Sumo Logic Stock: Valuation Is Too Rich (NASDAQ:SUMO)

Investment thesis

I recommend to not invest in Sumo Logic (NASDAQ:SUMO) at this current valuation. I agree that SUMO has a strong value proposition, and it has certainly shown over the past few years that it can execute and grow. The issue I have with SUMO is the valuation. While it has come down quite a bit from its peak, the expected growth over the near term is a lot worse due to a bad macro environment. As such, I think it is safer to invest when the stock price is lower so that we have more margin of safety.

Business overview

SUMO is an analytics and log management service accessible through the cloud. The company’s offerings allow businesses to gather and examine machine data from various virtual sources, including servers, virtualization and security infrastructure, network devices, custom applications, and databases.

Every industry getting disrupted by technology advancements

Almost every industry needs to go digital or risk being disrupted. Customers nowadays demand instantaneous service. Successful businesses understand that in order to keep up with customer expectations, they must consistently provide them with new and improved products and services. Leaders can no longer use ignorance as an excuse for failing to ensure the company’s operational and financial success. In the case of security, this is especially important to keep in mind as businesses digitize and risk both data loss and damage to their reputation. Executives are not the only ones responsible for this sort of accountability. The entire workforce is now tasked with figuring out how to boost intelligence by connecting data islands spread out across the organization’s IT infrastructure and other business procedures.

In order to keep up with rising customer expectations, businesses are increasingly transitioning into software providers by expanding their use of cloud-based applications, automating their processes, and mining data from digital signals. Organizations need to rethink their IT frameworks, development processes, and the use of tools across multiple public cloud providers to facilitate distinct digital services while keeping their data safe. A successful modern company must constantly publish and enhance its offerings or face disruption.

Adopting a multi-cloud strategy is crucial for the success of today’s businesses, in my opinion. Distributed application workloads that can be run in the cloud offer significant benefits to businesses over on-premises alternatives. Companies that are “cloud native” are designed for the cloud from the start, while companies that started out on-premises are making the move to the cloud at a rapid pace. I do think businesses are just starting to adopt cloud services, though.

However, as businesses adopt multi-cloud strategies, they must deal with the complications of managing and protecting a wide variety of environments. Complexity and digital sprawl are exacerbated by the fact that different environments all use their own unique architectures and sets of tools. Because of its inefficiency, complexity, and high management costs, digital sprawl prevents timely decisions from being made. In addition to not being real-time or scalable for the cloud, most technologies on which businesses rely only provide partial data. It is difficult for businesses to glean insight from crucial key performance indicators in cloud environments due to a lack of control and visibility into metrics.

SUMO’s solution

SUMO uses its own unique AI/ML technology to perform real-time anomaly detection and prediction, thereby unleashing the full potential of customers’ data. This helps users get continuous insights even when they are unsure of what questions to ask, as the signal can be easily distinguished from the noise. SUMO provides analytics and insights for a large user base, consisting of both technical and non-technical personnel from relevant departments and other business lines. Workload monitoring, user alerting, anomaly discovery, threat detection, incident response, and customer churn prediction are just some of the many uses for its intuitive dashboards, which can be used as-is or modified easily. In addition, SUMO’s Continuous Intelligence Platform integrates with a wide range of data science tools and technologies, allowing users to glean even more insights and intelligence.

Strong network effects

SUMO’s business model is bolstered by network effects, which drive rapid user growth, an ever-increasing return on investment for platform users, and a long-term competitive edge.

Typically, a customer will start using SUMO after discovering an initial use case. As the first adopter begins to see results from SUMO’s platform, he/she usually share their learnings and work with other groups using SUMO. Therefore, increasing numbers of teams are implementing Sumo Logic and broadening their application scope. As the SUMO platform grows in terms of users and use cases, it will receive increasingly varied data, enabling businesses to draw more robust conclusions. The more people learn, the more people want to use the SUMO platform, and so on and so forth, creating a powerful virtuous cycle.

Additionally, the SUMO differentiated Continuous Intelligence Platform offers customers exclusive visibility into the architectures, procedures, and tools used to develop, manage, and protect today’s cutting-edge applications and infrastructures. With these in hand, SUMO provides its customers with benchmarks and the option to extract anonymized datasets from SUMO for use in projects. In addition, SUMO is able to innovate and fine-tune its solution roadmap thanks to customer feedback on the methods it uses for application development, maintenance, and security. I anticipate that SUMO will keep making use of the Continuous Intelligence Platform to increase the value it offers to its expanding customer base, thereby fostering even more widespread adoption.

Strong sales model

The SUMO sales model targets new customers and encourages existing ones to use the platform more extensively. It is common for customers to add more users and use cases to their subscriptions as time goes on, which in turn generates more data for the SUMO platform and increases the probability of adopting more modules or upgrading the contract. SUMO’s free trials are supplemented by an inside sales team geared toward the mid-market and direct sales team aimed at the enterprise. In addition, the popularity of Sumo Logic has been boosted by the growing community of dedicated users who promote it in online forums, Slack channels, and user groups.

Internally, SUMO makes use of the information gleaned from its customers’ use of the Continuous Intelligence Platform to improve both customer service and retention rates. I think this makes it possible for SUMO to anticipate and meet the needs of its customers at all times.

Strong improvement to profitability

While SUMO’s net-new ARR continued to slow and landed roughly in line with consensus, the company reported a positive 3Q22 with healthy revenue and margin upside. While realigning its cost structure to the long-term operating plan, SUMO has increased its FY23 guidance, especially regarding profitability.

Despite Q3 being relatively unaffected by macro factors, management did note a worsening of macro headwinds as budget scrutiny increased. Given the macro volatility and investor sentiment, I think it is prudent for the company to shift focus from growth to profitability, which it appears to be doing.

Valuation

My model suggests SUMO is worth $7.76, if it trades at 1.7x forward revenue multiple in FY23.

Model walkthrough:

1. Revenue to follow management full year guidance in FY23. While the TAM is huge and there are certainly observable long-term trends, the near-term bad macro environment (as mentioned) is expected to be a headwind to growth. Hence, I expect growth to be materially slower than the past.
2. SUMO used to trade at mid-single digits forward revenue, but I assumed valuation to continue trading at the current levels given the change in rates – which impacts valuation of high-growth-but-profitless companies like SUMO.

Risks

Competition

Competitors abound in the market in which Sumo Logic participates, and so do the rapid advancements in technology. Splunk and Elastic are two examples of larger, more established vendors with strong cloud offerings that are gaining traction in a variety of markets.

Path to profitability

Any investor looking at the software sector will notice that the focus has shifted from growth to profits. While SUMO has made good progress toward profitability, if it is unable to consistently execute in order to solidify this path to profitability, the narrative surrounding the stock may deteriorate.

Conclusion

I am not in favor of investing in SUMO at this time due to concerns about the company’s current valuation. While I recognize that SUMO has a strong value proposition and a history of successful growth, the current economic conditions may impede the company’s near-term growth prospects.