Black_Kira/iStock via Getty Images

Black_Kira/iStock via Getty Images

C3.ai (NYSE:AI ) is a leading software company, which provides Artificial Intelligence services to enterprises. The company is poised to ride the wave of growth forecasted for AI. The global Artificial Intelligence (AI) market is forecasted to grow at a meteoric 20.1% CAGR from $387 billion in 2022 to over $1.3 trillion by 2029. C3.ai serves an envious list of large reputable customers from The US Air Force and the Department of Defence, to large energy companies such as Shell & Engie. They have been growing revenues at a 40% CAGR over the past couple of years, while the stock price has declined massively.

C3.ai was one of the hottest tech companies of the 2020 market rally and went public at a lofty valuation of $119/share. Since then the stock price has spiraled down by over 85%. This decline was mainly driven by high inflation & rising interest rate fears, which has compressed the valuation multiples of all growth stocks. Inflation is a major issue for all companies but the volatility can also present buying opportunities for the long term investor. Let's dive into this company's business model, Financials and valuation to find out more.

C3.ai powers artificial intelligence solutions via it's suite of software applications. These include:

Their flagship AI Application Platform uses a "model driven architecture", this basically uses models as a set of guidelines for design specifications. The end result is a low code solution, which enables faster deployment and lower cost for customers.

The company's AI applications are prebuilt software tools, which aim to accomplish a variety of goals for businesses. A short list includes:

Their AI Data Vision product uses AI (go figure) and visualisation techniques to find hidden patterns in large data sets. Enterprises generate a huge amount of data but in many cases it is siloed in different places and thus difficult to unlock value from it. Tools such as the AI Data vision product can help to gain insights from this. Given the Big Data market is forecasted to grow at an 11% CAGR and reach $273 billion by 2026, C3.ai should be poised to benefit.

The final product called "C3 AI Ex Machina" enables anyone to develop AI models insights without writing code. The is a timely product given the national shortage of software engineers and their rising salaries.

C3.ai has grown their customer base by a meteoric 82% YoY, with the customer number jumping from 121 to 218. The beauty of being an enterprise service provider, is they don't need many customers to generate substantial revenues. In the most recent quarter, revenue increased by 42% to $69.8 million compared to the same quarter last year.

The company's revenue is primarily (82%) driven by subscription services with just 18% from professional services. They recently won a 5 Year, $500 million production agreement with the DoD which adds substantial security to their future revenue. While also validating their product offering as a best in class solution for AI, not just a gimmick.

The company operates with an extremely high gross margin of 75%, which is typical for a software business and could climb higher as their professional services make up less of their revenue base moving forward, which is the current trend.

They did produce a operating loss of -$163 million in the trailing 12 months. However, an analysis of the income statement shows a $124.8 million R&D spend and the rest is going on sales, marketing and general expenses. Thus, in my eyes they could be "profitable" if they wished but it makes more business sense to reinvest the cash free gross profits, in order to improve their technology and grow further.

C3.ai has a strong balance sheet with $1 billion cash of the end of the quarter and virtually no debt. They have also authorised a stock buyback program for up to $100 million over the next 18 months.

In order to value C3.ai, I have plugged the latest financials into my valuation model, which uses the discounted cash flow model of valuation. I have conservatively forecasted 25% revenue growth for the next 2 to 5 years. After which I am conservatively predicting the growth rate to slow to a 2% terminal rate by year 10. In terms of margins, I have predicted operating margin to expand to 20% in 6 years as the company reaches scale.

C3.ai valuation (created by author Ben at Motivation 2 Invest) R&D (created by author Ben at Motivation 2 Invest)

C3.ai valuation (created by author Ben at Motivation 2 Invest)

R&D (created by author Ben at Motivation 2 Invest)

To increase the accuracy of the valuation further, I have capitalised their R&D expenses.

C3.ai (created by author)

C3.ai (created by author)

This gives me a valuation of $20/share, the stock is currently trading at $16.90 at the time of writing and is thus ~8% undervalued.

The stock is also trading at a forward price to sales ratio = 5.7, which is significantly below historic multiples of above 20.

C3.ai does have competition in the digital transformation industry from companies/products such as: Aibee, ASAPP, SAP National Security Services, Qubole, MathWorks, SparkCognition and Alteryx. However, from C3.ai's elite customer base (DoD) and the fact that only a small number are required to grow revenues substantially, I don't believe this is a major issue.

It is no secret Inflation is at 40 years highs and much above the Fed's 2% target. Morgan Stanley predicts at least 6 interest rate hikes in 2022 alone, as the Fed tries to curb inflation. Higher interest rates mean higher discount rates and thus cause a devaluation of growth stocks, as their valuation tends to be more biased upon future growth in cash flows. Also, as companies experience rising input costs and margin pressure they may be less enticed to spend on new software.

C3.ai is a tremendous company and is really a leader in Artificial Intelligence applications for enterprises. With the growth in AI and Big Data, I would expect C3.ai to get tailwinds from these growing trends. Their subscription business model is strong with high gross margins and the stock looks to be undervalued currently. The only major risk in my eyes, is the macro economic force of high inflation and rising interest rates. However, I don't believe inflation and rising interest rates will last forever, so for the long term investor this looks to be an opportunity for Growth at a reasonable price (G.A.R.P).

This article was written by

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.