HCP - Can HashiCorp Manage To Thrive In The Midst Of Macro Headwinds?

2023-04-05 08:51:08 ET

Summary

• HashiCorp has seen rapid growth in its 10 years of existence.
• Its products, which are quite varied, all are designed to make it easier for users/developers to create and deploy web-based applications.
• Its focus, thus far, has been on products that provide privileged access management and products that help users optimize their web deployment activities.
• Because these are high priority investment categories for users, the company has better been able to avoid some, but certainly not all, of the macro headwinds constraining the growth in IT spending.
• The company has already begun its pivot to profitability and those results were visible both last quarter and in the company's guidance.

HashiCorp; One of the last new issues through the door; It has achieved operating progress while it share price has contracted

It has been just about 18 months now since high growth IT shares peaked, and about 1 yea r since the first major software company, UiPath ( PATH ) called out deteriorating demand conditions in its quarterly earnings report. At this point, the recession in global IT demand growth has been well documented. With yesterday's ISM manufacturing report, it appears that a recession is starting in the overall economy . While the Fed may not yet have achieved all of its goals with regards to demand destruction within some segments of the economy, it has certainly succeeded in upending growth prospects for most IT vendors. Even the best of the best in the IT space have seen growth rates slow, usage growth evaporate, and seat growth become challenging. So, what's left?

HashiCorp ( HCP ) produced a significant upside surprise when it reported operating results in early March . The company had forecast revenues to be about $124 million; actual revenues were $136 million. The company's RPO balance (backlog) rose 49% year over year. The company had forecast that its non-GAAP operating loss would be around $53 million; its actual non-GAAP operating loss was and the company's earnings $27 million, or about half the loss that it had expected. The company focuses on RPO balances and does not yet report ARR. The company was one of the few whose net retention rate has not fallen materially; it remained above the company's long-term expectation at 131% last quarter.

HCP is certainly not escaping macro headwinds. It has been experiencing the same kind of increased deal scrutiny and lengthier deal cycles as has almost every other company in the it space. But at least so far, the headwinds it is experiencing seem to be less severe than has the case for many other high growth IT vendors. In particular, while some deal sizes have trended lower in a fashion somewhat analogous to Zscaler's current experience, this company had a record deal count last quarter. Part of the reason, I believe, for HashiCorp's demand resilience is that its solutions are often part of a cloud spend optimization project within an organization while other deals are part of cyber-security initiatives, both priority spending areas for most enterprises.

HashiCorp may not be a name on the lips of most investors, and indeed there will be those readers, or potential readers, who might ask, why consider a small, little known software company, when most else in the enterprise software space is on sale? Fact is, HCP shares are on sale as well and a rather deep sale at that, and while results of Q4 were certainly influenced by macro trends, the company is doing better than most peers in terms of maintaining strong growth with a valuation that has compressed greatly since the company went public in Dec. 2021.

So far the shares haven't shared greatly in the rally seen for most high growth IT shares since the start of this year; and are only up by about 8% since the start of the year despite having reported a relatively rare beat and raise quarter with some reasonable expectations that the company can continue to exceed its estimates. While the shares rallied noticeably after the release of quarterly financial data, that share price spike from that rally mostly evaporated when the market swooned in reaction to bank failures, and concerns about the health of the global financial system.

In fact, it was the combination of relatively strong operating performance along with a reasonably positive outlook, coupled with relatively compressed valuation, that have brought the shares to top of mind for me. Part of the relatively poor share price performance of this company probably relates to its projection of making non-GAAP losses and burning cash in the current fiscal year, While the company provided substantially improved margin guidance for its current fiscal year, and spoke to improving cash flow metrics, it is still projecting non-GAAP losses for FY '24 as well as a negative free cash flow margin, and many investors are unforgiving of the shares of companies that can't make profits. That said, and despite the macro headwinds, last quarter was the first quarter in which the company achieved positive operating cashflow, driven by the seasonally strong increase in deferred revenues. Stock based comp. actually declined on a sequential basis and is far below year earlier levels. SBC expenses as reported were 28% of revenues last quarter.

