Another hyper-growth, loss making subscription software company - but with a bit of a twist!
HubSpot (NYSE:HUBS) is just another one of those highly valued, loss making, software companies whose revenues are primarily based on a subscription model - or is it? Many of these companies have similar valuations, similar charts and roughly similar growth rates and business models. So why take a look at this one in particular. Simple really. Its size, its valuation and the recent purchase of Demandware (NYSE:DWRE) by Salesforce (NYSE:CRM) and the purchase of Marketo (NASDAQ:MKTO) by Vista Equity Partners has made HUBS a logical target for consolidation in a consolidating space. And the fact is that the company is a category leader with a bit higher growth rate and a bit more rapid improvement in profit metrics.
Writing this on a Monday morning after the announcement that Symantec (NASDAQ:SYMC) is buying Bluecoat and that Microsoft (NASDAQ:MSFT) is acquiring LinkedIn (NYSE:LNKD) for $26 billion or no less than 7X sales at the least suggests that valuations in the IT space are going to reflect merger potential and HUBS has that for any company that wants to establish a toehold in the marketing automation space. Both SAP (NYSE:SAP) and IBM (NYSE:IBM) come to mind as potential acquirers but there are many others - I wouldn't have thought that MSFT would be interested in LinkedIn but that is what happens when companies feel impelled to build their cloud revenue base.
As I will show below, based simply on a merger potential, and using Marketo shares as almost a direct comparable, HUBS has a potential takeover premium of greater than 40%. Marketo is being bought for 6.6X EVS, while Demandware, another significant competitor in the broadly defined marketing automation space, is being bought for 8X EV/S. HUBS is growing somewhat faster than these recently acquired companies. Further, it has achieved some level of positive cash flow. But no one can really know if a takeover will happen or at what price. So, after trying to compare the potential valuation of HUBS to that of Marketo in terms of the enterprise value of each company, I will have to see if the operating profile of HUBS might sustain a purchase recommendation as well.
Marketo has been a direct competitor with HUBS. Needless to say, there are other vendors similarly situated to one degree or the other. Obviously, Shopify (NYSE:SHOP) has seen recent share price strength because of its analogs with DWRE, although it has now pulled back in the latest market correction. And there are other businesses in allied spaces that I plan to cover in subsequent articles. But for now, I will concentrate on HUBS, both from the point of view of its value as an investment but also as a potential consolidation target in what is logically a consolidating space.
Just to make the consolidation analysis upfront and with as few caveats as possible, Marketo and HUBS are very similar in size according to the latest consensus estimates. HUBS is forecast to grow quite a bit more rapidly than Marketo over the next two years. Both Marketo and HUBS have significant losses. In Q1, however, HUBS was cash flow positive by a small amount while Marketo had a cash burn of almost $10 million. Marketo's stock-based comp expense was 50% greater than the same expense for HUBS and deferred revenue growth for HUBS was significant, rising by more than $8 million in Q1 while Marketo had no increase in deferred revenues. For what it is worth, HUBS had a Q1 beat and raise. Marketo's quarter was in line with flat guidance. HUBS has a bit more cash currently than does Marketo. The HUBS cash of about $4/share is 8% of the market cap.
Marketo is to be bought by private equity for $1.79 billion. The current enterprise value of HUBS is $1.61 billion. Given the above statistics, HUBS would certainly have greater valuation metrics than Marketo in a buyout. Better growth, cash flow positive and significant growth in deferred revenues are worth something, although how much is not an easy metric to quantify. It is harder still for me to gauge the differences in technology and user satisfaction between the two companies. Just as a working hypothesis, I think that HUBS ought to be worth 25%-30% more than the takeout value of Marketo in terms of EV/S, suggesting that a consolidation would produce a premium of greater than 40% when compared to current share values
What Is an In-Bound Hub?
Sounds like a target for an artillery barrage.
Basically, HubSpot offers solutions for relatively smaller enterprises to try to improve the efficiency of their marketing efforts. The target market is basically similar to that of Shopify, and HUBS and SHOP offer joint solutions. Of course, SHOP builds "stores" and websites and facilitates web transactions. HUBS helps users to improve their web sites and all other channels of digital marketing. Most recently, a company called Groove, which is a HUBS partner, has begun to offer a solution that leverages shopping cart data in order to develop targeted marketing campaigns. While SOP and HUBS play in the same space, they do so at different points in the life cycle of prospective customers. There is some, but not much, potential overlap.
