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Small-Cap Confidential
Undiscovered stocks that can make you rich

Cabot Small Cap Confidential 268

Today’s new addition has all the attributes we look for in a small-cap software stock.

The company is young, management is insanely smart, the products fit a huge need, growth is 30%+, and the sales team is growing quickly.

In short, it’s an extremely attractive opportunity. Which is why we’re jumping in right after the company came public.

Enjoy!

Cabot Small Cap Confidential 268

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The Big Idea
Whenever a lawsuit is filed the first thing that happens is lawyers on both sides go through a discovery process.

This means searching for relevant information, facts, and evidence. It requires sifting through tons of materials – emails, documents, financial statements, mail, voicemails, etc. – to find tidbits of information that can help build a case.

It’s labor intensive. With associates and lawyers often working on multiple cases simultaneously and dealing with different technologies it can be a real challenge to do the discovery process efficiently.

Inherent manpower limitations and workflow challenges led to the creation of software that could help streamline things. It’s an obvious solution, but many products started out, and still are, pretty awful. They are slow, clunky to use, offer limited cloud functionality and have poor artificial intelligence (AI) and machine learning (ML) capabilities. And they are expensive!

The market has been ripe for disruption. And it has finally arrived, courtesy of Kiwi Camara.

Born in Manila, Kiwi Camara moved to Ohio, then Hawaii, at a young age. When he was 11, he wrote a medical paper on alternative treatments for rheumatoid arthritis. It was published in the Hawaii Journal of Medicine.

Camara then skipped high school and at 16 he graduated summa cum laude with a degree in computer science from Hawaii Pacific University. At age 17 he enrolled in Harvard Law School and in 2004 became the youngest graduate. He was 19.

Fast forward a few years and in 2007 Camara founded a law firm, Camara & Sibley, with his best friend from Harvard, Joe Sibley.

After seeing the issues with the discovery process firsthand, and having a good handle on computer science, Camara developed a tool inside the firm that used AI and ML to streamline things. His cloud-based solution – made by lawyers for lawyers – made discovery faster, easier, and less expensive.

In 2013 Camara stopped practicing law and fully committed to building a company around his team’s software. To say that he is an interesting guy would be an understatement. The term “visionary” may be more appropriate.

Now, the software company he founded is disrupting the market. And not just because Camara built a better mousetrap for law firms.

His software is used by corporations across all industries. If they have a need for legal services, they can use it. It may well displace a lot of the legal work that professional services firms – like KPMG, PwC and Deloitte & Touche – do for corporations.

This is exactly the type of company we like to get into early. It has to the potential to disrupt not just one industry, but two.

The Company
CS DISCO (LAW) has developed a next-gen AI-powered cloud software platform that helps corporate law departments, law firms and legal service providers operate more efficiently by automating and simplifying workflows. Users say the platform can slash time per case by roughly 30%.

The company’s AI and ML powered applications are built around its eDiscovery solution, which is most commonly used by corporate legal departments and outside council for litigation and other legal matters.

It’s important for investors to understand that DISCO’s solutions aren’t just used by law firms. Companies from any industry can use them. Also, if a law firm is a customer, they don’t actually pay CS DISCO. Those charges are passed through to corporate clients who pay usage fees.

DISCO is a particularly disruptive force in the legal services market, which is considerably bigger than the market for legal-specific software (roughly $11.5 billion versus $4 billion). This industry sprang up years ago when corporations realized it didn’t make sense to pay big software bills for hosted solutions that often sat idle in between legal matters. Instead of maintaining those systems, companies just outsourced the legal work, much of which includes the discovery process.

Now that Camara has cracked the code and built a software platform that charges based on usage, and which can be turned on and off at will, corporate legal teams are back in business. These teams can now take back control of their timelines and reduce dependence on outside service providers.

Bottom line – if a company is big enough to have a legal department (i.e. around 2,500 employees) and/or requires meaningful help from outside council (probably companies with 100 or more employees), they are a potential DISCO customer. This implies the global addressable market is somewhere in the range of $20 billion to $40 billion. That’s a wide range because, with greater efficiency, spending on software should reduce spending on manpower, which is expensive.

As of the end of June 2021 the company had over 900 direct customers, including corporate legal departments and law firms. Average revenue per user (ARPU) is around $90,000. Ten customers generate 20% of revenue, and over $1 million each.

Examples of current corporate customers include PayPay (PYPL), Peloton (PTON), Southwest Airlines (LUV), Shopify (SHOP), Accenture (ACN), McDonald’s (MCD), Lyft (LYFT) and Fannie Mae (FNMA). Sample law firm customers include Simpson Thacher & Bartlett, Phelps & Phillips, Manatt, Allen Matkins, Seyfarth Shaw and WilmerHale.

Mr. Camara is considered something of a visionary in the market and was formerly a practicing lawyer. He is surrounded with high quality executives, including a CFO, CRO and CCO that were also practicing lawyers. Many members of the executive team also have deep experience in the legal technology industry, including with direct competitors.

The attraction of a modern software platform that is easy to use, easy to understand, that looks and feels like other modern user interfaces, and which is built by lawyers for lawyers should not be underestimated when it comes to viral, word of mouth/network effect growth potential.

