C3.ai: Riding The AI Wave, With Fading Margins? Not I (NYSE:AI)

MotionIsland Investment Thesis C3.ai, Inc.’s (NYSE:AI) investment thesis has enough for both sides of the argument. Needless to say, a compelling story comes into play. But also, the fact that C3.ai has no debt and nearly 20% of its market cap is made up of cash, can’t be brushed away. That being said, the business is already priced at 9x sales. How much more multiple expansion are investors hoping to get for a business that, for every $4 of revenues, burns through about $1 dollar of non-GAAP losses? Furthermore, I believe that its path to profitability is still a few years away. Consequently, I remain neutral on this stock. Rapid Recap In my previous analysis, back in April, I said, C3.ai has the makings of a poor investment. Indeed, the only reason why I don’t issue a sell rating on its stock is that its balance sheet doesn’t carry any debt, and hence issuing a sell rating on a stock with a clean balance sheet is a risky recommendation. That being said, notwithstanding its debt-free balance sheet, I argue that its stock is overvalued for what it offers investors and that this stock is best avoided. Author’s work on AI I’ve been neutral on this stock for a while. The stock, as you can see above, has been very volatile. And while there are some positive aspects to consider in this stock, I charge that there’s not enough to this name to warrant my investment. Here’s why. C3.ai’s Near-Term Prospects C3.ai specializes in providing enterprise AI applications. These applications are built to help large organizations optimize their operations by leveraging the entire AI value stack, from infrastructure to advanced machine learning models. C3.ai offers a range of solutions, including predictive maintenance, supply chain optimization, and energy management, making it easier for businesses to implement and benefit from AI without having to develop these complex systems in-house. In the near term, C3.ai’s prospects appear solid, driven by the market’s demand for AI applications. The company reported significant revenue growth, with subscription revenue surging by 41% y/y in fiscal Q4 2024. Additionally, C3.ai has expanded its customer base across various industries, including federal, defense, and aerospace sectors, and continues to see high interest in its generative AI products. Nonetheless, C3.ai also challenges. For example, C3.ai is transitioning to a consumption model, which has resulted in a decline in average total contract value and reduced remaining performance obligations. I’ve discussed my views on companies that transition to a consumption business model numerous times. I won’t rehash it now. I will simply point out the pay-per-view versus Netflix (NFLX) business model. One where your customers are rewarded with a good service for using the platform, and the other where they are rewarded with a bill. What will increase customer satisfaction? Given this balanced background, let’s now discuss its fundamentals. C3.ai’s Revenue Growth Rates Point to +30% CAGR AI revenue growth rates C3.ai’s guidance points to solid growth ahead. Not only is fiscal 2025 expected to see more than 30% CAGR on the top line, but this is an acceleration from the prior year. And naturally, that’s something that is incredibly compelling. If one were to add some nuance to this interpretation, one could declare that the comparables with the prior year are low enough that it is rather easy for C3.ai to point towards 32% top-line growth for its current quarter, fiscal Q1. Where I believe the plot gets rather more interesting will be how C3.ai continues to deliver strong growth rates against the remainder of its quarters of the prior year. To summarize, the setup here is that this isn’t black or white for either the bulls or the bears. There’s undoubtedly growth coming for C3.ai, but how it shakes out, is where things will get interesting because its hurdle is high, starting fiscal Q2 2024. Given this context, let’s now discuss its valuation. AI Stock Valuation — 9x Sales As mentioned earlier, this setup is nuanced. There are some positive and negative aspects. The positive undoubtedly zeroes in on its impressive balance sheet. Case in point, C3.ai holds approximately $750 million of cash and no debt. This means that more than 20% of its market cap is made up of cash. That’s just so bullish, that this consideration alone prevents me from putting a sell rating on this name. And yet, here’s the core of my negative thesis. Two aspects are worth discussing. Firstly, the business’ gross margins are not expanding with increased scale. This is troublesome. AI fiscal Q4 2024 As you can see above, its non-GAAP gross margins have compressed by 400 basis points y/y. That immediately puts pressure on the multiple that C3.ai will get. More concretely, investors are more than willing to pay a higher multiple, for a business that demonstrates a path to profitable scalability. But this business appears to become less profitable the bigger it becomes. Secondly, in the best-case scenario, as C3.ai scales up over the coming year, its losses will be roughly flat with the prior year. This means that C3.ai’s non-GAAP operating losses will be around $90 million, give or take. For a business that’s expecting around $400 million in revenues, to incur non-GAAP losses of around $90 million, means that its path to profitability is still a far distance away. The time to back growth stocks, with a compelling AI story will come to an end, as investors start to become more discerning and aware that AI will be used in all areas of our life, and that just having an attractive ticker doesn’t automatically make it commensurate with an attractive return. The Bottom Line In conclusion, while C3.ai offers a compelling story with its debt-free balance sheet and significant cash reserves, I remain cautious. The high valuation at 9x sales and the company’s struggle with profitability amid impressive revenue growth raise concerns. Despite the solid near-term prospects driven by market demand for AI applications, the transition to a consumption model and compressing gross margins make me wary. Given these factors, I find it prudent to remain neutral on C3.ai, Inc. stock until there is clearer evidence of sustainable profitability and scalable growth.

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