Description

PATH – Investment Thesis

June 2022

All figures presented in US$ millions, except for per share data

All share price data as of market close, 6/28/22

The software sell-off provides an opportunity to invest in a cash flow generative, market share leader growing north of 30% with 98% gross retention at a compelling valuation with downside protection when structured through the sale of puts.

UiPath Inc. (“PATH” or the “Company”) is a leading Robotic Process Automation (“RPA”) vendor.  PATH stock currently trades at $20.02.  We are proposing a long position expressed through the sale of January 2023 $20.00 puts, which at the current price of $4.10, generates an annualized return of ~46%^[1] if PATH’s share price remains above $20.00.  This trade provides 100% principal protection so long as the share price declines less than 21%.

Recognizing that revenue multiples are no longer in vogue, at the $15.90 effective conversion price – i.e. the price at which the investor would be required to purchase the shares – investors are underwriting to a 4.7x FY24 ARR multiple (year ending 1/31/24)^[2].  

Assuming “normalized” EBITDA margins of 40% and 30% forward growth, we think fair value is materially higher than the current share price (~44%+).  If you find these assumptions unfitting for VIC, we more than understand and hope you will forgive us.

Situation Overview:

PATH provides an automation platform that helps enterprises discover, run, and measure automation opportunities within an organization.  Since the Company’s introduction of its enterprise RPA platform in 2015, PATH has grown ARR at a CAGR of ~68% over the past three years and is the #1 share player in the RPA market.  

PATH is facing several headwinds that are weighing on the stock: 1) Potential slowdown in sales to European customers, which represent ~30% of total revenues, 2) negative FX impacts, and 3) change in sales leadership.  As a result, management’s FY23 guidance is for ARR to grow ~30%, a deceleration from ~60% in FY21-FY22.  These headwinds, matched with industry concerns around competitive dynamics and the broader tech sell-off, have led to a ~75% share price decline since the Company’s IPO in April 2021.  

Consistent with PATH’s focus on profitable growth, on June 27th, management announced a ~5% reduction in headcount, increased FY23 operating margin guidance, and reiterated FY23 revenue and ARR guidance.

We believe: 1) Despite a challenging market backdrop, secular demand for RPA offerings will continue to drive 30%+ ARR growth, even if enterprise IT budgets shrink.  2) With >80% gross margins and FCF forecasted to be neutral/positive this year, the strength of PATH’s operating model should separate it from unprofitable software names.  3) PATH’s best-in-class RPA offerings are robust against competitive solutions and will continue to take market share.  

We recommend selling PATH’s January 2023 $20.00 puts for an annualized return of 46% and 21% downside protection.

Investment Thesis:

1. Management guided to FY23 ARR growth of 30% (vs. 59% in FY22).  This now appears conservative given 50% growth in Q1

PATH guided to 30% ARR growth in FY23 (midpoint of $1,205m in ARR) on the Q4 FY22 earnings call.  While ARR growth was expected to decelerate (given PATH’s increasing ARR base), this missed consensus estimates of 36%^[3], sending shares down 26% following the announcement.  

Management noted three headwinds impacting FY23 ARR:

• Write-down of Russian business: $15m ARR headwind
• FX: $20-25m ARR headwind
• Large deal uncertainty: Unquantified ARR headwind from macroeconomic uncertainty in Europe and some impact from the sales leadership transition

With 30% of the business in Europe, the market appeared particularly concerned about the impact of European macro on large deals.  The impact from the sales leadership transition also raised questions about the extent of go-to-market changes.

As one of the first software companies to attempt to quantify the potential impact of the war in Ukraine, PATH was understandably conservative with ARR guidance, particularly in the face of rapidly contracting software valuations.  However, management indicated at that time that there were no pauses in the pipeline or any slowing of budgets^[4].

Guidance proved to be conservative when the Company reported ARR growth of 50% YoY in Q1 FY23.  After adjusting for quantified headwinds, FY23 ARR guidance was raised to 37% YoY growth, above initial consensus estimates.  

Management has since indicated they are seeing a more normalized spending environment (as executives become more accustomed to the macro environment) and higher customer prioritization for automation products (given a focus on driving productivity to fight inflationary impacts)^[5], suggesting continued deal materialization through the year.