CS DISCO is based in Austin, TX and generates 95% of revenue from the U.S. It has a small presence in London.

We will start with a half-sized position given this is a new IPO and reports Q2 results today.

Platform & Products
DISCO’s platform offers the many benefits of a modern SaaS solutions that was born in the cloud. The short list includes flexibility, scalability, easy deployment (most done in a day), great user experience, and consumer-friendly interface. This is achieved through use of modern technologies that are hosted on Amazon Web Services, including Snowflake, Kafka, Elasticsearch and AWS Lambda.

DISCO’s solutions help drive efficiencies across legal team workflows in areas such as case management, legal document review, data collection, compliance, disputes, and investigations.

There are three products:

DISCO eDiscovery
DISCO launched the company with the eDiscovery product, and it still accounts for the vast majority of revenue (around 85%). After initial data ingestion (text messages, phone records, financial info, emails, etc.) associates spend a few hours to review, score and/or tag materials, then the AI engine takes over to curate and categorize the information. From this point forward the platform operates as the central database and workflow for the team. Pricing is per-gigabyte, per month.

DISCO Review
Review was launched in 2017 and uses AI to give a faster and more accurate review of the most relevant legal documents that have floated to the top during the discovery process. At this point lawyers need to scan and skim documents, and Review reduces the number of lawyers and manhours that process requires. Despite being a newer solution Review is likely used by 10% to 15% of eDiscovery customers (which is a requirement for using Review). The product likely accounts for 5% to 7% of total revenue. Pricing is per-gigabyte, per month.

DISCO Case Builder
Just launched in 2020, Case Builder it a tool built specifically to help prepare teams of lawyers for litigation. Legal teams use Case Builder just like sales teams use collaboration software, except in this case the content revolves around witness testimony, video depositions, transcripts, exhibits, etc. instead of information from sales-related calls, meetings, and emails. Case Builder doesn’t contribute much revenue yet but it likely will in time. Notably, since it is a system for lawyer collaboration and for automating deposition management the target user is somewhat different than eDiscovery and/or Review, so the sales motion is a little different. Case Builder pricing is based on a traditional, per-seat subscription model.

Growth Initiatives
Sales & Marketing Investments: DISCO is investing heavily in sales capacity to drive growth since there appears to be more than enough demand. The sales team has grown by 50% over the last four years, is expected to grow by another 50% by the end of 2021 and continue to ramp up from there.

Grow International: International is less than 5% of revenue but grew by 150% in 2020. Clearly there is room to expand overseas, and DISCO is putting boots on the ground to make that happen.

Growth Through Software AND Legal Services: DISCO offers law firms a better mousetrap than legacy software vendors, and it offers corporate clients the chance to break their dependence on legal service providers. This creates immense opportunities as the value proposition is different from much of what is currently on the market.

Growth Through Network Effect: Lawyers move firms and work with other lawyers all the time. As word spreads of a great solution made for lawyers by lawyers, there’s potential for DISCO to become a solution almost everyone uses. Because these law firms pass through the usage costs to clients they also act as a sales partner.

New Solutions: Both Review and Case Builder are relatively new products and together generate less than 10% of total revenue. But it’s not out of the question that a customer that starts with eDiscovery and expands to both Review and Case Builder could double (or more) their spend with DISCO.

The Business Model
DISCO generates roughly 85% of revenue based on a usage model. The number of users doesn’t matter. The more data a client feeds into the DISCO platform the more they pay. The remaining 15% of revenue is from a subscription model that includes certain levels of usage. This business model creates very low barriers to entry. However, revenue can be lumpy at times, depending on how busy clients are.

Law customers pass usage charges on to customers, thereby acting as sales partners (it’s normal for law firms to suggest various partner solutions to their clients). The primary sales effort is to land new clients then sell them more solutions and help them ramp up the share of eDiscovery spend allocated to DISCO.

The Bottom Line
DISCO has not reported since coming public. It grew revenue by 41% to $68.4 million in 2020. In the most recent quarters (Q4 2020 and Q1 2021) revenue grew by 35% ($19.2 million) and 35% ($21.1 million), respectively. The company is not profitable, and likely won’t be for several years given investments in sales and marketing. Adjusted EPS was -$0.05 over each of the last two quarters.

Management reports the first quarter as a public company today, after the bell. Given that guidance was provided in the S-1 I don’t expect any huge surprises. That said, one would hope (expect) that management was conservative in their guidance to set DISCO up for a beat-and-raise cadence.

In Q2 (ended June 30) analysts expect revenue to grow by 85% to $29.1 million and for adjusted EPS loss of -$0.18. That supernormal growth rate is due to a couple of significant cases/new clients. Current consensus for full-year 2021 is for revenue to grow by 46% to $100 million and for adjusted EPS loss of -$0.76. In 2022 revenue is seen up 30% to $130 million.

Stepping back, we should expect 30%+ growth for several years and, given 70% gross margins, the ability for DISCO to be profitable sooner rather than later but for management to prioritize investing in growth, thereby pushing profits out several years.