HUBS has something of a "freemium" pricing model. Users can try the application for free for 30 days. Potential users can get the HUBS CRM app for free. HUBS recently introduced a sales package. The basic version is free and the 'Pro" version cost $50/month.
The basic marketing software has a minimum set-up charge and then costs $200/month billed annually. The least expensive marketing package only includes 100 contacts as part of the package. Most users I suspect are going to need to buy add-on capabilities. There are price points for additional contacts, a pro package which is the most popular alternative and costs just short of $10,000/year and an enterprise package which costs $30,000/year. There are plenty of additional add-on features that are sold but the CRM package that is offered by HUBS is "free" or it really is part of the overall marketing software that users buy. The conversion rate of CRM users to paying customers is a key metric in terms of forecasting the company's profitability.
Last quarter, the average revenue per customer grew a startling 18% year on year. A lot of this is actually users buying more add-ons and moving to higher pricing tiers and buying additional licenses. It should be noted that this company has sold lots of product to the "small" component of the SMB space. Those users churn as they go out of business or run into financial problems. Like many companies, HUBS reports its churn statistic based on the combination of actually churn and the value of renewals. That number is close to 100% which essentially means that the smallest users are falling off and the larger and newer users are spending more.
Just to give those readers who are not involved in web commerce some idea of what one buys, the basic package from HUBS includes solutions that assist in content creation, facilitate targeted e-mail marketing, manage social media suites and a very primitive form of analytics. The most advanced package allows users to do A/B testing, predictive lead scoring, facilitates revenue reporting and helps users to build custom event automation triggers. At the enterprise level, HUBS solutions are going to be competing to some degree with the solutions of Salesforce's Exact Target and the Adobe (NASDAQ:ADBE) marketing cloud.
To a certain extent, one might think that the HUBS process is rather elementary and perhaps it is that, but the process apparently gets significant results and reasonably favorable reviews. Given that this company basically targets the mid-market, not too surprisingly none of its references are particularly well known. Perhaps the best of these testimonials is one from Shopify that uses the HubSpot product to transform its own sales automation process to the one that it purchased from HUBS. Unlike some of the other testimonials that have somewhat incredible sales increase figure this testimonial merely talks to a higher volume of transactional sales and happier sales employees. Again, it was somewhat surprising to see the head of sales of one marketing automation firm talk about the success it was with the product of another marketing automation firm.
The other interesting testimonial, again with the appropriate caveats, is a study done earlier this year by an MIT Sloan School student. I would note that the two founders of this company met as grad students at Sloan School and the CEO is still professionally affiliated with the school. So, the genesis of the report is probably a function of the MIT relationships. In any event, the study shows 4.1X the number of site visitors within one year, 3X more leads per month within one year and 72% of HubSpot users who saw an increase in sales revenues within one year.
HUBS has a very partner-oriented sales model. Several of the testimonials are from industry participants who customize and resell the HUBS solution. An interesting aspect of the set of testimonials were just how many of them actually came from other marketing automation companies. This company currently has 3,100 partners. Clearly, not all of that number is going to be effective and a smaller cohort still is going to sell HUBS solutions every quarter. But a partnership effort of such a scale is a significant pillar in the growth of this company.
One company, headquartered in The Netherlands, said to be a leader in something called branding automation and brand management, claimed it had increased revenues by five times and customers by three times. I confess to being a bit incredulous that a company in the field, which was founded as recently as 2010, needed a tool to improve its own marketing. Other than calling up all of the references it would be difficult to validate their claims - but I have to give HUBS the benefit of the doubt in assembling quite so many testimonials. In this particular case, the chief marketing officer of the Dutch company decided to integrate HubSpot with an existing application it was using from Salesforce. I say that is interesting because CRM actually offers a targeted marketing solution that it acquired when it bought Exact Target in 2012 and established its "Marketing Cloud." CRM has been more successful than most larger vendors in selling marketing automation software and perhaps this testimonial is an outlier… except that there are a few others that are shown by HUBS.
