation is now an act of survival. We expect amazing digital experiences from the brands, companies, academic and government institutions that we buy from, partner with, or get educated by.
Software and the Internet have transformed the world. Software no longer merely supports a business, rather it is embedded into every part of a modern digital organization. In a similar way that manufacturing companies transformed how they designed, built, and delivered products using automation throughout the industrial era, organizations in today’s digital era must transform how they build and deliver software to keep up with the insatiable demand.
American Eagle, a PagerDuty customer, needs to monitor their inventory and physical stores to ensure there are no operational issues preventing customers from browsing and buying in-store. They also have a significant ecosystem of e-commerce sites and apps they need to ensure are always working. Even a minute of an e-commerce site being down costs the average e-retailer half a million dollars in lost sales (Source: PagerDuty). More so, the customer is likely to leave and never come back.
As more commerce shifts to digital, the need to operate digital properties and ensure their performance, reliability and resiliency becomes more and more important. Digital operations is business critical. Consumers, and increasingly employees, are demanding perfection. Downtime means lost revenue, churned customers and lost productivity.
However, running high performant digital operations is very complex. The scale they are run at is significant. Digital operations integrate numerous third party services and solutions, causing an explosion of digital events that is hard to manage. It's not possible today for developer's to know and prepare for what might happen once they release their product, service or app into operations. It's chaos. And, the urgency required to respond to incidents in real time is of the highest order to be able to meet the extremely high expectations consumers and employees have of their digital experiences.
One of the ways to manage this complexity, and operate digital businesses efficiently, is an increasingly popular software development and delivery methodology called DevOps. Beyond just the combination of software development (Dev) and IT operations (Ops), DevOps is about establishing collaborative cross-functional teams that share responsibility for building software and managing the software once it goes live and becomes operational.
Rather than software development teams building new software to power a company's digital experiences and then throwing it over the fence for an entirely differently team to operate in a production environment, DevOps forces the software development teams that built the digital service to also operate it scale. The developers feel the pain if something they built isn't scaling well, or has bugs. They are highly motivated to make sure their code works, that it's well tested, resilient, and architected for success. With the success of a business depending on innovation and the quality of their digital experiences, software developers and IT operators must collaborate across the software lifecycle.
Since the first ever DevOps conference in 2009, it has seen significant adoption amongst software and IT operations professionals. According to Statista, many organizations are adopting DevOps. As of 2018, only 9% of surveyed organizations had not adopted DevOps with no future plans.
DevOps is a cultural shift and can’t be accomplished with tools alone. However, to reach their full potential, teams still need a shared, automated toolchain across the entire software delivery lifecycle to create an end-to-end view and resolve issues quickly when they emerge.
This is where PagerDuty comes in. PagerDuty was founded to support DevOps. Amongst the chaos and complexity DevOps faces when trying to operate digital businesses at the levels of perfection demanded, they need a solution that gets them from signal to action directly and immediately. PagerDuty is a cloud-based platform that allows businesses to improve the constant collaboration between software developers and IT operators in the DevOps model, helping them quickly address high priority incidents that inevitably occur in the midst of today's complex digital world.
PagerDuty is the leader in the incident management market. They have been at it since the founders worked at Amazon as interns and decided there was a better way for developers and engineers to respond to problems. If PagerDuty is able to capture a major share of the market, it could be worth a double bagger in time for PagerDuty investors. Where things start to get interesting and where there could be some real upside is a new category that is emerging and that PagerDuty is helping define, the digital operations space. The practices, methodology and tools used in DevOps that PagerDuty helped pioneer are also relevant outside of software engineering.
"Digital operations are becoming life changing and disruptive. All these different applications and services are life-critical today. Up until now the strategies have been NOCs (Network Operations Centers) or IT service management and ticketing tools. These strategies aren't cutting it anymore...We are moving beyond the dysfunctional ways of behaving, and into a new paradigms for operations."
- Charlie Betz, Principal Analyst, Forrester
Read on to learn more about the opportunity ahead for PagerDuty and whether they are well positioned to capture and therefore drive significant investor gains.
While PagerDuty positions their offering as a real time digital operations platform, I'm not ready to call it a mature platform yet.
