Is C3.ai Stock A Buy During The Dip? Not Really

Introduction

"Some people get rich studying artificial intelligence. Me, I make money studying natural stupidity." - Legendary investor Carl Icahn

Well said, Carl. Well said. But what if you could do both? What if you could short a company touting its presence in the hottest trend of the era, while its revenues are shrinking, cash is burning, and stock is rising? What if its financials look so artificial that it strains your intelligence? What if the stupid thing to do would be to let the natural hype pass without capitalizing on it?

C3.ai (NYSE:AI) had its splashy debut in the public markets at the end of 2020. AI stock proceeded to lose 90% of its value over the next two years, as growth dissipated and investors soured on loss-making companies. Then, ChatGPT hit the world this year, and people rushed out to buy any stock that could be tenuously linked to the trend, including publisher BuzzFeed (BZFD).

Company background

C3.ai is an enterprise software company that deftly added AI to its name in 2019 to capitalize on an emerging trend, reminiscent of the time decades ago when companies were adding .com to their name. It had previously changed its name to C3 IoT, when the Internet of Things was hot. The company was incorporated in 2009 and has its headquarters in Redwood City, CA. It was founded by its current CEO, Thomas Siebel, who has had a storied career as the founder of Siebel Systems, a customer relationship management software provider that was bought by Oracle (ORCL) in 2005.

C3.ai's software enables its clients to analyze data, track customers, optimize inventory, manage supply chains, and prevent fraud. In other words, a grab bag of functions that any number of other software companies provide. What it seems to be is a supplier of discounted customized software to one company in particular, Baker Hughes (BKR). Baker Hughes accounted for 31% of the company's revenue in the latest completed fiscal year ending April 2022, and 43% in the latest reported quarter. Baker Hughes also co-markets the company's offering to customers in the oil and gas sector.

C3.ai quarterly financial overview

For the quarter ending January 31, 2023, the company reported $66.7 million in revenue, down 4% YoY. Operating income was a loss of $72 million (-108% operating margin, a figure few companies other than pre-commercialization biotechs match). It declared a non-GAAP net loss of $0.06 per share after excluding $57 million in share-based compensation. The share count, at 110.7 million, was up 5% YoY.

The company has a market capitalization of $2.5 billion. It has a healthy cash balance of $0.8 billion. It thus has an enterprise value of $1.7 billion, amounting to 6x its annual revenue.

The balance sheet showed accounts receivable jumping to $144 million from $80 million at the beginning of the fiscal year, nine months ago. Property and equipment showed a large increase to $75 million from $15 million. The cash flow statement was dreary, with net cash from operations for the nine months being an outflow of $143 million, even after $168 million of stock compensation was added back. Capex was $60 million against depreciation of a mere $3 million. Depreciation is likely to increase in the future, hurting the company's margins.

The company guided to $71 million in revenue for the next quarter (down 2% YoY), with an operating loss slightly worse than the current quarter.

The short-seller allegations

Recently, a short-seller has alleged that the company has confusing disclosures, and has been aggressively recognizing revenue as evidenced by the large increase in accounts receivable. The company has provided a response to this. There are some other minor allegations like the company likely shifting expenses from cost of revenues to operating expenses in order to show a higher gross margin. From a fundamental point of view, I don't believe these are very relevant.

AI stock valuation and recommendation

AI's huge stock compensation (85% of revenue in its latest quarter) ensures that employees will always have plenty of shares to sell into the market. This is a real cost to shareholders, even if management believes otherwise. To value the company, I will assume that it will reduce this over time, and reach an operating margin of 4%.

A 4% margin on current annualized revenue of $267 million would result in normalized annual operating profit of $11 million. The company has enormous net operating losses (accumulated deficit of $745 million), so it would be reasonable to assume that the company will never pay taxes. Thus, it would have the same $11 million in after-tax operating income or $0.10 per share. A company that isn't growing revenues would normally deserve a low multiple, but in recognition of the AI hype, I will assume that revenue growth will soon improve. So I will apply a 30x multiple to arrive at a per share value of $3 for the business. Then I will add back the $7 per share of cash on the balance sheet to arrive at fair value for the shares of $10, or more than 50% downside from the current share price of $23. The stock was close to this level at the beginning of this year.

In a bull case, the company will get to an 8% operating margin. This would result in normalized annual operating profit of $21 million or $0.19 per share. I will apply a 60x multiple to get to a value per share of $12 for the business. Adding back $7 per share of cash would result in fair value for the shares of $19, which is still lower than the current price. The large number of shares ensures that it is hard to get to a high fundamental value for the stock.

In a bear case, the company will continue to generate losses and never become profitable. In this case, I would value the company at its cash of $7, for 70% downside from the current share price.

I recommend that investors sell any positions in AI stock. For those who like to hedge portfolios with short positions, I recommend shorting the stock. I would caution that the short interest is high at 27% of float. One may also employ options strategies to reduce risk, like selling out of the money calls, buying puts, or selling out of the money puts against a short position.

External ratings

Seeking Alpha's quant rating system gives AI a composite rating of 3.5, equating to a hold, with A+ for momentum and revisions, A for growth (driven by capex growth as it turns out), B- for valuation, and D- for profitability. Wall Street analysts are similarly lukewarm, with a rating of 2.7, translating to a hold.

Risks are high

The risks here are high on both the long and short side. The stock is volatile, and any position can incur large mark to market losses, so I recommend keeping it small. The main risk for any small or mid-cap company is acquisition risk. It is possible that another software company, egged on by its investment bankers, may want to own a piece of the AI hype, even at the cost of a few hundred million dollars of operating losses a year. I believe that private equity would be turned off by the losses, but one can never discount what investors with access to other people's money may do.

On a fundamental basis, the company could ride the interest in AI to rapid revenue increases, accompanied by a reduction in costs.

Looser money could make the stock go parabolic as retail investors chase a hot new trend.