Smartsheet: Good Rebound Quarter But Valuation Still Too Much

Jan. 07, 2020 4:18 PM ETSmartsheet Inc. (SMAR)15 Comments3 Likes

Summary

  • Smartsheet reported a strong Q3 quarter with revenue growing 53% and billings growth 52%, both above expectations.
  • Management raised FY20 revenue guidance by ~$3.5 million at the midpoint, more than the ~$2 million Q3 revenue beat, signaling strength in the business.
  • Valuation remains expensive at ~18x forward revenue and the current price reflects at least two more years of strong revenue growth.

Coming off a rather disappointing Q2, Smartsheet (NYSE:SMAR) reported a strong Q3 earnings and raised their FY20 guidance. The stock initially traded down ~5%; however, over the past few weeks, the stock recovered the loss and then some, now up ~5% since earnings. Initially, I thought the stock would be down a bit and it could present a good buying opportunity; however, investors continue to bid the name higher as there is a lot of confidence in the long-term growth.

Q3 revenue grew 53% which was better than expectations and remained consistent with Q2 revenue growth. Operating margins continue to remain weak at -29%, though billings growth of 52% was better than expected. The company continues to reinvest in their S&M and R&D, which is likely driving the strong revenue growth. In addition, the company's recent Fed RAMP authorization gives SMAR another avenue of potential revenue.

Management also raised their FY20 revenue guidance by ~$3.5 million at the midpoint, more than the ~$2 million revenue beat during Q3. However, valuation remains a bit excessive at ~18x forward revenue as investors are already baking in a few more years of strong revenue growth and execution.

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Yes, revenue growth remaining 50%+ justifies a premium valuation, but at ~18x forward revenue, the stock is already pricing in strong revenue growth over the next two years. Using somewhat bullish revenue growth projections, we could see FY22 revenue of ~$590 million, or ~8x FY22 revenue. With the stock at ~$45, the ~8x FY22 revenue valuation makes sense, though this means investors will need to hold onto the stock for a few years until their investment pays off.

While valuation remains at a premium level, I would wait until the stock drops below $40 before picking up some shares.

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.

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.

Q3 Earnings and Guidance

For Q3, SMAR reported another strong quarter of revenue growth, which came in at 53% to $71.5 million and was above expectations for ~$70 million. It's impressive how consistent revenue has been so far this year, with 55% growth in Q1 and 53% growth in Q2. Even as the company approaches a $300+ million run-rate in revenue, there are still plenty of growth opportunities remaining. SMAR continues to expand their market share, and after recent receiving their Fed RAMP authorization, they now have better access and ability to sell directly to the US government. This optionality opens up another potentially meaningful and sticky revenue source.

Source: Company Presentation

Subscription revenue continues to be the growth engine of the company and investors continue to place a higher emphasis on this revenue stream given its high visibility and natural recurrence. For Q3, subscription revenue was strong at 55% growth to $64.4 million, representing over 90% of total revenue. While subscription revenue remains by far the most important, services revenue during the quarter came in above expectations, growing 34% to $7.2 million. While this revenue is more challenging to forecast, the strong revenue growth complements the subscription revenue strength.

Just as important, billings growth remains impressive and grew 52% during the quarter, similar to the 52% growth last quarter and above expectations for ~48% growth. Billings growth is a great indicator of future revenue growth, and given the continued strength in billings, SMAR is poised to continue their ~50% revenue growth for some time.

One other important metric investors follow is net revenue retention, which came in at 134% during the quarter. This metric demonstrates the company's ability to sell additional products to existing customers, essentially focusing on up-selling products to their existing customer base.

Source: Company Presentation

Gross margin for the quarter remained consistent at 82%, driven by 88% margin for subscription revenue and 32% for service revenue. However, operating margin for the quarter came in at -29%, compared to -22% in the year ago period. The biggest driver in the margin decline was due to S&M expenses increasing to 66% of revenue, compared to 60% in the year ago period.

SMAR is still in a position where they are afforded the flexibility of having negative operating margins as the company invests in both S&M and R&D in order to gain scale and rapidly grow their revenue base. Once the company starts to see their revenue growth decelerate to a more stable longer-term growth rate, the company will be able to leverage their scale and quickly expand margins.

Despite the lower operating margins, the better than expected revenue led to an EPS loss of $0.15 during the quarter, slightly better than the expectations for a $0.18 loss.

Source: Company Presentation

Q4 guidance includes revenue of $77-78 million, which was slightly above consensus expectations for ~$76 million. The 48-50% growth rate expectation is also slightly below the 53% growth seen the past two quarters. With operating margin expected to be -25-28%, the company is still several years away from reaching an operating profit.

For the FY20, management raised revenue guidance by ~$3.5 million at the midpoint, to $269.4-270.4 million, up from $265-269 million. The ~$3.5 million raise was also slightly more than the ~$2 million beat in Q3, implying the company continues to see strength in the core business, potentially from their recent Fed RAMP authorization. FY20 revenue growth is expected to be ~52% for the full year, which could be a little conservative considering management's history of beating and raising expectations.

Valuation

Valuation for SMAR continues to be challenging given the extreme premium. The stock currently trades at ~18x forward revenue, which is rather expensive even for a stock growing revenue 50%+. While some companies can achieve this high of a valuation with 50%+ revenue growth, SMAR's weak operating margins and lack of FCF present more of a risk.

After lowering their operating margin guidance after Q2, the stock traded down ~30% at the low point, which was likely necessary in order to reflect the company's revenue multiple contracting. Even with revenue guidance remaining ~52% for FY20, the company's current valuation makes it difficult to get comfortable starting a position in the name.

ChartData by YCharts

SMAR has a current market cap of ~$5.4 billion, and with ~$550 million of cash/investments and no debt, the company has a current enterprise value of ~$4.9 billion. Management's current FY20 revenue guidance of $269.4-270.4 million implies revenue growth of 52% for the full year. While this could be a little conservative, the company's strong growth rate is the support for their premium valuation.

If we assume revenue growth slowly decelerates next year, at even 50% growth, this would result in FY21 revenue of ~$405 million, representing a ~12x forward revenue. Taking this a step further, if revenue were to decelerate to only 45% in FY22, this could result in ~$590 million in revenue, or an ~8x FY22 revenue.

When looking two full years out, an ~8x multiple does not seem too expensive; however, this assumes only a small amount of revenue deceleration even as the revenue base continues to get bigger. Another thing investors will start to focus on is operating profitability. With operating margins expected to be -25-28% for FY20, the company could still be a few years about before turning a profit. FCF remains negative, though they could start breaking even in the upcoming quarters.

With the stock ~$45, I think investors are already assuming another strong two years, which I agree with. However, it appears most of the potential upside could already be priced into the stock. With the current valuation ~18x forward revenue, investors have to look at a longer time horizon in order to see valuation come down to a more realistic level. Over the long term, SMAR is poised to retain their market leader title and deserving of a premium valuation.

Risks to SMAR include revenue growth or operating margin missing guidance, which could send the shares down a lot. Companies with fast revenue growth tend to trade poorly if they miss expectations. While I believe revenue growth expectations are slightly conservative, if they were to miss, we could see shares trade down quite a bit.

This article was written by

Individual investor with hands-on experience in the equity markets. Largely focusing on Tech companies or major mispricings in the market.
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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.

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