Smartsheet: Smart Investment At An Expensive Multiple

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

Smartsheet reported a very strong Q1 with revenue growing 55% and beating consensus expectations.

Management raised full year guidance and now expects revenue to grow 47-49%, which appears to be conservative.

Valuation remains at the high-end of other fast growth software peers at 20x forward revenue, but is a great long-term hold.

With the stock reaching all time highs, investors have to begin to question how much higher the stock can go. However, Smartsheet (SMAR) continues to post very impressive results, sending the shares up and to the right. The company reported strong Q1 results and raised full year guidance, underlying solid business fundamentals and momentum.

Revenue grew 55% to $56.2 million, which was above consensus estimates for ~$54.5 million. Revenue was led by subscription growth of 57%, which actually accelerated from 56% growth in Q4 (Source: Company Presentation). The subscription revenue is a very powerful revenue stream as it comes with higher margins and greater visibility, aiding the company's premium multiple.

Management also raised guidance by over $8 million at the midpoint, signaling their optimism in a strong fiscal year. While shares are near all time highs, I believe valuation is close to being maxed out and any additional upside will come from the company's strong history of beat and raise quarters.

Chart Data by YCharts
With the stock up over 120% year to date, investors have to begin to question the valuation and how much more it is able to stretch. I believe over time the company will continue to report very solid quarterly numbers and profitability will continue to improve, leading to a premium valuation. However, in the meantime, valuation appears to have reached a high water mark that will be difficult to keep rising.

Though challenging to know where valuation could ultimately plateau, I don't see the revenue multiple getting much larger considering the company is likely to report decelerating revenue growth due to the law of large numbers and the numerous challenges in continuing to grow revenue over 50% each quarter. While this is not a short thesis, I believe the stock could trade sideways over the next quarter or two until revenue catches up to the multiple and valuation comes down slightly.

General Overview

SMAR is one of the leading cloud platforms enabling more efficient work execution by 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 notednearly 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). 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.

Q1 Earnings and Guidance

During Q1, SMAR reported revenue of $56.2 million, which grew 55% compared to the year ago period and was ahead of consensus estimates for ~$54.5 million. Revenue growth has remained above 55% for the past few quarters as SMAR continues to rapidly expand their market share amid growing business momentum. Billings growth continues to remain very healthy, growing 52% in Q1, demonstrating the company's ability to continue to generate highly visible, long-term revenue streams.

Source: Company Presentation

What continues to remain impressive is the company's ability to maintain subscription revenue a few percentage points above the overall company revenue growth. The subscription revenue is very valuable as it provides a highly visible revenue stream that is largely recurring. The remaining portion of revenue comes from services, which represented only 10% of total revenue and grew 38%. Gross margins continue to remain above 80%, largely due to the software operations coming on at high margins.

Source: Company Presentation

During the quarter, SMAR reported an operating margin of -25%, which is ~500bps better than the year ago period, an impressive growth. Q1 typically is the lowest margin quarter, as margins typically improve throughout the year. As the company continues to grow in scale and can better leverage their current operations, there will be less of a need for operating expenses, thus, operating margin will naturally grow over time.

Also during the quarter, the company reported FCF margin of -23% in a Q1 that is typically high investment. This margin improved from the -27% margin in the year ago period and as seen in the chart above, FCF margin typically improves throughout the year.

Source: Company Presentation

Management also provided Q2 guidance and raised the full year guidance. For Q2, management is expecting revenue of $63-64 million, which represents a 49-51% growth. Operating margin is expected to be -27-29%, which would be worse than Q1, despite Q2-19 operating margins improving by 9 percentage points compared to Q1-19 operating margin.

For FY20, management is now expecting revenue of $262-265 million, which represents 47-49% growth (previously expected 42-45% revenue growth). I still believe this revenue guidance remains slightly conservative as guidance implies revenue deceleration in Q3 and Q4. We have seen growth remain 55%+ so far this year and guidance implies the later part of the year to significantly decelerate which seems unlikely given the company's recent strength and history of beating their guidance.

Valuation

Valuation for SMAR continues to remain challenging as revenue growth in near the top end of all software companies, though operating margins and FCF margins continue to be negative. Revenue grew 66% in FY18 and 60% in FY19 and with management guiding to 47-49% revenue growth this year, this implies quite a bit of deceleration. Though I believe guidance is conservative, management is doing the right thing by providing a revenue number they are able to beat throughout the year.

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.

Chart Data by YCharts

SMAR's valuation continues to remain near the high end of the above peer group, trading at 20x forward revenue. Even if management's guidance proves to be conservative, SMAR is trading at a relatively expensive multiple. Part of the reason the multiple is so expensive now is the stock's year to date performance, up nearly 120%, one of the top performers in the market.

If we assume FY20 revenue comes in at $265 million, at the top end of management's guidance, and grows another 40% in FY21, which would be a lot of deceleration, we could see FY21 revenue of ~$370 million, which would imply a current multiple off ~15.5x, still a relatively expensive multiple to be paying.

Over time, SMAR is poised to be a market leader deserving of a premium valuation. With revenue growth remaining steady above 55% and billings growing at a fast pace, it is plausible SMAR maintains a premium valuation for the foreseeable future.

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.