PagerDuty has done a good job evolving from a single on-call management product offering to a more comprehensive digital operations platform. They have made progress on their platform capabilities but there is more work to do.
PagerDuty enables developers to build apps on top of its platform (https://developer.pagerduty.com/). However, developer adoption of their platform seems nascent with very few public examples of 3rd party software companies that have integrated PagerDuty functionality into their own custom apps.
There is a level of network effect and stickiness that PagerDuty has achieved with DevOps professionals that is compelling. The more developer and IT professionals within a customer account that use PagerDuty, the more value accrues for the teams that are on the system. Notification tools like PagerDuty are only useful if the right people in an organization are on them so they can get the right alert at just the right moment. As noted by one of the early investors in PagerDuty, Bessemer Venture Partners, PagerDuty often goes viral internally once they add a new customer:
Companies noticed that implementing PagerDuty was a much better solution than building a version from the ground up. At which point, DevOps and IT users would evangelize the platform internally to other teams, adding more and more users to the system. In our diligence, we learned that each new logo brought an average of 10 net new users onto the platform, and they were relatively sticky ones. At that time, logo churn rate was only at one percent. - Bessemer Venture Partners (PagerDuty pre-IPO investor).
There is also a network effect between customer adoption of PagerDuty and the 3rd party systems integrating with it. As more companies adopt PagerDuty, other 3rd party vendors have a greater incentive to integrate with PagerDuty. The end result is a flywheel of business value for its customers. New 3rd party integrations lead to more accurate and timely alerts and signals, which means improvements in customers digital operations reliability, responsiveness, and ultimately innovation. Better business results for customers leads to more customers adopting PagerDuty, which leads to more 3rd party vendors integrating with PagerDuty. This flywheel effect has resulted in an industry leading 350+ 3rd party system integrations. It's major competitors, Opsgenie and VictorOps, have 200 and "100s" of 3rd party integration respectively (note: I interpret Opsgenie public disclosure of "100s of 3rd party integrations as a public way of admitting they have less than PagerDuty). Not an insurmountable lead, but a lead nonetheless. s
Despite all the positives, companies are not building their businesses on PagerDuty like they are on other, true platforms. PagerDuty helps companies run their digital operations effectively but I don't see a ton of lock-in if a better product came along. I'm not convinced it's hard for customers to walk away from PagerDuty. It would be real work to migrate to another incident management system, but they could move to a competitor without significant negative impact to their business. The good news is PagerDuty has a low churn rate (5%), so they appear to be doing good by their customer. With increased competition this could change.
PagerDuty has defined their total addressable market (TAM) as digital operations management, and have quantified it to be worth $100B. It is broken down into the on-call automation and incident management market worth an estimated $25B, a DevOps niche market, and the remaining $75B TAM includes more enterprise wide use cases. This is a classic crossing the chasm move, from a niche market (DevOps/IT professionals) to the more lucrative mainstream market (digital operations enterprise wide). In the case of the PagerDuty investing thesis, it is the difference between decent returns and monster returns.
The million dollar question is can PagerDuty move from today's niche of DevOps into mainstream enterprise?
Let's break these two markets down to better understand their dynamics and whether PagerDuty is well positioned to break through a $25B incident management market into the supposed $75B digital operations management market.
PagerDuty has sized the incident management market by multiplying their average revenue per user ($25/month/user) by the 85 million potential users they believe exists when you account for all the developers, IT, security and customer support professionals globally. Allied Market Research estimates the global DevOps market will reach $9.40 billion by 2023. Like all public companies, PagerDuty has probably inflated their TAM. Let's split the difference.
The bigger problem I see with this market is that deal size can be quite small. PagerDuty recently reported 348 customers with annual recurring revenue over $100,000. I worry about their potential for achieving the high growth rates that are expected at this stage, on the back of $100,000 deals. I assume that because they are not promoting the number of $1M deals they have, there aren't many. The small deal size is intuitive. There are only so many DevOps professionals in any organization, digital first or otherwise. Incident management does not scale enterprise wide, let alone get very far outside of IT. It would be interesting to see if PagerDuty could better monetize by moving away from its current user based licensing model to either a metered, cost per device covered (for Internet of Things scenarios) or outcome based pricing model. If PagerDuty is preventing the loss of tens of millions of dollars of revenue per year caused by system downtime that has got to be worth more than $100,000 in customer spend per year.
