ESMT - EngageSmart: Strong Growth And Margin Expansion Supported By Underlying Momentum

2023-06-05 16:07:24 ET

Summary

• ESMT remains a buy due to its consistent growth, healthy EBITDA margins, and focus on digitization of consumer bill payment processes and mental healthcare services.
• ESMT's underlying momentum is supported by robust quarterly transaction volume growth, expansion into new markets, and a promising outlook for FY23 and FY24.
• The company's 70+% gross margin suggests ample room for further EBITDA margin expansion.

Thesis

I believe the thesis for EngageSmart ( ESMT ) remains sound, and I reiterate my buy rating despite the stock being pressured recently. To begin, I believe it is important to stress that ESMT is a profitable business with healthy EBITDA margins and 20+% annual growth. In the current economic cycle, where many high-growth software companies are forced to cut growth for profits, I think this is one thing that makes ESMT stand out. As long as ESMT continues its consistent growth, I expect incremental margin increases to keep showing up in the numbers, driving up operating margins. Keep in mind that ESMT's gross margin is 70+%; this means the company has lots of room to grow its EBITDA margin. Given the robustness of SimplePractice's net adds, I am optimistic about the company's future growth. On the other hand, enterprise segment performance for ESMT is also strong, especially for Invoice Cloud, where I expect continued contribution at solid incremental margins, as revenue per enterprise customer is up 18% YoY. When I consider these factors together, I see ESMT as a winner: it capitalizes on secular trends that are accelerating the digitization of consumer bill payment process, while also benefiting from the rising demand for mental healthcare services and the increased use of technology in private practice. In terms of valuation, I note that valuation has contracted back to 6x, and I expect the growth and profitability profile of ESMT to continue to provide valuation support.

Underlying momentum continues

The recent 24% increase in ESMT's quarterly transaction volume to 42.6 million is indicative of the platform's robust underlying performance. This, in my opinion, is illustrative of how the ESMT Enterprise segment is protected from macro headwinds by the defensive nature of InvoiceCloud payments. In fact, management has stated that the macro environment has not had a significant negative effect on the company so far and that inflation has had a negligible net effect due to the variable nature of interest rates. Importantly, the growth was not only driven by increase in transactions, ESMT also captured new customers, driving the total number of customers to 3,390 (added 56 vs 4Q22). Because of the increasing need to streamline operations and cut costs, I have no doubt that InvoiceCloud will maintain its strong performance. As a point of reference, 45% of payments are made online for the average InvoiceCloud customer. This leaves a lot of room for growth, in my opinion. Management has stated their intention to increase digital adoption to 80% through the implementation of a strategic marketing plan backed by a dedicated customer success team.

ESMT's performance strength is not isolated to the Enterprise segment, its SMB segment (SimplePractice) continues to drive the business forward as well. Despite a challenging competitive environment, mental health solo practitioners drove strong SMB growth of 36% in 1Q22. I expect SimplePractice to continue to demonstrate its strength as it grows into new markets, such as those occupied by chiropractors, occupational therapists, etc., as well as by group practitioners. While I agree that extending reach to group practitioners is a promising strategy, I am wary that doing so will be as easy as it sounds. Even though the growth opportunity is promising, the model is less certain because supporting larger group practices may necessitate additional investments and possibly a change in GTM for SimplePractice. However, this is not an intractable issue; rather, it is one of implementation that we can only watch and judge as it unfolds.

Guidance

Management has provided updated 2Q23 and FY23 guidance. They are now anticipating FY23 revenues between $380 and $384 million, with adjusted EBITDA between $69 and $71 million, yielding margins of 18%. This marks an increase from the previous projection of $66.5 million to $69 million. 2Q23 revenue is now projected to be between $92.5 and $93.5 million, with adjusted EBITDA between $15 and $15.5 million. The most intriguing part of the new forecast is the implication that ESMT will finish FY23 with a run rate revenue of around $400 million (FY23 forecast minus 1H23 revenue, divided by 2). At $400 million, it already implies a 4% increase from the mid-point of FY23 guidance. As such, I believe there is a high possibility for ESMT to meet FY24 consensus as ESMT only needs to grow an additional 20% (ESMT has historically always grown more than 20%) to meet consensus.

Valuation

The stock has traded back down to 6.8x forward revenue, which I believe is an appealing entry point given the clearer outlook for FY23/FY24 and the business's ongoing strength. Importantly, the path for EBITDA margin expansion should be maintained as ESMT continues to drive 70+% gross margin growth at a rate of 20+%. Looking at the stock chart, we can see that the stock reversed its downward trend following the 1Q23 results, which I believe indicates that investors are more appreciative of ESMT. I anticipate that this increase will continue as ESMT grows and expands its margin. I modeled ESMT to exit FY24 at 8x valuation, just 1x below its average, to be conservative.

Conclusion

ESMT continues to demonstrate strong growth and margin expansion, supported by underlying momentum. Despite recent pressure on the stock, the thesis for ESMT remains solid. With a gross margin of 70+%, I believe ESMT has ample room to increase its EBITDA margin further. ESMT's focus on the digitization of consumer bill payment processes and the growing demand for mental healthcare services positions it as a winner in the market. Finally, management's guidance for FY23 and updated projections imply a positive outlook, with a potential to meet or exceed consensus expectations.

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