Smartsheet: Don't Be Surprised When Bubbles Burst

Summary

• Shares of Smartsheet fell more than 20% after the company reported horrendous Q1 results and dour FY21 guidance.
• Of particular note is the fact that Smartsheet's billings growth has tapered off to just 30% y/y, though it had previously grown north of 50% y/y.
• Previously, Smartsheet was one of the biggest winners in the software sector, as investors bet that its collaboration software would enable remote work trends.
• Shares still look expensive at ~13.2x forward revenues, especially with cash flow deterioration from higher personnel costs.

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Many investors lately have felt that the markets are getting a bit hot and over-anticipating the speed of the economic recovery, but some companies are running far hotter than others. Smartsheet (NYSE:SMAR), a mid-cap software company and recent IPO that focuses on work collaboration tools, is an example of a stock that has run far ahead of its fundamentals, and investors have finally realized that it was a bubble waiting to burst.

Investors piled heavily into Smartsheet this year on the bet that the transition to remote work would derive a bigger need for collaboration tools. At one point, shares were up ~30% year-to-date. Yet this turned out not to be the case, as Smartsheet's growth faltered significantly in its first quarterly earnings release since the coronavirus began to color its results. Shares plunged more than 20% in a single day, virtually wiping out all of the stock's year-to-date gains.

Data by YCharts

As I noted in my prior article, market volatility is not the right time to invest in overvalued, untested names. And even after this setback, Smartsheet shares still retain a huge valuation premium. At current prices near $46, Smartsheet still has a market cap of $5.43 billion. After we net off the $544.2 million of cash on Smartsheet's balance sheet, we're left with an enterprise value of $4.89 billion.

Smartsheet's guidance update, meanwhile, takes a lot of wind out of investors' prior enthusiasm for the stock. The company is now guiding to $360-$370 million in full-year revenues (+33-37% y/y), though Wall Street had hoped for $371.5 million (+38% y/y).

Figure 1. Smartsheet guidance updateSource: Smartsheet 1Q20 earnings deck

Against the midpoint of this revenue outlook, Smartsheet trades at a hefty 13.3x EV/FY21 revenues. For a company facing this much demand uncertainty, and given the fact that most SaaS peers expected to grow at a ~30% range trade at low-teens or high single-digit multiples already, I don't see much upside to Smartsheet at current levels. Add that to the fact that Smartsheet is in a competitive environment - its products compete against much better-known software giants such as Microsoft (MSFT) and Atlassian (TEAM) - and we're not sure we can fully justify a premium valuation for Smartsheet.

That being said, huge price dips are always good to keep a close eye on. Given some of the merits that Smartsheet still holds - its improving margins (outside of the current quarter), strong balance sheet and near-breakeven cash flows, for example - I remain neutral and would say Smartsheet becomes attractive if it hits the 10x forward revenue price point, implying a $36 price target and 22% downside from current levels. Another big drop will get us there, but don't rush to catch the falling knife just yet.

Q1 download

Let's now take a look at Smartsheet's first-quarter results in greater detail. The earnings summary is shown below:

Figure 2. Smartsheet 1Q21 resultsSource: Smartsheet 1Q21 earnings release

Revenues grew 52% y/y to $85.5 million, barely showing any deceleration from last quarter's growth rate and beating Wall Street's expectations of $81.1 million (+44% y/y) by a comfortable eight-point margin. But as seasoned software investors are aware, revenue is sort of a lagging indicator into true underlying demand trends. It's billings that gives us the best picture of how Smartsheet's growth will trend in the future - and in this regard, Smartsheet's story has changed dramatically.

As you can see in the chart below, Smartsheet's billings dropped off a cliff in Q1- decelerating twenty-eight points from Q4 to just 30% y/y growth in Q1.

Figure 3. Smartsheet billings trends

Source: Smartsheet 1Q20 earnings deck

What's even worse is that Smartsheet has signaled that things will get worse before they get better. The company's Q2 guidance implies Billings growth will fall to a catastrophic 15-17% y/y range. The fact that the first half of FY21 will average out to a ~20% billings growth rate actually calls into question whether Smartsheet's full-year revenue guidance of 34-37% y/y is even feasible.

Part of the problem is Smartsheet's large exposure to SMB clients. CFO Jennifer Ceran noted as follows on the Q1 earnings call:

Contrasting enterprise strength we saw COVID related softness in our SMB segment, which represented approximately 28% of our ARR at the end of the quarter. And from customers and certain impacted industry segments, notably travel and hospitality and retail. We care deeply about the well being of our customers and as such supported those most impacted with extended terms or adjustments to quarterly and semi-annual billings. This support had a negative impact to our billings growth rate in the quarter."

Ceran noted that Smartsheet made additional billings concessions to struggling clients in the quarter that ended up reducing billings by $2 million, or ~2%. (We'd like to point out here that REITs have been pummeled this year for doing similar things for their clients, but some heavily-overbought tech companies have done the same thing).

And while Smartsheet's management noted that churn has been flat so far (though churn may take awhile to catch up to the tough macro environment; churn may tick up in Q2 or Q3), net expansion rates still fell there points from 135% last quartet to 132% this quarter, driven by lower upsells.

Figure 4. Smartsheet retention trendsSource: Smartsheet 1Q20 earnings deck

None of these results had positive impacts on profitability. Many struggling tech companies have made up for revenue shortfalls by reducing their workforce, trimming exec salaries, and taking an axe to general overhead spending - but we've heard little from Smartsheet on this front. In fact, as you can see in the chart below, despite improvements in operating margins (which is one of the reasons we still have hope in the stock), Smartsheet burned through -$28.2 million of cash in the quarter while FCF loss margins widened substantially to -33%, ten points worse than -23% in the year-ago quarter. Thankfully Smartsheet still retains a debt-free balance sheet with ~$0.5 billion of cash, so we don't have any near-term liquidity concerns for this company to make it through the current pandemic.

Figure 5. Smartsheet margin trendsSource: Smartsheet 1Q20 earnings deck

Key takeaways

Smartsheet is a perfect illustration of the fact that all richly-valued software companies trading at high-teens valuation multiples are priced for perfection. But amid this difficult environment, execution (especially for companies exposed to SMBs) can falter. And unlike many other tech companies that have signaled verbally that April or May have been encouraging recovery trends, Smartsheet hasn't given us a light at the end of the tunnel just yet.

Keep a close eye on this stock to drop further, but don't pounce on it immediately.

Analyst’s 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.

Comments

[Send]

Thanks so much for your analysis

[gexb]

what other richly valued companies may have a similar fate as SMAR?

[Dinesh S]

One thing helping this bubble , analyst keep raising stock price targets

[gexb]

yep , Needham & Company LLC raised PT to $67 and Cannacord raises to $55, they must be deep underwater in their investments in SFIX.....