More consequential to shareholder potential gains is the estimated $75B digital operations management market. PagerDuty defines digital operations management as harnessing the power of data to act when it matters most. They claim its about reimaging operations out of necessity to meet the demanding expectations of the experience economy (read digital business).
While it is intuitive that there is a direct correlation between the growth of an organization's digital business and the need to manage them, I struggle in seeing how this adds up to a $75B TAM. Given the importance of the digital operations management market to the PagerDuty investing hypothesis, we will dive deeper in a moment.
From a single point solution for on call management to a "platform" for digital operations, PagerDuty has done a good job of building out its product portfolio.
PagerDuty differentiates its product from competitors across three key attributes - cutting out the noise, reducing time to resolution and its promised Return on Investment.
PagerDuty prides itself on "no false positives", meaning the incident alerts PagerDuty sends to on call technicians in the middle of the night are real issues that demand their intervention. Through the collection of billions of data signals over its 12 years of existence, both machine data and human response data, PagerDuty is in a unique position to cut out the noise and only deliver incident responses that require human response.
It’s not uncommon for a large enterprise to have hundreds of monitoring tools, such as Nagios for server monitoring, Pingdom for website monitoring, and New Relic for application performance. Typically, signals from all of these monitoring tools are blasted to one person or a whole IT Ops team, with no prioritization or filtering or mechanism to escalate and route alerts to the right person. Not only do the critical signals get lost in the noise but alert fatigue sets in due to continual false positives. PagerDuty fixes this by ingesting incoming alerts from virtually every monitoring tool on the market. As alerts are ingested, PagerDuty de-duplicates and normalizes them to cut down on noise.
In a digital world where minutes can cost companies millions of dollars in lost revenue, seconds count. One of the most important metrics in the incident response management market is time to incident resolution. Essentially how long it takes to fully resolve an incident from the time it occurs. This is another area where PagerDuty excels and its because of their investments in machine learning and automation. PagerDuty is able to help customers move from a reactive and response mode to being proactive and predictive. On average it takes companies 80 minutes to resolve an incident, and with the machine learning and automation capabilities of PagerDuty customers are able to cut time to resolution to just a few minutes.
PagerDuty offers a very compelling business value proposition to its customers. Backed by 3rd party analyst IDC, PagerDuty is able to point to an average ROI for customers of 731% over a three year period. By reducing the number of incidents and time to resolve an incident I have no reason to doubt the significant return PagerDuty customers realize on their PagerDuty subscriptions.
While major analysts such as Forrester or Gartner do not cover the market, PagerDuty was rated a market leader by another reputable source G2.
PagerDuty has established itself as the leading product in the incident management space. What I worry about is one of their now deep pocketed competitors coming along and providing a better product. With well funded cloud vendors Splunk and Atlassian both recently acquiring PagerDuty's two primary competitors - VictorOps and Opsgenie, this is a real threat.
Developers love PagerDuty. And why wouldn't they? PagerDuty cuts out the noise and only notifies them when a real incident that requires their specific attention. It also helps automate aspects of and streamlines the incident response process. This means less interruption in the middle of the night when they are on call and more time for them to develop new cool apps. Prior to PagerDuty coming along dev teams needed to build and maintain their own proprietary incident management system, which includes configuring and reconfiguring the third party systems they use as part of their technology infrastructure. PagerDuty does this out of the box, on their behalf, with as many as 350+ third-party systems.
Perhaps the best indication of developer love for PagerDuty is that some of their biggest customers are amongst the most developer focused and technically discerning cloud companies - Twilio, Zoom, Box, Elastic, Datadog, Okta and Cloudflare are just a few. It's pretty common to see these customers on stage at a PagerDuty conference pledging their love for PagerDuty.
PagerDuty's optionality resides in their ability to execute on the newly defined digital operations management space. While it appears to be a logical next step for PagerDuty, expanding into new markets will require new muscle. With its incident response focus, PagerDuty is well known amongst DevOps professionals. Digital operations use cases involve non-IT audiences, primarily business responders (customer service reps notifying customers of a service disruption) and stakeholders (CFOs needing to be informed of service outages that impact revenue).
