BlackLine: Certain To Stumble
Summary
- Despite a beat to analysts' Q1 estimates on both the top and bottom line, the small margin of the beat sent BlackLine shares down 5% after reporting.
- This breaks BlackLine's two-quarter streak of positive earnings reactions.
- Investors didn't miss the fact that the company added only 89 new customers in the quarter, sharply down from 117 in Q4 and still down from 92 in the prior Q1.
- Growth continued to decelerate to 34% y/y, down sharply from 42% y/y in Q4.
BlackLine (NASDAQ:BL) has just reported Q1 earnings, and in a rather surprising turn from prior quarters, the company's stock has tanked nearly 5% in response to what appeared to be, at least on face value, a good quarter. The negative earnings reaction BlackLine suffered in Q1 breaks a two-quarter streak in which BlackLine shares have continued rising and claiming accolades as a Wall Street favorite:
BL data by YCharts
Despite the Q1 fall, I believe BlackLine still has further to fall. The argument is almost purely valuation based. BlackLine has a fantastic ERP platform and finance software functionalities that cover a gap not well-established among other ERP software giants, but its own hyper-growth stage will eventually succumb to the realities of growing scale - as we saw this quarter. Net new customer adds lagged behind the numbers that BlackLine posted both last quarter (Q4) and in the prior Q1.
BlackLine's market isn't exactly a greenfield opportunity, and finance and accounting software are not necessarily easy implementations. For the most part, it seems that the company has already acquired a lot of the low-hanging fruit as its customers. It's true that BlackLine's base of ~2,300 enterprise customers is impressive. But going forward, it may find itself in competitive bakeoffs and proof-of-concepts that will find the company expending heavy sales dollars to convince old-fashioned companies to move off their existing ERPs, which is a tremendously difficult task.
BlackLine used to see growth in the 40s and high 30s, but already, we can see its y/y growth rates slip to the low 30s this quarter. For the full year, even though the company raised its revenue outlook (Q1 was a true "beat-and-raise" quarter) to $222-225 million, the midpoint of that range implies just 26% y/y growth. The 30% growth threshold seems to be a psychological threshold for investors, and once BlackLine slips below that mark, it may face a serious devaluation.
As previously noted, the thesis against BlackLine is based solely on valuation, not on the company's quality. At its post-Q1 share price of $40.81, BlackLine has a market cap of $2.16 billion. Netting out the $114 million of cash it has on its balance sheet, the company has an enterprise value of $2.04 billion.
Against the midpoint FY18 guidance of $223.5 million, this implies an EV/FY18 Revenue multiple of 9.2x. That might be an appropriate valuation multiple for a software company growing in the 40-50% range, but BlackLine's growth is expected to severely slip in the back half of this year. The company is also still maintaining a fairly sizable GAAP loss margin, though FCF has broken positive in a few strong quarters like Q4 - but there's nothing on the bottom-line side that can support its valuation quite yet.
In the 18 months since BlackLine's IPO, shares have already risen more than 2x from the IPO price of $17 - a fantastic return for early investors. Yet it seems that investors haven't realized that BlackLine's growth pace isn't quite as robust as it used to be, and have forgotten to adjust the valuation accordingly. I'm continuing to pass on BlackLine until it sees a better, cheaper valuation. I've got my eye on $32, a price target that represents 7x EV/FY18 revenues - where other SaaS companies growing in the high 20s tend to trade on average.
Q1 download
Here's a look at BlackLine's full Q1 results:
Figure 1. BlackLine Q1 results
Source: BlackLine SEC filing
BlackLine grew its revenues by 34% y/y to $51.3 million in the quarter, beating analyst expectations of $50.3 million (+32% y/y) by just a sliver. But investors' main focus in the quarter was the sheer impact of deceleration - last quarter, the company had grown at a stellar 42% y/y, making this quarter an eight-point deceleration. Full-year FY17 growth for the company was 43% y/y. This signals that BlackLine may not follow a smooth deceleration curve, with growth rates dropping a few points every quarter until it reaches a manageable equilibrium - rather, BlackLine may continue to see these large swings in growth rates, creating unpredictability which investors are allergic to.
With BlackLine's full-year FY18 guidance also implying just 26% y/y growth (17 points of deceleration from FY17), the deceleration narrative is even more frightening. Deceleration is obviously normal for growing tech companies - BlackLine can't be expected to hold growth at 40% forever - but if its growth rate is about to drop off into a more normal range, why should the stock trade at its current premium?
Note that BlackLine adopted the new software accounting standard, ASC 606, on January 1 of this year. The accounting change has a minor effect on the top line, but BlackLine has also revised its prior-year comparisons, such that a discussion of its growth rates is still an apples-to-apples comparison.
Investors also caught on to the fact that BlackLine added just 89 net new customers in the quarter. This is down sharply from 117 net adds in Q4 (though Q4 tends to be a strong quarter for IT spending, so sequential changes may not be as meaningful) and also down from 92 net adds in the prior Q1. Of course, net customer additions is an imperfect metric - obviously, if BlackLine signed one Fortune 100 company, that's preferable to signing 10 SMBs. But nevertheless, the drop in customer additions is yet another indicator of deceleration.
The good news, however, is that BlackLine did make some small progress on the profitability front. The company already had a high GAAP gross margin of 75.9% in 1Q17; this quarter, it upped its gross margins by 140bps to 77.3%, a huge improvement for a company that's already in the upper echelons of the gross margin charts. GAAP operating losses of -$7.6 million also represented an operating margin of -14.7%, better than the -18.5% margin it saw in 1Q17. This was driven primarily by the gross margin improvement, but the company also saw some operating leverage improvements on the R&D and general administrative cost side as well.
Pro forma EPS of $0.01 beat analysts' expectations of -$0.03. Free cash flow in the quarter was still negative at -$1.5 million, but that's significantly better than -$3.3 million in 1Q17. Operating cash flows, on the other hand, turned positive to $1.8 million, up from -$1.7 million in the year-ago period.
How should investors react?
At face value, BlackLine's earnings don't look terrible. A beat on the top and bottom lines, as well as a decent increase to guidance ranges for FY18, isn't bad by any measure. But recall that investors have become particularly picky in Q1, with stock selloffs in response to strong earnings becoming more the rule than the exception. With BlackLine's tiny beat to consensus top-line expectations, the selloff is more or less in line with how other technology companies have traded in response to strong earnings this quarter.
Another disappointment coming out of this quarter - the company's huge eight-point deceleration was in effect an acknowledgement of the massive deceleration to come this year. When BlackLine first guided to just ~25% y/y growth for FY18 after it exited Q4 at a 42% y/y growth rate, perhaps investors thought management to be overly conservative and ignored the guidance. But with growth slipping so sharply this quarter, it seems that the guidance range is more or less confirmed.
A stock with negative operating margins and a growth rate in the high 20s/low 30s is just plain average in the software sector, so BlackLine should also not trade above average valuations of ~6-7x. Shares are likely to see additional pressure from here.
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