2. PATH continues to be on a clear path to profitable growth at scale, driven by low capital intensity and an improving operating profile.  Recent executive changes and ongoing operating initiatives should help the Company drive positive FCF and target operating margins of 20%+

Despite growing ARR at a 62% CAGR between FY20-FY22, PATH is at a major inflection point, having driven 8% adjusted operating margins and neutral adjusted FCF in FY22.  Longer-term, the Company has indicated a target model of 80%+ gross margins and 20%+ operating margins, driven by 30-35% S&M margin, 12-18% R&D margin, and 7-9% G&A margin^[6].

Figure 1^[7]

The key driver of long-term FCF is PATH’s ability to leverage S&M expense.  Given a 139% net retention rate (“NRR”) and a 98% dollar-based gross retention rate, we expect material sales leverage.

As the Company approaches $1bn in ARR, management is now focused on driving profitable growth^[8].  Recent C-suite appointments support this change in focus, with new additions (Co-CEO and Chief Business Officer) having clear experience scaling enterprise technology companies.

The Company has guided to positive operating profits and neutral/positive free cash flow in FY23, with several ongoing operating initiatives that should help drive profitability going forward, including:

• Cloud Transition: Cloud offerings have grown rapidly since their introduction in FY21 to over $140m in ARR (inclusive of both hybrid and SaaS deployments), representing ~15% of total ARR (Q4 FY22).  This is the fastest growing portion of the business, representing 55% of new logos^[9] and doubling YoY in Q1 FY23.  With very strong 80%+ gross margins for the cloud business, the Company should see greater operating leverage as this business continues to scale

• GTM Strategy: Driven by new sales leadership, PATH announced a simplified GTM strategy in Q1 FY23.  Going forward, the Company will be focused on expansion through a higher touch model in key accounts that have not previously had dedicated attention.  Cohort analysis indicates that total ARR / landing ARR is 62x and 233x for the top 100 and top 25 customers, respectively^[10], indicating a large opportunity for further expansion.  The new GTM strategy is also focused on driving new logos through digital sales and expanding the partners/channel ecosystem, both of which should drive margins

• Restructuring: Following substantial headcount investments in FY22, PATH recently announced a $15m restructuring program in which they will reduce the global workforce by ~5% and engage in other operating efficiency measures.  No impact is expected to FY23 ARR

3. Despite increasing competition in the space, most notably from Microsoft (“MSFT”), concerns around the commoditization of PATH’s offerings have not materialized.  PATH’s platform is more technologically capable and stickier than the market appreciates

The RPA industry is fragmented and has seen competition intensify in recent years.  The major competition vectors can be seen below:

• RPA Vendors: Other than PATH, traditional RPA vendors include Blue Prism (“PRSM”) and Automation Anywhere (“AA”).  These three companies make up the majority of the industry, with PATH at 34% market share, PRSM at 10% market share, and AA at 9% market share^[11].  PATH’s best-in-class, truly end-to-end solution should continue to drive market share gains from these traditional competitors

• Business Process Management (“BPM”) Solutions: BPM companies offer some automation solutions as an extension to their core platforms (focused on improving and optimizing business processes).  In contrast to RPA solutions that reside above the application layer and focus on mimicking the way a human user interacts with their desktop (i.e. UI), BPM automation is limited in that it focuses on the backend and relies heavily on API integrations.  Competitors include Appian and Pegasystems

• Automation Point Solutions: Companies that offer specific automation solutions that are adjacent to traditional RPA offerings (e.g. process mining, test automation, etc.), but not end-to-end.  PATH is increasingly competing with these point solutions as the Company expands its product suite.  Competitors include Celonis, Hyperscience, and ABBYY

• Enterprise Platform Incumbents: Platform vendors with large enterprise customer bases that have entered the RPA space (generally through acquisitions or partnerships), including MSFT, ServiceNow, Salesforce, and SAP

PATH primarily competes against PRSM, AA, and MSFT.  The Company sees ServiceNow, Salesforce, and SAP in less than 1% of opportunities^[12].  

Gartner’s Magic Quadrant shows PATH as the leader in the RPA market, with Gartner highlighting the Company’s product strategy (end-to-end strategy focused on enterprise automation), UX focus (including ease of use), and customer/partner ecosystem.  PATH’s leadership position is further supported by channel checks and equity research, which consistently mention PATH’s time to value, high ROI, and scalability as additional differentiators.  