The company has no debt and should have had around $47 million in cash at the end of June. Factoring in IPO proceeds (about $220 million) and cash needs in the second half of the year DISCO should end the year with around $245 million in cash.

Risk
Legal Service Providers/Prof. Service Firms: These companies (Deloitte & Touche, KPMG, etc.) have existing relationships with many corporate clients and could develop internal eDiscovery platforms and/or work with other eDiscovery providers (like Relativity) to retain and/or grow their client base.

Sales & Marketing, R&D Missteps: Growing the sales force, and executing on sales goals, is key to this growth story. If the team doesn’t get the job done the stock could suffer. Same goes for new product development, which is part of the long-term growth story.

Legacy Providers Could Step Up: There are several eDiscovery software vendors and it’s always possible that one or more could step up their game and/or disrupt the market with new offerings.

Consumption Model Pros/Cons: It’s not currently difficult to swap eDiscovery platforms. If clients were to start disliking the consumption model they could step back from DISCO. Also, with 85% of revenue tied to consumption and the inherent challenges forecasting legal spend there is potential for some lumpiness in revenue.

New IPO, Not Profitable, Reports Q2 Today: LAW is part of the crop of 2021 IPOs that are strong now but could easily falter if investors pull in their risk tolerances or step back from growth-oriented names. Adding a Q2 report into the mix this afternoon raises the likelihood of near-term share price volatility.

Competition
DISCO competes with both legacy, on-premise software providers, modern SaaS providers, and legal service providers. On-prem competitors include Relativity (probably the biggest name in the industry), Open Text and Nuix. SaaS providers include Relativity One, Everlaw, Logikcull and Reveal. Legal service provider competitors, most of which use either the on-premise or SaaS solutions from Relativity, include Deloitte & Touche, FTI consulting, Ernst and young, KPMG, PwC, Epiq, Consilio, KLDiscovery, UnitedLex and LightHouse.

The Stock
Trading Volume: Including the IPO day (4.9 million shares traded) daily average volume works out to around 400,000 shares. As a practical matter we’re seeing closer to 200,000 shares trade hands on a “normal” day.

Historical Price: LAW came public at 32 on July 21 and rose 28% the first day. The stock then traded in the 40 to 45 range before an early-August rally carried it briefly above 55. Since August 16 LAW has traded mostly between 50 and 55, with a few days closing slightly above and below that range.

Valuation & Projected Price Target: LAW trades with an EV/2022 Revenue multiple of 23 (assumes $130 million in revenue). That’s above the average multiple of roughly 16.5-times for a broad sample of SaaS peers, but not out of whack as compared to other high growth stocks (DDOG, SHOP, TEAM, ZS, BILL, etc.). LAW could easily trade up to a multiple of 25 to 30. Should revenue growth come in ahead of expectations a higher multiple on higher sales would validate an even higher share price. For now, we’ll assume a multiple near 27 is about the peak, which implies a share price around 65.

Buy Range: We are starting with a half position in LAW near the current price and I will update our buy range via Special Bulletin tomorrow, after we have today’s Q2 earnings result.

The Next Event: Management is expected to present Q2 2021 results after the closing bell today, September 2.

LAW-Company Profile

LAW-Financials

LAW-090121

Updates on Current Recommendations

Stock NameDate BoughtPrice BoughtPrice on 9/1/21ProfitRating
Accolade (ACCD)8/6/20404820%Buy
Arena Pharmaceuticals (ARNA)2/2/18395746%Buy
Avalara (AVLR)2/1/1940186365%Buy
Cerence (CRNC)10/1/2050113127%Buy
CS Disco (LAW)New54Buy
Everbridge (EVBG)12/2/1616161941%Buy
Fiverr Intl (FVRR)3/5/2032179453%Buy
Inspire Medical (INSP)10/4/1959224283%Hold
JOANN (JOAN)8/6/211513-14%Buy
Kornit Digital (KRNT)3/4/2110213027%Buy
On24 (ONTF)7/1/213822-41%Buy
Q2 Holdings (QTWO)4/1/162490279%Hold
Repligen (RGEN)11/2/18 and 12/31/1859286383%Hold
Revolve Group, Inc. (RVLV)4/1/21466236%Hold
Sprout Social (SPT)9/3/2036121232%Hold
Thunderbird Entertainment
(THBRF, TBRD.V)
5/6/213.83.5-9%Buy

Please email me at tyler@cabotwealth.com with any questions or comments about any of our stocks, or anything else on your mind.

Glossary
Buy
means accumulate shares at or around the current price.
Hold means just that; hold what you have. Don’t buy, or sell, shares.
Sell means the original reasons for buying the stock no longer apply, and I recommend exiting the position.
Sell a Half means it’s time to take partial profits. Sell half (or whatever portion feels right to you) to lock in a gain, and hold on to the rest until another ratings change is issued.

Disclosure: Tyler Laundon owns shares in one or more of the stocks mentioned. He will only buy shares after he has shared his recommendation with Cabot Small-Cap Confidential members and will follow his rating guidelines.


The next Cabot Small-Cap Confidential issue is scheduled for October 7, 2021.

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