When the company went public , it had a revenue run rate of about $300 million, and a non-GAAP loss margin of 28%. Last quarter, the company's revenue run rate had reached $543 million while its non-GAAP operating loss margin had fallen to 20%. The shares started trading at around $80 , and they are now down to $28/$29. Of course readers are going to say that the world is very different now than was the case at the end of 2021, and I certainly can't disagree with that. That said, even by the standards of the past 18 months, this kind of a valuation compression, particularly given that the company is still projecting 25% revenue growth this year despite macro headwinds, has made the share worth considering in my opinion.

Valuations, one way or the other, really don't mean much if a company doesn't have some specific high-growth market niches based on fairly unique technology. It also needs to be able to use that technology to build a strong customer franchise, and to create a significant competitive moat. Finally, a successful vendor needs to establish that it already starting to pivot to focus on profitability and free cash flow generation. I believe that HCP ticks all those boxes, and the next section provides some insight into how and why this is happening.

Can HashiCorp, or really any other high growth IT company achieve positive returns in the current environment of macro headwinds?

There have been a few signs that investor sentiment is changing. Some are technical in nature such as the golden cross event of a few days ago. Others are a bit more substantive for a fundamental analyst such as this writer. For example, Braze ( BRZE ) another high growth IT company, reported its result s late last week. It was a fairly typical report featuring a modest revenue beat and a stronger beat in terms of earnings. This was the company's initial forecast for its FY 2024 year, and like many other companies, it guided revenues below the prior consensus. Unlike some companies, it did not raise its EPS forecast. The shares responded to that guidance by a notable valuation spike. In my own experience, this is the hallmark of the end of a bear market, i.e. guidance is less than optimal, but shares no longer react furiously to negative guidance.

I think HashiCorp's forecast, as will be discussed later, is significantly de-risked, even when compared to the forecasts of other IT vendors. Even in the current environment, I think a forecast constructed on the basis explained by this company can be beaten. But I do not expect to see guidance raised. It is possible, however, that guidance doesn't need to be raised for the shares to enjoy a higher valuation, particularly if margins and cash flow generation do exceed forecasts.

For an investment in HashiCorp to work, the environment needs to pivot toward a risk-on mentality. Some of that appears to be in progress, but it is a process and not a single event. This is not an article about trends in inflation, Fed speakers and Fed expectations or market technicals. But it would be naïve to suggest that HashiCorp shares can appreciate significantly and over several quarters until the environment is firmly set toward a risk-on tendency. I will suggest however, that when the pivot to a risk on paradigm arrives and is maintained, HashiCorp will be a significant beneficiary and can see sustained relative appreciation. And that is the basis on which I am recommending the shares.

What problems is HashiCorp solving and has it developed unique solutions with a strong competitive moat

HashiCorp is a set of solutions that are meant to provide users solutions to enable provisioning, security, networking and application deployment in their web deployments. It is all about automating infrastructure. Its products have some fairly typical goals in trying to improve time to market, reduce the cost of operations and improve security and governance of complex cloud deployments. All of the company's offerings are based on an open source model.

The problems that HashiCorp is solving can be broadly defined as those of solving bottlenecks in user workflows on the web. Because the company has a number of offerings, it can be somewhat problematic to rate the company's overall competitive position. For example, many of the competitors that Gartner calls out as leading HashiCorp alternatives are cyber-security vendors in the privileged asset management space. While the company does have a cyber-security offering it calls Vault , this is really only a single component of what the company offers. What the company is trying to sell is that it is a one stop shop for all of the critical components of cloud infrastructure automation. Given the size of the company, it has had significant success in selling that message, and it is possible to find some very passionate users of HashiCorp's products. HashiCorp's success, ultimately, is going to be a function of its ability to sell users and potential users that they want to work with a single central partner for web infrastructure and to view their networks on a single control plane developed by that partner.