Figure 2^[13]

Analysis of key competitors is below:

1. PRSM (acquired by strategic acquirer SS&C Technologies following a bidding war with Vista Equity Partners) - £184.8m ARR at 10/31/21 (~$225m, 20% YoY growth, 117% NRR)

PRSM is a UK-based company, primarily focused on the financial services vertical.  PRSM has struggled to keep pace with the rate of innovation of PATH and AA as the RPA market has evolved.  Product feedback for PRSM’s Intelligent Automation Platform often references limited attended (i.e. user-managed) RPA capabilities, unintuitive/complex UI, and lack of complimentary product offerings, including low-code development and API/AI integration.  PRSM was taken private in March 2022 by SS&C Technologies for ~$1.6bn, which has led to some migration away from the platform and continued displacement by PATH^[14].  The Company has recently noted that PRSM has faded out over time and is not seen often in new opportunities^[15].  

2. AA (private) - ~$200m revenue^[16]

AA is PATH’s most direct competitor, with both attended and unattended automation on its enterprise-focused Automation 360 platform.  Like PATH, AA offers adjacent RPA offerings to expand use cases, including low-code development, process discovery tools, and AI/ML.  Automation deployment is flexible (cloud, on-prem, or hybrid), and, notably, AA has a partnership with Google Cloud where the companies jointly develop AI and RPA solutions.  

Despite AA offering an end-to-end automation solution, customers cite better product roadmap execution, fuller product capabilities (particularly around attended automation and process discovery), and ease-of-use for PATH^[17].  This is in line with IR’s comments that PATH is the more end-to-end platform^[18] and management’s comments that PATH continues to replace AA^[19].  

3. MSFT

As a leader in Gartner’s Magic Quadrant for RPA, MSFT has made significant strides since it first entered the market in 2019.  In 2020, MSFT acquired Softomotive, and soon after, made its Power Automate Desktop product free, offering limited RPA capabilities for all Windows 10-11 users (with additional costs for cloud deployment, API integration, and AI/ML).  More recently, MSFT has expanded into process mining capabilities with its acquisition of Minit in March 2022.

While a commonly cited headline risk factor for PATH, MSFT’s RPA offerings are focused on citizen developers and personal productivity in contrast to PATH’s comprehensive, enterprise-level solutions.  MSFT has previously indicated that “hundreds of thousands of organizations” are using the Power Automate platform^[20] vs. PATH’s 10,330 total customers.  Despite limited financial disclosure, MSFT appears to have many smaller organizations on their platform with lower total RPA spend per customer.

In spite of MSFT’s enterprise relationships and entering the market three years ago, MSFT is a distant competitor with only ~2% market share^[21].  The Company indicates they only see MSFT in a small part of their addressable market, and generally down market^[22].  Additionally, PATH has indicated they are not seeing incremental pricing pressure for their software^[23], ^[24].  CEO Dines talks about the competitive dynamic below, explicitly indicating MSFT is not building “enterprise automation.”  

Figure 3^[25]

Dines also discusses the key reasons MSFT is not set up to compete in the enterprise space below:

• Focus on attended automation: Channel checks indicate MSFT is still a minor player in the unattended automation space, limiting enterprise-level use cases.  Dines refers to unattended automation as half of PATH’s business

• Rigidity in deployment/connectors: Automation inherently is a market that lends itself well to application/cloud agnostic platforms, given cross functionality drives end-to-end automation.  Power Automate is naturally heavily focused on MSFT-based applications, and can only be deployed through MSFT’s public cloud (no on-prem deployment)

Figure 4^[26]

While our independent channel checks note that MSFT has made significant progress, they consistently support Dines’ claims.

Even if MSFT and other competitors were able to build enterprise-level capabilities in the future, automation solutions are very sticky.  As indicated by PATH’s NRR, customers on the platform rapidly add incremental automations and use-cases, locking them into the ecosystem.  PATH services 63% of the Fortune 500 (including 8 of the top 10)^[27] with 98% dollar-based gross retention.  As an early mover in the space, we believe having a head start in penetrating these large accounts gives PATH a competitive advantage over newer companies, particularly in terms of switching costs and data collection (usage patterns, feedback, etc.).