Marketing Automation: Who's on top and who is not
Sometimes when I write these articles it is more or less impossible to quantify things like market share. It would seem to me that market share would be among the most significant information that a potential customer might want to know about in evaluating their potential supplier. You might think that all of the sites that purport to provide advice to prospective customers about which solution to buy would actually have such basic information. There are literally dozens of such services, but it is exceptionally rare to see any kind of credible market share analysis that can be used as presented.
In this space, however, there is at least one service that does market share analysis. Marketing Automation Insider is actually a service that provides both blogs, tool reviews and tool comparisons. Marketing Automation uses data from something called "BuiltWith" which is a tool that monitors 309 million web sites and is thought to have the latest available information on usage in the web site software market. According to its most recent analysis, done earlier this year, HubSpot had by far the largest market share in 2015. HubSpot has a commanding 42% market share in the small business marketing automation space. HubSpot had by far the largest number of users.
In the enterprise space, Eloqua and Pardot are tied for the leader position with both having a 31% share. HubSpot is in third place with a 22% market share. Pardot is nowadays owned by Salesforce and is part of that company's marketing cloud. Eloqua was bought by Oracle (NYSE:ORCL) back in 2012 for more than 8X revenues which is an extraordinary number to pay for a company that was growing revenues by all of 27% annually when it was acquired. Just as a gut check, HubSpot would be worth $2.15 billion using 8X revenues plus cash. Given its faster growth rate and positive cash flow generation, it would be easy to justify something like 20% more than the Eloqua valuation or $2.6 billion as a comparable.
It is perhaps surprising to see just how low the marketing automation penetration rate actually is. As of the end of last year, fewer than 4% of the top 10,000 websites had adopted some kind of marketing automation solution. Of course, the penetration was significantly less than that in the SMB space that HUBS targets. Marketing automation appears to have reached what is called a "credibility" tipping point according to this survey. It forecasts that over the next 2-3 years that "HubSpot and Eloqua will continue to engulf their respective corners of the market. Given the external growth of the market, though, it's likely that most major vendors will continue to grow with the expansion of the market."
To be sure, there are other sets of statistics that present a somewhat different picture because of definitions. A blog called Emailmonday says that 49% of "companies" are using marketing automation. Since the same blog says that only 4% of firms with 20 or more employees use marketing automation, it is a bit difficult to assess just how penetrated the space is. Another study says that 25% of Fortune 500 business to business companies use marketing automation. In trying to sift through all of the different surveys, it really comes down to definitions and the market that's being analyzed. Some users have tools but few users actually do anything significant with the tools they have. If they do use the tools, it is usually for the most basic functionality such as e-mail marketing or a tool to post blogs. It is safe to say, I believe, that there is a huge untapped market for marketing automation solutions and that proportionately it is larger in the SMB than in the enterprise space.
When I try to take a holistic view of what this means to HUBS, I think the conclusions are straight forward enough. HUBS has a very high market share in its target space and its SMB target space is barely penetrated, at least from a usage standpoint. There is some evidence that the HUBS tool produces significant positive results. Some evidence that the HUBS platform is well liked and used by other marketing automation vendors included a testimonial from SHOP that it has adopted the HUBS solution. And there is lots of evidence that the marketing automation space is growing more rapidly than most other areas in IT and that the concept has reached the so-called "credibility tipping point."
What's the competitive moat?
When I look at software companies and competitive moats, I rarely look at feature/function differentiation. Technology itself is rarely a competitive moat in the IT space. Some readers may think that this company or that company has a unique feature or two, but the fact is that if such a feature or function is significant and if the large vendors in the space aren't asleep, whatever feature or function seems to be important will soon be copied and sold as part of their solutions. That is especially true when the competitors in the space include Oracle, Salesforce and Adobe. They have the resources and the infrastructure to create whatever solution seems appropriate to their own marketing departments.
Usually I like to use the analysis of Gartner's MQ reports since they are widely distributed and accepted. But in looking at this space, there is clearly a definitional issue. The best that Gartner can do is to call HUBS "a vendor to watch." They do not include HubSpot in their survey of digital marketing hubs.