The company offers all of its products in self-managed versions but its most rapid growth is coming from its Cloud Platform which is still just 11% of revenues, and is still evolving. At this point, not all of the company's products are available on its cloud platform, but that will be a development focus over the next few quarters. Over time, I expect that the HashiCloud offerings will be an increasing proportion of revenue, similar to the experience of many other software vendors.

HashiCorp's model, as mentioned, is based on open-source technology and both of its founders have been developers with broad experience in that software area. Many users download the free version of the company's products, and then convert to the paid version which includes the features necessary for the company's products to be used in commercial deployment. The company has a proprietary configuration language it calls HCL. It was originally designed to be used with one of the company's tools, Terraform, but it is now more broadly used. HCL, which has a visual appearance similar to JSON, was the fastest growing language last year, with growth of 56% exceeding the growth of other languages such as Rust and Python . In making channel checks, I got some sense that the use of HashiCorp was almost akin to a cult technology, amongst a few developers.

HashiCorp's set of solutions may seem a bit opaque to some readers in that they don't seem to be tightly related to each other. The relationships between all of the company's products which include offering in security, deployment, network management and what the company describes as applications are not immediately apparent to many readers. The HashiCorp platform is not all one thing or the other. It is often described or defined as a cyber-security company, but that doesn't do justice to the scope of its offerings. But it really isn't necessary to become an expert on all things HashiCorp to appreciate the company's strategy and its opportunities.

I absolutely don't want to pose as some kind of IT guru. I am not. While I have a background in what today is described as the IT infrastructure space, it was in sales and marketing leadership roles. Technology changes and what I knew when I worked for an IT infrastructure provider-which was of course not called that back in the day-in no way suggests that I have deep domain expertise when it comes to all of HashiCorp's products and solutions.

One key component of the HashiCorp technology strategy is that it is multicloud. Most enterprise customers do have some instances of the 3 major public cloud deployed, along with other clouds. This leads to complexity and roadblocks in providing a proper infrastructure framework. HashiCorp's solutions are designed to unify disparate deployment philosophies into a standardized, automated methodology that can be used across all clouds.

HashiCorp has a very substantial cohort of user groups -HUGs as they are called. The most recent data suggests that these groups had more than 40,000 members with 150 chapters in over 60 countries. These user groups are advocates for HashiCorp's solutions. Some of the members are almost evangelical in terms of the strength of their commitment to the various HCP offerings.

Overall, I like the animating philosophy behind the company's product strategy. Multi-cloud is one key. But so too are HashiCorp's concepts of offering users a single pane of glass to control deployments and serving as a single central partner for infrastructure for the cloud. And HashiCorp is a company built by developers with solutions that appeal to many developers. I believe that a focus on these strategies is currently resonating with users and will most likely continue to do so, and provide a strong growth tailwind when the IT space turns the corner from its current recessionary environment and outlook.

The company has partnerships with all of the major public cloud vendors and regardless of the current growth slowdown in cloud migration, it will benefit as more workloads and new applications are deployed on the cloud. HashiCorp's raison d'etre is basically to serve what might be described as the white spaces in between what can be found in the walled garden eco systems of the major public cloud providers.

At this point HashiCorp has offerings within 4 significant product groups. Its security products, which are now offered in a zero trust bundle, include Boundary and Vault. Its infrastructure products include Terraform and Packer, it has a networking product to automate and mesh that capability called Consul and a series of products that HashiCorp call applications and include Nomad , Waypoint and Vagrant. Consul and Vault are often used together.

The company's two core products are Terraform and Vault. Its other two important product offerings are Consul and Nomad. Terraform and Vault currently account for about 85% of the company's revenue. The company doesn't break out revenues or growth trends by products on a regular basis. The CEO suggested that Terraform has seen a bit faster growth over the last 2 quarters. The CTO believes that this is a function of cloud users needing to manage costs more effectively.