4. With the product suite expanding to RPA adjacent offerings, PATH’s end-to-end automation platform is driving win rates and differentiation relative to other providers.  Key focus areas include process mining and task mining

By expanding its product offerings to include API management and AI-based computer vision, PATH has differentiated itself through its truly end-to-end automation platform.  Per Forrester’s RPA Inquiry Spotlight 2022 report, Forrester received 410 RPA inquiries between February 2020 and December 2021, with PATH receiving more than any other competitor (2.7x the next closest vendor).  72% of total conversations focused on automation platforms^[28], highlighting the increasing importance of the fulsome automation suite for customers.

PATH breaks out its platform into six key automation functions: Discover, build, manage, run, engage, and measure/govern.  Key products for these functions, along with a short description of each, can be seen below.

Figure 5^[29]

PATH has emphasized process mining and task mining as key products because they functionally start the automation flywheel by identifying areas of potential improvements that could be candidates for automation opportunities at high ROIs.  Together, these products fully detect the key aspects of various business processes within customers’ existing business workflows using both back-end and front-end solutions.  Gartner’s recent CFO survey, which included 400 respondents, noted that CFOs see investment in process mining as key to unlocking RPA returns^[30].

Figure 6^[31]

Process mining and task mining are seeing strong uptake within PATH’s customer base, growing much faster than the Company’s already fast-growing core business^[32], supporting Gartner’s findings.  Today, PATH is the #2 player in the process mining space^[33] behind Celonis^[34], highlighting the Company’s strength in identifying and subsequently selling adjacencies into their customer base.  

Valuation:

PATH lacks public company comparables, as the one direct public competitor, PRSM, was taken private at an estimated valuation of ~5x NTM ARR.  PRSM was growing 20% YoY vs. PATH’s 50% YoY growth, was 1/4th the size of PATH, and was having execution issues.  

While we may have drunk the growth Kool-Aid here, given the high growth rate and scalability of the business, we have derived our valuation based on forward ARR 3.5yrs out.  We calculate ending ARR of ~$2.6bn in FY26, implying a 30% ARR CAGR, and apply a normalized 40% EBITDA margin.  Given PATH’s 80%+ gross margins, incumbent position in the market, and operating leverage given its expansion-driven model, we believe PATH could produce EBITDA margins as a steady-state business in line with other best-in-class enterprise software companies.  Management’s current long-term operating margin target is 20%+, which includes investments in growth and 30-35% S&M margins^[35].

Below we have applied a 20x EBITDA multiple to our FY26 normalized EBITDA estimate (discounted back at 10%).  This gets us to a share price of $28.85, ~44% above the current trading price, highlighting a favorable risk/reward in the context of our proposed trade structure.

Figure 7^[36], ^[37]

Company Overview:

Business

Founded in 2005 by Daniel Dines, current co-CEO, and Marius Tirca in Bucharest, Romania, PATH has quickly grown to become the leader in RPA.  The Company’s RPA offerings seek to displace the vast number of manual, repetitive processes that exist in traditional business workflows.  Despite the ubiquity of technology within enterprises today, a significant number of employee hours are spent on time-consuming functions such as data entry and reconciliations.  

Figure 8^[38]

Legacy automation solutions were inadequate in solving these problems in a cost-effective and efficient manner.  Automation had been technologically limited to individual applications, preventing automations which spanned the application layer.  Over time, automation techniques began to allow for rules-based processing, primarily through the use of APIs, but these solutions also lacked flexibility (restricted by which APIs were available).

In contrast to these legacy back-end offerings, RPA was the first automation technology to shift focus to the front-end.  By attempting to mimic the keystrokes of a human user, RPA emulates the way in which an employee would navigate a particular workflow, including logging into applications, manipulating data, and executing transactions.  By sitting above the application layer, RPA greatly expanded automation use cases.  

RPA scripts, which the industry refers to as “bots” or “robots”, are of two types which vary in the amount of human input required to complete a particular workflow: Attended and unattended.  

Attended bots aim to supplement employee labor.  Unattended bots aim to replace employee labor by completely automating tasks.  

Figure 9^[39]

PATH illustrates an insurance claims processing use-case below, in which four of PATH’s robots can increase monthly claims processing by ~5x and reduce human effort by 80%.  

Figure 10^[40]

PATH utilizes a land-and-expand model to grow by focusing on proof-of-concept (“POC”), often in use cases with quick time to value (a couple of weeks to a couple of months), such as the example above.  