PagerDuty calls out three primary characteristics that make digital operations management use cases a natural fit for PagerDuty's existing capabilities: real time (i.e., when seconds count), unplanned or unpredictable and mission critical.
For digital operations management PagerDuty is used to detect issues or real time opportunities, orchestrate cross-functional teams across geographies and departments, so that the organization can solve a problem before end consumers or end users feel that problem. It's about moving from resolving things better to predicting and preventing issues, or capitalizing more quickly on unpredictable opportunities.
As these real customer scenarios highlight, PagerDuty is being used today for digital operations:
GoodEggs uses PagerDuty to enable warehouse operations and development teams to analyze signals from refrigeration units to ensure food stays fresh for deliveries
The Gap uses PagerDuty for store operations
PagerDuty is used for organ donation. When an organ becomes available, PagerDuty is used to manage the workflow. No better example of something that is time sensitive and business critical.
A resource company uses PagerDuty to manage fuel trucking terminals. They have instrumented their logistics system to understand what trucks are inbound, what is needed where in the supply chain and the status of the fuel trucking terminal to optimize how they move assets around.
Peleton uses PagerDuty to track shipments to customers to ensure on time delivery and increased efficiencies
PagerDuty's vision for how it's platform can be the central nervous system of digital operations is very compelling. However, I need to see more use case examples like the above to know that there is a big market here and not just some select, highly innovative customers that have found unique use cases for PagerDuty that won't scale. It's still early days in this mainstreaming strategy of PagerDuty so I can have some patience.
Make no mistake, whether PagerDuty can successfully cross the chasm from its current niche into a mainstream market is the crucial question that determines if PagerDuty will be a decent investment versus an amazing investment.
I believe this lack of certainty on PagerDuty's ability to truly expand beyond the niche DevOps market is what has held the stock in the $20-$30 range over the last four or five months, at a relatively low Price to Sales (P/S) ratio of ~13. Their developer platform peers are seeing much higher multiples. It's not uncommon for Wall Street to underappreciate the Total Addressable Market of a tech company but I'm not certain that is what's happening here. They must demonstrate some more wins in the digital operations space to show they can break out of their DevOps niche.
PagerDuty is led by Jennifer Tejada, the much loved CEO. Prior to taking over as CEO at PagerDuty, Mrs. Tejada was CEO of Keynote Systems, where she led the company to strong, profitable growth before its acquisition by Dynatrace. Tejada spent her formidable years in senior marketing positions at Proctor & Gamble. If you want to be picky the one negative (and only in my opinion) on her resume as CEO of a tech company is her lack of technical depth. I prefer CEO's that provide technical leadership as part of their remit but Tejada more than makes up for it with her other capabilities. Additionally, the founding CEO Alex Solomon has stayed on as CTO as he himself made the case for a new CEO to take the company to the next stage.
Tejada was a much sought after executive when she left her last position. She has been recognized externally extensively. She was named one of the Top 25 Women Leaders in SaaS by The SaaS Report in 2017 and was also named to the 2018 Silicon Valley Business Journal/San Francisco Business Times Upstart 50 list.
The recognition I value the most for CEOs is when it comes from their own employees. They are the best judge of a CEO and in the case of Mrs. Tejada her employees have spoken with a resounding approval of the job she is doing. She received a perfect employee approval score of 100% from Glassdoor.
PagerDuty is in really good hands and its leadership is definitely one of the most compelling aspects of PagerDuty as an investment opportunity.
PagerDuty excels in some key performance areas. Existing customers are spending more with them each year (net expansion rate) and they have great margins. Their growth rate for the cloud segment is lackluster, which keeps their Price to Sales ratio well below their peers.
My Bottom Line
I have a small, starter position in PagerDuty but I'm NOT ready to issue a recommendation. I will be monitoring their upcoming annual conference to better assess if they are successfully crossing the chasm from their current DevOps niche into a mainstream market. This transition will be critical to any long term thesis for investing in PagerDuty.
I will provide a formal recommendation (or not) once I complete my analysis of the other cloud platform providers I'm covering in this five part series. I want to compare PagerDuty against some of the top tech growth stocks available. Up next is ServiceNow. Stay tuned.
Follow me on Twitter @OwlWealthy to read my analysis when it's fresh off the press.