Terraform is described by HashiCorp as a solution to automate infrastructure and to accelerate provisioning across multiple business units and functions. Of course there are multiple competitors in this space, and I have linked here to the Gartner survey of what else is on the market. Terraform's benefits include its ability to help users improve the efficiency of their cloud deployments which can be a significant factor in optimizing the costs associated with the cloud.

Vault is the company's security automation solution. As most readers realize there are loads of cyber-security solutions in the market. The HashiCorp approach is to protect secrets through a heightened identity policy. The application automates security management and minimizes service interruption from mismatched and outdated authorizations. This is an application that competes in the privileged asset management space. I have linked here to Gartner's competitive evaluation . This evaluation does not include Okta ( OKTA ) which is obviously the leader in identity management and which has a horse in the PAM space.

Like many companies offering security solutions, HashiCorp has been refining its packaging options to highlight its zero trust capabilities. It now has an explicit zero trust bundle for multi-cloud environments. There has been some early success in terms of customer response to the product. It is one factor, amongst several, that has the potential to ensure that HCP continues to beat its revenue estimates over the coming years.

HashiCorp is a relatively young company and it continues to build out the capabilities of its various products, as well as to introduce new products. Many of the surveys that I linked above represent opinions compiled long before the company introduced significant enhancements to its products. Despite the rather average survey results, HashiCorp has a relatively large and enthusiastic user cohort.

The HashiCorp offering is designed to work together. HashiCorp's customers typically go through an evolution from a free download of open source software, to the acquisition of the HashiCorp paid solution of that software for a single product to deploying multiple HashiCorp products. As mentioned earlier, and a bit of a standout from other IT vendors at this point, HashiCorp's retention rate, although down marginally last quarter, was still 131%.

HashiCorp's outlook-Tempered expectations but still achieving substantial growth

These days, regardless of much else, it is inevitable to see software companies struggle against macro headwinds. Despite some impressive revenue metrics, HashiCorp has experienced its share of headwinds, but that said, the impact of those headwinds is seemingly somewhat less for this company than many others that I follow.

HashiCorp focuses on Remaining Performance Obligations in its financial presentation. RPO is not my favorite methodology for looking at sales performance; it is likely to be seasonal, and it is obviously sensitive to contract duration. That said, backlog growth has remained consistent, despite extended large deal cycles. The company's RPO balance rose by 50% year on year at the end of Q3 and by 51% year on year at the end of Q4. Sequentially, the company's RPO balance rose by 22%, obviously impacted by deals closing/renewing at the end of the fiscal year.

The company is estimating revenue growth of 25%+ for the full year. But that really is less an estimate than a floor. The company has, and continues to exclude larger contracts with uncertain timing from quarterly guidance. The guidance provided reflects uncertainties and a more measured view for the full year outlook. If/when larger contracts actually do close, they will be upside to the guidance provided, and this was the pattern even in the company's latest quarter. The company is projecting a lower close rate throughout the fiscal year, designed to account for the macro uncertainties that are impacting most IT businesses. In the course of listening to many conference calls, I hear many management teams talk about pipeline and coverage ratios. This company's CEO, Dave McJannet, observed:

And certainly Armon (the company co-founder and currently its CTO) and I have been in market a lot and it reaffirms the front end interest is certainly there. I think we're seeing just a lot more caution both with procurement departments slowing things down and extending deal cycles, but also general caution overall just like all of our peers.

I think that is likely to be as objective an answer as there is. Just how prospective customers react to risk elements in their own environment can't be readily ascertained, and even those companies trying to validate forecasts just don't have the second sight to evaluate the current environment. Yesterday, the economic picture was further confused by the announcement of an oil production reduction by large producers. This is expected to lead to higher headline inflation and lower global growth. There is speculation as to the possible range of Fed reactions; an oil price spike is thought to act as a tax increase for the economy.

