Smartsheet: Valuation Appears To Be A Smart Buy

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About: Smartsheet (SMAR)
by: Individual Investing Ideas
Summary

After being up nearly 70% post-IPO, Smartsheet is now down ~15% from their recent highs.

After reporting another solid Q3 earnings, Smartsheet is poised to continue their revenue growth near 60% for the next few quarters.

Valuation has contracted over the past few weeks, although still remains near the high-end of premium valued companies.

Smartsheet (SMAR) remains one of the hottest tech stocks this year, up nearly 40% since their IPO in late April. Just like the majority of other tech stocks, October and November took out a decent size of SMAR’s gains. SMAR reported a strong Q3 earnings and with the stock down ~15% from recent highs, now could be a great opportunity to build a position in a fast-growth long-term winner.

Not too long ago, SMAR was trading over $32 a share and valuation appeared to be a bit stretched. However, the recent pullback and strong Q3 earnings report, with revenue growing an impressive 59%, reinforces SMAR’s success over the long-term. Their previous mid-teens revenue multiple has compressed a bit to low double digits, however, this remains somewhat appropriate given their opportunity to develop into a market leader over the next few years.

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SMAR data by YCharts

This remains a difficult name to value because of the large addressable market SMAR has to operate in. Even though Q3 revenues grew 59% (compared to 59% in Q2) with very consistent gross margin, SMAR is being valued as one of the best software names in the industry. The recent ~15% correction provides an opportunity for long-term investors to build up a position in this name.

General Overview

SMAR is the leading cloud-based platform for work execution, helping employees plan, organize, manage, and automate their work tasks. Customers are able to access their accounts online via a web-based interface or through a mobile application. As businesses continue to grow and develop more complex data files, the need to properly store, organize and manage these becomes all the more important.

The company has noted that nearly 60% of all work being done is through unstructured or dynamic data sets, meaning this can become complicated to manage or change for employees (Source: Company Presentation). This means there the largely untapped market is still open to be disrupted and SMAR is one of the leaders in this industry. SMAR works in five general platforms for work execution: Capture (information collected in a structured and consistent format), Automate (automating work execution tasks), Plan and Manage (aligning work teams and organizations), Report (real-time visibility into work), and Scale (consistency of work execution). Each of these platforms enables customers to improve specific areas of their business operations. Source: Company Presentation

SMAR has been able to rapidly grow revenues because of the underlying transition from on-premise methods of data organization to cloud-based applications. By moving these efforts to the cloud, customers have more optionality and flexibility in how they manage, organize, and present their data. In addition, the transition to the cloud means customers will spend less on internal infrastructure building and more on third-party application providers, such as SMAR. This trend is likely to continue and as companies continue to grow in size, complexity, and global reach, SMAR’s TAM will expand with additional revenue following.

For F18, SMAR increased revenue by 66%, reaching $111 million. Their dollar-based net retention rate was 130% with gross margins over 80%. Following the strong F18, SMAR has been off to a hot start in F19, with Q1 revenue growing 65% and gross margin remaining strong at 80%. Q2 showed a very similar trend with revenue increasing 59% and gross margin of 81%. Q3 followed a similar pattern with revenue growth of 59% and gross margins of 82%.

Q3 Earnings and Guidance

SMAR reported another strong quarter with Q3 revenues increasing 57%, a slight deceleration from the 59% growth in Q2. Gross margins continued to remain very healthy at 82%, compared to 81% last quarter. Because of the software operations of SMAR, gross margins are expected to be ~80% and will continue to stay there over the long term. This is one of the main reasons why these SaaS companies trade off of such high forward revenue multiples.

Source: Company Presentation

Q3 revenue of $46.9 million was ahead of management’s estimates for $43.5-44.5 million and demonstrates the ability of SMAR to increasingly grow their already fast paced revenue. For the full year, management now expects revenue to be $174.6-175.6 million, implying revenue growth of 57-58% (previously expected $167-169 million, which implied revenue growth of 50-52%). I expect revenue to be very strong for the entire year and heading into FY20. Management will likely continue to be slightly conservative with their guidance because newly public companies with fast growth rates can’t afford to miss an earnings this early on in their life-stage.