Most commonly, an initial, simple automation is built that can be used day-to-day and improve efficiencies.  Over time, employees begin to build their own automations.  Channel checks and equity research indicate typical ROI on initial POC often in the range of 50-60%^[41], which drives expansion to other departments across the organization quickly.

Figure 11^[42]

PATH’s industry-leading retention rates support expanded customer usage over time.  The cohort analysis below highlights how ARR from PATH’s top 50 customers increased by a median multiple of 81x vs. the ARR generated in each customer’s first month as a customer, with earlier cohorts continuing to increase spend over time.  

Figure 12^[43]

PATH’s customers span several industries, demonstrating the broad-based applicability of the Company’s offerings.  

Figure 13^[44]

Product Suite and TAM

PATH’s vision is to enable what it refers to as the “fully automated enterprise”, representing companies where automation will be integral to their operations.  In addition to UI automation, PATH’s offerings are increasingly focused on API management (particularly helpful for high-volume transactions) and AI-based computer vision (which helps better emulate human users and solves for the long-tail of manual processes).  PATH believes these three automation pillars can help the platform effectively discover, run, and measure automation opportunities across use-cases.

Bain suggests that the expansion of automation platforms by incorporating broader capabilities such as those mentioned above has increased the size of the addressable market for automation software to approximately $65bn^[45].  This is in line with management’s TAM estimate of $60bn, based on their bottoms-up build seen below, indicating a large greenfield opportunity relative to PATH’s current ARR:

Figure 14^[46]

The Company has rapidly innovated in its product suite since 2015.  PATH provides more details on each of its products in its S-1.  Key offerings are listed below:

• UiPath Studio (“Studio”): Drag-and-drop robot development platform designed for individuals ranging from professional software developers (Studio Pro) to professional RPA developers (Studio) to citizen developers (StudioX)
• UiPath Robots: RPA scripts (both attended and unattended) that emulate human behavior
• UiPath Orchestrator (“Orchestrator”): Allows for the deployment, tracking, and logging of robot activity

Pricing and Deployment

Research indicates PATH’s pricing model to be based on the following factors:

• Seat-based fees based on the number of users provisioned to use the platform
• Capacity fees based on the number of robots being used
• Platform component fees based on the specific features (i.e. products) active on the platform

RPA has historically largely been deployed on-prem (given sensitive internal data automation and UI automation requiring access to physical/virtual desktops).  As a result, the vast majority of PATH’s revenue today is from term licenses and associated maintenance and support revenues.  

In FY21, the Company began selling hybrid and cloud solutions.  Today, customers can deploy PATH’s solutions on-prem, in public, private, or hybrid cloud environments, and on Automation Cloud, PATH’s managed, multi-tenant offering.  Importantly, PATH implements a deployment-agnostic pricing model (i.e. universal pricing across deployment types), such that customers are able to choose how they want to deploy PATH’s products without being constrained by pricing.  PATH sees deployment choice on their platform as a key differentiator relative to cloud-only deployment competitors.

Risks:

1. New competitors in the RPA industry could drive pricing pressure and increase customer churn

Increasing competitive pressures from RPA players and companies in adjacent industries entering the space could drive pricing pressure and higher than normal churn for PATH.  However, PATH’s quick time to value, enterprise-level capabilities, and incumbency with large accounts give us confidence in the Company’s competitive positioning, with no pricing pressure seen thus far

2. Macro environment could drive a slowdown in large RPA deals

Current macro could drive a slowdown in enterprise-scale deals across domains, including RPA, but the inflationary environment thus far has driven an increased prioritization for PATH’s solutions (50% YoY ARR growth in Q1 FY23)

3. Execution risks surrounding product innovation and GTM

PATH’s continued growth requires successful execution to capitalize on the growing RPA industry, particularly with regards to the Company’s product roadmap and new GTM strategy

4. Loss of RPA relevance long-term

RPA solutions could be increasingly obsolete as manual processes within legacy applications/systems are eliminated through out-of-the box solutions from original vendors. This is unlikely in the near/medium-term, with extensive opportunities currently for process automation

Catalyst

• Continued ARR growth above conservative FY23 guidance
• Progress towards operating initiatives (including GTM strategy and restructuring) driving margins
• 2022 Investor Day (9/27/22)