Share prices of C3.ai (NYSE: AI) sank after the enterprise artificial intelligence (AI) software company's subscription revenue growth in its latest quarter disappointed investors. The stock is now down nearly 26% this year.

Let's take a closer look at the tech company's recent earnings report and see if the sell-off is an overreaction.

Disappointing subscription growth and guidance

For its fiscal 2025 Q1, C3.ai saw its revenue climb 21% year over year to $87.2 million, which was a slight acceleration from the 20% growth it saw last quarter. The revenue total came in between the $84 million to $89 million that management had previously forecast. Subscription revenue rose 20% year over year to $74.5 million, but that total was below the 41% growth C3.ai saw in Q1. Subscription revenue growth had accelerated each quarter over the past year, so the big step down in growth was a disappointment.

The company had gross margins of 59.8%, which is low compared to most software companies, which often have gross margins of 75% or more. Its adjusted gross margins, which take out stock-based compensation expenses, were around 70%. Subscription gross margins, meanwhile, were only 54.7% for the quarter, which was a decline from 56.4% in Q4 but an improvement from 50.4% a year ago.

C3.ai remains unprofitable, with the company posting an adjusted earnings per share (EPS) loss of $0.05. The company did generate $7.1 million in free cash flow. However, it said it would be free-cash-flow negative in fiscal 2025 Q2 and Q3 as it invests in its business, before returning to positive in Q4. It does expect to be free-cash-flow positive for the full year.

It ended the quarter with $762.5 million in cash and marketable securities and no debt.

Looking ahead, C3.ai management forecasts fiscal Q2 revenue to range between $88.6 million and $93.6 million, representing 22% to 29% growth. For the full fiscal year, it forecast revenue to grow between 18% and 27% to a range of $370 million to $395 million. That was unchanged from its prior guidance.

The company has been transitioning from a subscription, or software as a service (SaaS), model to more of a consumption-based model, which appears to be adding both lumpiness and less predictability. However, there were some good signs in the quarter related to future growth. The company closed 71 deals in the quarter. This was a 122% increase from the 32 it signed last year, and also up from the 47 it signed in Q4 and 50 in Q3.

Pilots, meanwhile, were up 117% year over year to 52 agreements. These are short three- to six-month term contracts during which customers can try out its service. Of its signed 224 pilots, 191 are still active, either having converted to full contracts, being negotiated, or still in the pilot period.

Should investors buy the dip

Following the drop in its stock price, C3.ai trades at a forward price-to-sales (P/S) ratio that is just about 7 based on current fiscal-year analyst estimates. Given its projected low- to mid-20% revenue growth, that is not expensive.

That said, there are a few things I don't like about the C3.ai story. One is that its gross margins are lower than most software companies, especially on the subscription side of its business. Meanwhile, the transition to a consumption-based model has made it much more difficult for the company to forecast its results. This will likely lead to more volatility come earnings time.

On top of that, the company's use of stock-based compensation is aggressive and greatly dilutes shareholders. Its share-based compensation of $54.7 million was 62.7% of its Q1 revenue of $87.2 million. Over the past year, C3.ai's share count has risen from 118.2 million to 127 million, a 7.4% increase.

While I think the C3.ai story remains on track, I'd like to see improvements in the areas of gross margins and lower stock comp to want to buy the stock. As such, I'd remain on the sidelines.

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