C3.ai's decline will likely continue if the fundamentals don’t improve

"The second half of this year is expected to be different and more challenging than the first half. In the first six months of 2023, stocks across the board soared amid the AI hype. Both high and low-quality names surged during this period as the AI boom created a mini-bubble. Yet, after a brief period of AI euphoria, investors are now refocusing on fundamentals and penalizing stocks that rose purely on AI hype. It seems that AI company C3.ai ($AI) is one of them.

Shares of this AI company have fallen over 52% in the past three months due to disappointing fundamental performance. Losses accelerated after C3 released Q2 earnings results in early August, which showed a lack of growth momentum despite the AI boom and continued deep losses.

The selloff that began in early August is likely not over yet, as C3's fundamentals remain poor, and there are no signs that the company is benefiting from the AI boom, despite being an AI company. Coupled with the lack of profits and continued shareholder dilution, this stock appears to be an easy sell. Let's see why.

No Clear Business Strategy, Poor Customer Metrics

Even after the recent selloff, AI stock is still up 111% year-to-date. However, this rally is driven by AI hype rather than the company's underlying fundamental performance. Its financial and business metrics are unusually complex, making the business difficult to analyze. For instance, we don't know exactly how many customers C3 has, as it has recently changed the definition of 'customer'. This lack of clarity suggests that the company lacks a clear growth strategy and is uncertain about the type of customer to focus on and how to price its services. The latest definition of 'customer' is this:

As you can see, the company includes paid trials in the customer count, just because they generate revenue during the pilot period. Based on the above definition of 'customer,' C3 had 287 total customers in the previous quarter, and in the most recent quarter, its total 'Customer Engagement' was 334, which includes paid trials and real customers.

Confusing reporting aside, C3 doesn't seem to be benefiting from the AI boom. The company does reveal the number of deals it closes every quarter, and there's no sign of growth momentum. As you can see below, in Q1 FY24, it closed 32 new deals with an average total contract value (TCV) of $0.8 million. By contrast, in the same period last year, it closed 31 deals but with an average TCV of $1.4 million, or 75% higher. This is concerning, as the company is struggling to grow amid the AI boom.

Continued Weak Top & Bottom Line Performance

C3 is growing extremely slowly, which is a red flag for the business, considering we're in the midst of an AI revolution, and companies that are leaders in their spaces like Samsara ($IOT) and Nvidia ($NVDA) are experiencing significant demand and rapid growth. Yet, C3 reported revenue growth of just 10.8% in the most recent quarter to $72.3 million, which is rather disappointing. While the company expects growth to accelerate in the next quarter to 19% at the midpoint of the expected range, the full-year outlook suggests revenue growth in the mid-teens, which doesn't reflect the demand environment for AI applications. For some reason, C3 doesn't seem to be benefiting from the AI boom, as the company's growth rates are much lower than other AI companies.

The transition from a subscription to a consumption-based business model is certainly impacting the growth rate in the near term. In the bull case, the new customers that are now starting off slowly will expand their spending over time, ultimately spending more under the consumption-based model. As you can see below, the company says that it's at stage four of its transition, where consumption-based customers are slowly starting to increase their spending.

This transition will prove successful if C3's growth rates rise and stay above 20% for the next couple of years, which is required for the company to be considered 'high growth.'

In the near term, revenue growth is not expected to significantly pick up, and combined with the deep losses and shareholder dilution, it's a toxic combination for investors. In the most recent quarter, C3 reported an operating loss margin of -102%, which is terrible, only slightly improved compared to the -112% margin in the year-ago quarter. While operating expenses fell 4% y/y during the quarter, the cost of revenue spiked 73% due to the increase in pilots that generate low or no revenue for the company but increase its costs.

Even on an adjusted basis, C3 delivered an adjusted operating loss of -28.6% in Q1, vs. a -22% margin in the year-ago quarter. The significant deviation between the adjusted and non-adjusted operating margin is caused by C3's high stock-based expense, which results in significant shareholder dilution. Its operating cash flow (OCF) in the most recent quarter was $3.9 million, but this positive figure is misleading. 44% of all operating expenses in Q1 were in the form of stock-based compensation, which helped C3 deliver an artificially positive OCF. In reality, C3 is still deeply unprofitable, and it appears to rely on stock-based comp to conceal its weak bottom line, at the expense of investors.

What Else

C3 is an unusual and controversial growth story. Its growth rates certainly don't reflect the growth of the AI market, which raises questions about the company's ability to win and gain market share in this high-growth space.

$AI is not cheap, as it has more than doubled so far this year, but its fundamentals haven't caught up with the stock. If the weak fundamental performance continues, there's significant downside risk. But if the transition to the consumption-based model proves successful and revenue growth accelerates to over 20%, AI stock may rise again. For now, it's a risky and speculative AI play.

I’ve no positions in the stocks mentioned.

The boring Disclosures: Newsletters express the opinion of the authors. Nothing in this email is a buy or sell recommendation. I'm not a financial advisor; make your own decisions.