That being said, however, HubSpot earned the highest customer satisfaction score amongst all products in the space according to G2 Crowd. Customer satisfaction, regardless of the source, is an excellent moat. G2 Crowd ranks HubSpot as the best overall marketing automation software with a rating of 88. Its nearest competitors are Pardot at 83 and Marketo at 80. Oracle/Eloqua has a ranking of 70.
Most users believe that HubSpot's solutions are much easier to use, require much less training and are far more intuitive than the competition. Is there some magic technology silver bullet that accounts for HubSpot's success? Probably not. It is mainly a matter of emphasis and background. Marketo started life as an e-mail platform and that is where it still does best. HubSpot was always about an integrated platform and that remains its secret sauce. It is just far easier to use and it provides a far more holistic view of contacts. Further, Marketo is significantly more expensive than HubSpot and requires a third party tool that costs $1000 to do personalization.
What's the competitive moat for HUBS? Ease of use, time to benefit, price and first mover advantage which should never be underrated. At the end of the day, all of those attributes are a powerful competitive moat even though technology per se is not amongst them. HubSpot is No. 1 in its space and there's nothing I have seen that's likely to change that any time in the foreseeable future.
Growth of the Marketing Automation Space
As of today, the Market Automation market isn't huge. Current estimates range from about $2-$4 billion for 2016. The CAGRs over the next few years are in the range of 9%-14.5%. The CAGRs are in the SMB space where penetration rates are the lowest.
The cost of marketing automation software is dropping modestly. On average, users spend about $800/month these days compared to $900/month in 2010. Part of the reason for the relatively modest growth rates is the inclusion of CRM as part of the growth rate calculation for marketing automation. CRM CAGRs are now in the 6% range and hence drive down the estimated growth rates for the product categories that are actually components of the markets in which HUBS competes.
The major growth in the space is actually coming from the adoption of multi-function platforms. Targeted e-mail already has a 91% penetration rate. Social media automation has about a 70% penetration rate. Some of the more advanced functionality such web site personalization, social monitoring, content and score leads are really nascent and that is where most of the growth will come from.
Rather than attempt to reach an answer regarding the growth of the automation space, it is adequate from an investment prospective to say that the growth rate is high and the opportunities are large. It is apparent that HubSpot, among others, is competing in the sub-sectors with the highest CAGRs. Overall, it appears that the size of the market will be great enough to allow HubSpot and its larger competitors to grow by more 20%-30% for at least the next several years.
HubSpot's business model and its valuation
Every time I write about valuation for companies that are immature and sell their products on a subscription basis, I get lots of comments from readers looking at stock-based comp as a lodestar in the valuation constellation. Of course, the opposite is true. I rarely get questions from users regarding how much a particular company might be worth in a takeover.
In a perfect world, companies would not be allowed to present a pro-forma EPS calculation that just isn't pro-forma. Stock-based comp is no more a one-time expense than R&D or sales and marketing. It's just another way of paying people whose primary advantage to companies is that it has no cash consequences.
But then again, this is most certainly not a perfect world. In a perfect world, I could eat all the pasta I wanted and not get fat. In a perfect world, I might be summering in either Provence or Tuscany - I will go with Tuscany and I would be able to afford to buy all of the Sassicia I am able to drink. In a perfect world, the water in my pool would always be 86F without fooling around with a set of incomprehensible controls. In a perfect world, I would be able to eat foie gras several times a week without damaging my digestive apparatus. And in a perfect world, white truffles would be available 12 months a year at bargain prices.
Sadly, we do not live in a perfect world and we are likely to have to put up with the exclusion of stock based comp from pro-forma calculations for many years to come. For the foreseeable future, share valuations, regardless of personal preference, are going to rise and fall based on some kind of discounted cash flow analysis coupled with comparisons to comparables. Personal preference just doesn't enter into the equation.