This company, based on all of the commentary during the call, has done its utmost to de-risk its forecast, and that is about as far as I can go. While the company is projecting a full year non-GAAP operating loss margin of a bit less than 23%, which compares to the loss margin for the year recently reported of 26%, that is projected to fall to a loss margin of 12% by the end of the current fiscal year compared to the loss margin of 20% for the latest reported quarter, and to reach break-even 6-9 months thereafter, about 1 year ahead of the prior schedule. The company has forecast that its cashflow margin will achieve stronger improvement this year, than its non -GAAP operating margin, suggesting that the opportunity the company has to exceed its EPS forecast is not insubstantial. Any upside to revenue will have outsize impacts on margins; the company's non-GAAP gross margins were 85% last quarter, and this included the impact on gross margins of the very rapid growth of the HashiCorp's cloud hosted service which has lower than corporate average gross margins as it starts to ramp.

From my perspective, the fact that despite macro influences the company was able to sustain its bookings momentum is a positive sign. And the company's two leading products, Terraform and Vault are in the wheelhouse of a couple of significant priorities amongst users. Almost every user needs to optimize cloud spend, and Zero Trust is an overarching theme in the cyber-security world.

From those perspectives, I think that the HashiCorp projection for this fiscal year, in terms of revenues as well as earnings, which is, of course embedded in consensus expectations as defined by 1st Call, is as de-risked as anything else that I have recently seen.

HashiCorp's Business Model: Showing expected leverage as the company scales

When HashiCorp went public, investors were less demanding in terms of profitability and free cash flow and were more focused on growth. That has changed, of course, and the company has been making significant progress towards achieving non-GAAP profitability and free cashflow generation.

As mentioned earlier, HashiCorp's non-GAAP gross margins have already reached 85%. Gross margins on all of the company's revenue categories other than its own cloud-hosted services have continued to rise. Non-GAAP operating expense ratios have fallen significantly. Non-GAAP operating expenses were 105% of revenue this past quarter, compared to 109% of revenue the preceding quarter. Leverage was greatest for research and development expense which fell sequentially. General and administrative expense is still quite elevated but it was flat sequentially, while sales and marketing expenses rose marginally sequentially.

As mentioned, the company has forecast a 300 bps improvement in operating margins for the current fiscal year. Based on the trends in expenses, and their current levels, that appears to be more than a little conservative. Of course margin beats are going to be partially a function of the performance of revenue growth, but I think if revenues grow only at the rate that has been forecast by the company, the likelihood is that there would be a significant upside to the current consensus EPS forecast.

As mentioned, the company's free cash flow margin was negative 20% last year. The major difference between non-GAAP operating margins and free cash flow was the increase in deferred revenue. The company is forecasting that its free cash flow margin will improve to negative 10% this fiscal year, and I think that kind of improvement is probably a minimum expectation for the improvement in non-GAAP operating margins as well.

HashiCorp does used stock based comp. Comparisons on a year over year basis are distorted because of the way the Black-Scholes formula recognizes stock based comp. Essentially year earlier results were recording the vesting of options that occurred at and soon after the time of the IPO. The current stock based comp levels reflect "normal" levels of vesting and grants. Last quarter, SBC expense was about $36 million, or 28% of revenues. The prior quarter, SBC was $46 million or about 37% of revenue. SBC as a percent of revenue is likely to continue to decline, and it may decline in absolute terms as the company further constrains hiring.

I do not use reported SBC in my valuation analysis, because the Black-Scholes formula really doesn't reflect the actual cost of SBC which is shareholder dilution. Last quarter dilution was 0.96% sequentially. The company's estimated share count of 194 million reflect this kind of dilution and that is what I used in calculating valuation ratios.

HashiCorp's Management

HashiCorp was founded by two developers, Mitchell Hashimoto , for whom the company is named, and Armon Dadger. They met while students at the University of Washington, and founded the company together in 2012. Mitchell was the creator of many of the company's various products. He remains affiliated with the company but no longer in a management role. Armon is the chief technology officer of the company. The company's CEO is David McJannet who has led the business since 2016. David has had experience as a partner in Greylock Partners, a VC. Prior to that he was the head of marketing at GitHub, one of the key infrastructure/devops tools over the year, and now part of Microsoft . and before that he ran marketing Hortonworks. Those experiences have provided him with excellent background for his current role. The company's CFO is Navam Welihinda. He has been with the company since 2017 and previously worked as the VP of Finance at Compose, a cloud database vendor that was acquired by IBM ( IBM ).