SMAR also recorded billings growth of 69% y/y. Billings are a great indicator of a company’s revenue growth over the next 12 months. With billings growth significantly ahead of revenue growth, it is plausible that revenue growth remains nearly 60% for a few more quarters. In addition, SMAR reported subscription revenue growing 59% for the quarter, a testament to the company’s long-term revenue visibility.

Source: Company Presentation

The full year guidance remains very strong with revenue growth of 57-58% and free cash flow margin of (-11)%. Going by the Rule of 40 used for software companies, which adds the revenue growth percentage to the free cash flow margin percentage, SMAR’s Rule of 40 results in 46-47. Management recently provided their long-term model which shows gross margins remaining in the 80% range, however, they see significant improvement to their free cash flow margin. As the company gains scale and traction within the marketplace, as seen with most scalable companies, operating expenses such as R&D and S&M have a lot of leverage. Over time, SMAR has the potential to develop into a consistently profitable mid-20’s free cash flow generating company, however, that potential is many years away from happening.

SMAR also reported an improved net revenue retention, which reached 132% this past quarter, slightly ahead of 131% in Q2 and 129% in the year ago period. Management guided net revenue retention to >130% for Q4. During Q3, SMAR recorded 70%+ growth of customers with >$5k of annual contract value. This customer cohort now represents nearly 65% of total annual contract value. In addition, customers with >$50k ACV increased to 360 and grew nearly 150%. The penetration into larger contract deals will continue to be a big driver as SMAR moves up the market into larger enterprise contract deals. Though the small and middle market sized firms provide a great starting point for SMAR, moving into larger contract sizes will be beneficial for more stable revenue growth and more predictability into future revenue streams.

Valuation

Valuation can be tricky with these high growth software names, particularly because they generate negative free cash flow and negative earnings. SMAR grew revenue 66% in F18 and ~60% so far in F19 with negative free cash flow at a rate of negative mid-20’s margin. Because of the highly recurring and predictable revenue stream and inability to accurately forecast profits, forward revenue multiples are the most appropriate valuation metric.

Management’s guidance for F19 revenue is now $174.6-175.6 million which implies top-line growth of 57-58%. However, this is a rather large deceleration compared to 66% revenue growth in F18 and an overall ~60% revenue growth rate YTD.

A majority of SMAR’s direct peer group remains private (ex: Asana, Planview, Workfront), however, I used a selective group of publicly traded companies which operate in adjacent industries who are viewed as leading software companies. This group includes Box (BOX), Tableau (DATA), ServiceNow (NOW), Atlassian (TEAM) and Workday (WDAY). Each of these companies has grown their top line by solid double digits over the past few years and are forecasted to do so in the upcoming years. These names also trade on their respective revenue multiples.

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SMAR EV to Revenues (Forward) data by YCharts

SMAR’s valuation has contracted over the past few weeks, much like the broader market. Over time, SMAR is poised to be a market leader deserving of a premium valuation. With revenue growth remaining steady near 60% and billings growth growing even faster, it is plausible SMAR maintains a premium valuation for the foreseeable future. Q4 earnings will bring along management’s guidance for FY20 which will weigh heavily on investors determining the appropriate valuation.

Once area of concern is the company’s lock-up period. Typically restricted shares after an IPO may be sold after an 180 day waiting period, however, this time period fell into the company’s quiet period. Thus, not all of the restricted shares were eligible to be traded immediately. Over the next week, there could be an influx of 80+ million shares initially restricted that are now available to be sold in the market. The increase in shares available to be sold could cause some increased volatility. Note, this is not an increase in the number of shares outstanding, rather these are shares already issued that were previously restricted from being traded and now are free to be traded.

Over the long term, I believe SMAR will be a great investment, however, at the current valuation levels, it may become difficult to justify building a position in this name.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.