I know that most analysts and institutional investors are all well aware of the arguments related to the exclusion or the inclusion of stock based comp and simply have not found the analysis useful in forecasting the performance of share valuation for individual companies. So far as it goes, companies are mandated to provide a bridge from GAAP to non-GAAP presentations. Saying that a company is not a good investment because it uses pro-forma presentations is simply not validated by the preponderance of the empirical data. In my articles for SA, I try to provide the relevant data for stock based comp and let readers do what they will with the information. The fact is that I am trying to present investment ideas that might work and the issues of stock based comp will have little or no impact on that conclusion.
Regardless of the issue of stock based comp, shares of HubSpot are not in either the value or the GARP categories. Estimates are posted by 13 analysts. For what it is worth most of them are positive on the name. At the moment, there are three strong buys, six buys and three holds.
Based on the consensus of those 13 estimates, the company's EV/S for 2016 is 6.2X. Based on 2017 estimates, the EV/S would be 4.8X. Those are relatively reasonable valuations for a company growing at 30-plus and with substantial improvements in both margins and cash flow metrics. As mentioned earlier, DWRE was bought for an EV/S of 8X and Marketo was bought for 6.6X EV/S. If HUBS were to get bought, it would clearly enjoy valuations at least as high as DWRE based on the company's better cash flow and higher growth.
The non-GAAP earnings projections for HUBS are at below breakeven through next year. Estimates have crept up over the past quarter and the company has had a record of beating its forecasts since it has been a public company. That is likely to continue. The earnings guidance implies non-GAAP margins of about (8%). That would be a 600 bps improvement from 2015 results which in turn was a 1000 bps improvement from the prior year. Given the current trajectory, it seems that non-GAAP profits should be achieved in the second half of 2017.
HubSpot did achieve positive operating cash flow in both Q4 2015 and in Q1 2016. The company does forecast both operating cash flow and capex. Operating cash flow for 2016 is forecast to be about $13 million. capex, was $8.1 million in Q1 2016 and is forecast to run at $21 million for the full year. For full-year 2015, operating cash flow was at breakeven levels, a significant swing from the year earlier period. Most of that was driven by higher levels of deferred revenue, lower GAAP operating losses and a relatively significant increase in stock based comp. Stock based comp expense has flattened out the last two quarters and is down about 40% from its peak quarterly levels. Stock based comp is forecast to rise a bit in the next three quarters and based on guidance it would be 12% of 2016 revenues compared to 11.5% in the full year of 2015.
HUBS continued to achieve significant growth in deferred revenues which rose about 30% in Q1-2016 over the same quarter the prior year. Based both on Q1 results and the constituents of operating cash flow, it seems likely that actual 2016 cash flow will materially exceed guidance. Given that capex is very front loaded because of the build-out of a new headquarters, it seems likely that the company should be achieving positive free cash flow by the last quarter of the year.
HUBS will not appeal to value oriented investors. But based on using a model that gives significant weight to comparables and looks at this company improving its cash flow margins consistent with the recent past will yield significant appreciation potential. And the takeover potential at a significant premium is not inconsequential.
Summing up the Investment case for HUBS!
- HubSpot is the leading vendor in the marketing automation space.
- The marketing automation space appears to be consolidating quite rapidly with two major merger announcements in just the last few weeks.
- HUBS has built a significant franchise in its space by having a developed a suite of solutions that are easy to learn and use and which have developed a reputation for producing substantial ROI.
- The company is starting to see the benefits from its new "sales" tool that was introduced a few months ago.
- In the company's last reported quarter, average revenue per user increased by 18% indicating users moving to higher tiers and buying substantial add-on features.
- The digital market space, while relatively small, is growing quite rapidly with most forecasts suggesting double-digit growth through at least the end of the decade.
- Hubs continues to report non-GAAP operating losses but it is now consistently delivering quarterly operating cash flow. Its operating loss margins have been consistently narrowing and it should reach non-GAAP profitability before the end of next year.
- HUBS has a valuation that taking into account the company's operating cash flow, its market leading position, its significantly higher growth rate and its steadily narrowing losses suggest that it is worth significantly more in terms of valuation than either Demandware or Marketo, suggesting the potential for a very significant merger premium should a deal get done.
While HUBS is a long way from appealing to value investors, valuations based on using a blend between comparables and discounted cash flow of future cash flows suggest that the shares have a significant upside potential.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in HUBS over the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.