ESMT - EngageSmart: Getting Smarter

Summary

• EngageSmart has seen shares come down in 2022, while the business has been doing very fine.
• The company has seen sales growth stabilize at a high level, with real yet modest earnings reported.
• I like the improved setup here, as continued execution is required to deliver on an appealing investment opportunity.

Shares of EngageSmart ( ESMT ) have seen a tough time this year, like so many technology names. With shares re-testing their lows, it is time to update the thesis which goes back to January of this year when I concluded that I was still not engaging yet with the business.

A Recap

EngageSmart has gone public in September 2021, yet shares have been falling out of the gate, as the timing of the IPO coincided with the boom in technology valuations, while the company witnessed slower growth and saw deleveraging on the bottom line.

The company is based on the frustration of its founder to execute a simple task, that is trying to pay a utility bill. A mundane task like paying a bill, making an appointment and managing insurance claims are ripe to be automated, and that is just what EngageSmart´s software solution is doing for its clients.

With that goal in mind, EngageSmart has grown to offer its SaaS applications to 70,000 SMEs and 3,000 enterprise companies at the time of the offering, active across a wide domain of industries. The company went public at $26, translating into a $3.9 billion enterprise valuation, applied to a business which generated $147 million in sales in 2020, resulting in a 26 times sales multiple. The company actually reported a GAAP operating profit of $0.6 million, which is not really a profit, but again, it is not a loss. Moreover, 97% revenue growth for 2020 looked pretty decent as well.

Revenues rose 59% to $99 million in the first half of 2021, comprised out of 65% revenue growth in the first quarter and 53% growth in the second quarter, as shares rose to $34 on the first days of trading, pushing up the enterprise valuation to $5.2 billion.

Shares had come down to $19 in January as third quarter sales growth slowed down to 42% with quarterly revenues coming in at $55 million and change. The issue is that slower growth was accompanied by a net loss of $8.3 million, to an important extent driven by a $6.6 million stock-based compensation expense.

Part of this is due to the IPO of course, but adjusted for some items, a decline in EBITDA suggests structural margin pressure as well. With sales down to $19, translating into a $2.6 billion enterprise valuation, the company has seen sales multiples compress to 11 times, not cheap enough for me given the pace of growth decelerating and losses being apparent on the bottom line.

What Happened?

In February, EngageSmart posted a 37% increase in fourth quarter sales with revenues reported at $61 million and change. It is comforting to see a GAAP operating loss of just below a million, indicating a partial reversal of the trends. For the year, sales came in $216 million on which $30 million in adjusted EBITDA was reported.

The company guided for 2022 sales to grow to $280-$285 million, which marks solid 30% revenue growth, yet EBITDA of $29-$31 million is set to be dead flat in dollar terms, hinting towards further margin pressure and likely some realistic losses as well.

The company started the year on a solid note with first quarter sales up 42% to $67 million and change as the company posted a GAAP operating profit of $3 million on the back of a $10.6 million EBITDA number. Following the arguably strong start to the year, the company hiked the full-year guidance to $290-$294 million in sales and $38-$40 million in EBITDA, quite a big hike.

Second quarter sales even rose by 43% to arrive at nearly $74 million with GAAP operating profits increasing to $4 million, as these comforting results triggered the company into hiking the guidance a bit further. The pace of revenue growth has been resilient in the third quarter as well, with sales up 42% to nearly $79 million on which an operating profit of nearly $5 million was reported. On the back of the results, the company hiked the full-year guidance, now seeing sales just over $300 million with EBITDA seen at $47 million.

The 169 million shares now trade at $15, translating into an equity valuation of $2.5 billion here, or about $2.2 billion if we factor in a current net cash position of $293 million. Based on the share price stagnation and revenue growth, forward sales multiples have fallen to 7 times. Operating earnings trend around $20 million here, translating into sky-high earnings multiples, but at least the business is profitable.

And Now?

The reality is that the combination of sales growth and a decline in the share price has resulted in sales multiples having come down from 11 to 7 times, all while growth has stabilized at 40%, quite impressive. More important perhaps, the company has regained profitability and has actually been expanding profits a bit in recent quarters.

The question is how far the business can grow, as the potential is huge of course given the wide addressable market. In the third quarter, the company processed 3.5 million transactions, indicating revenues per transaction to come in around $2, or just a couple of pennies above that. That is not fair either, as the business model is based on fixed subscription fees and variable consumption revenues.

The numbers show that the company is doing better in monetization, with third quarter sales up 42%, driven by a 31% increase in the number of processed transactions and 26% increase in the customer count.

Based on an unleveraged balance sheet and statutory tax rates, the business should easily be able to post net earnings of around $15 million here, excluding interest income, translating into earnings potential of around $0.10 per share. It is this lack of substantial earnings power which prevents the business from trading at a reasonable current earnings multiple.

On the other hand, growth is solid and forward sales multiples will come down, so will earnings multiples by the current looks of it. Weighing all this together, I am a bit more constructive on EngageSmart, truly impressed with the operating performance this year, yet I recognize that the market for technology names have sold off in a huge way as well this year, with bargains appearing left and right.

I see potential in the shares here on a highly speculative basis, given the underlying strength, yet this requires still quite a long runway for growth before realistic earnings numbers can support the valuations here, but the reality is that the fundamentals in this story are better than is the case with many peers.

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