HashiCorp: Once a high flyer, now on sale at a reasonable valuation-summarizing this purchase recommendation

HashiCorp was one of the last new issues launched before the door slammed shut on highly valued new issues at the end of 2021. It isn't easy to define the company's offerings which are not all obviously related to each other. The company's products are multi-cloud, working on Microsoft ( MSFT ) Azure, GCP ( GOOG ), and Amazon Web Services ( AMZN ). This is a key selling feature, and the company partners with the 3 public cloud providers as well as many other software vendors.

The company follows a typical land/expand playbook in terms of its go to market strategy. Most users eventually opt for multiple HashiCorp products, and the company appears to have a cult-like following and an active user group that has been an effective resource for the company in obtaining new name accounts. Last quarter, despite macro headwinds, was a record for the company in transaction count. The company has recently extended its offering to a HashiCorp managed cloud, and this has been the most rapidly growing component of the company's revenues.

HashiCorp is dealing with the same macro headwinds that are plaguing the rest of the industry. Longer approval cycles, more deal scrutiny, and more deal chunking. Last quarter, the company's net retention ratio declined, but the decline was relatively modest from 134% to 131%. Macro headwinds resulted in the company initiating a growth forecast for the current fiscal year that is about 25%, despite achieving a significant beat last quarter in terms of revenues and bookings growth (RPO balances).

HashiCorp's relative position, in terms of its resistance to macro headwinds, is better than average, I believe. Its two most important revenue products are in niches that are top priorities for most users. Vault facilitates privileged asset management, basically a sophisticated and highly demanded form of identity management. Terraform is software that facilitates some elements of cloud cost optimization. It is easy to use, it automates manual processes, and developers seem to be strongly positive about deploying the product and the returns they have achieved in terms of productivity and providing a uniform experience to users. Its other two important products, Consul and Nomad are in earlier stages of commercial acceptance at this point, although both address substantial market opportunities and are key components of the HashiCorp platform.

It should be noted that HashiCorp's forecast excludes any estimates for large deals in a particular quarter, and that it has forecast a decline in pipeline conversion. So, it seems likely that its current forecast is as de-risked as any.

The company is achieving some leverage; last quarter leverage was particularly in evidence as the operating loss margin fell to 20%, compared to 24% in the prior sequential quarter. Last quarter was the company's first to generate positive operating cash flow. The company is forecasting to cut its operating cash burn margin in half in the current fiscal year.

HashiCorp's EV/S ratio based on my forward revenue projection, is a bit greater than 7X. That is about an average valuation for the company's estimated 3 year CAGR in the mid-high 30 percent range. Its relative valuation is somewhat less when including cash flow because of the rapid improvement of that metric. I might argue that HCP's valuation metrics are a bit more conservative than others given the extent to which its current forecast has been deliberately derisked. I also think the company's penetration of its target markets is probably lower than average, particularly as two of its 4 core products are just in their initial stages of commercial acceptance.

I don't think anyone, and certainly not this writer, will argue that HashiCorp shares are going to appreciate in a market not placing a premium on rapid growth. The company will achieve operating leverage; if revenues grow 25% and non-GAAP opex grows in low single digits as the company has forecast, that is inevitable. The company has already constrained hiring, but is not engaged in mass layoffs. But investors will need to pivot to a risk-on mode for more than a few days for HashiCorp shares to achieve significant appreciation. Some signs suggest that this process is underway. But my recommendation is based on HashiCorp's relative growth opportunity which I think has not been properly recognized. It is on that basis that I believe HashiCorp shares will achieve positive alpha over the coming year

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