GTLB - GitLab: Appealing Growth But Too Dilutive To Buy

2023-05-17 14:32:00 ET

Summary

• GitLab has been growing exceptionally well, maintaining very high-double digit growth.
• However, the company's capital structure is heavily reliant on equity financing, and GitLab has continued to dilute shareholders while also issuing plenty of stock-based compensation.
• Also worth noting is that this has remained consistent even when the company did not appear to need the cash from equity issuance to continue operating.
• As such it is clear to me that this company is likely being operated irrespective of shareholder returns.
• These factors, combined with a lack of profitability and cash flow, make this stock one to avoid unless there is a material change in its fundamentals.

Overview

GitLab Inc. (GTLB) is a container software company. While software containers have technically been around for some time (UNIX, 1979) they are seeing a resurgence in popularity and applicability in the cloud computing era. Indeed, they are particularly useful for cloud computing in particular .

These containers work by ‘containerizing’ other software and thereby serving as a standalone repository for its source code; a container holds the source code for other software. This comes with various benefits, including the capacity for interoperation across a variety of systems and devices, increased developer productivity, and increased security. GitLab operates its technology as a value-added set of services on top of an open-source technology, much like Red Hat.

GitLab first took its business public in Q4 2021 and has seen its shares sink significantly since then. Since its IPO GitLab has depreciated close to 75%, representing a high beta of 4.29 against the NASAQ Composite over that period.

Given this price performance it’s safe to say that the market has chosen to price GitLab quite cheaply. This article will review the firm’s fundamentals to see if its current valuation is warranted, while also establishing an outlook for its forward looking prospects.

Fundamentals

Starting with revenue we can see that GitLab has been growing robustly over the last 10 quarters. It is now generating over $100M revenue quarterly while having maintained an exceptional growth rate.

Although growth has moderated somewhat, the company to date is still well in the ‘very high growth’ ball park. It is also interesting to note that y/y growth rates increased a few times over the prior 8 quarters, although this has come along with downward volatility as well. This is definitely a growth company on the basis of its top line.

Gross margins have also remained exceptionally high. Since gross margins consistently stay at above 85%, I would consider this relatively high even against other software companies. This looks good.

The profit picture shows that this company has not yet turned the corner on profitability. Operating income remains negative, albeit trending towards parity; the last quarter was the smallest relative operating loss the company has yet posted.

Net income has also remained negative, and the trendline here is not clear due to high volatility.

Evidently then GitLab is a growth company that hasn’t yet made the transition to becoming profitable, and should be evaluated as such. The first thing I like to look at for companies like this is operating cash flow; this provides a critical perspective on how far along the business may be in its growth curve.

Here we see that GitLab has maintained consistently negative cash from operations. As with net income, there is too much volatility q/q and y/y here to establish a trendline or moving average. This company is losing money on both an accrual and cash basis for the time being.

The company’s capital structure is heavily reliant on equity financing. GitLab has minimal debt and is not in the habit of issuing debt.

The company issues shares quarterly while also continuing with its stock-based compensation program.

Overall this has resulted in a robust capital structure that nonetheless continues to dilute shareholders.

This dilution, as well as the market’s perception of it, are likely the culprits for the poor performance of the shares.

This creates a problem for prospective investors. Since the company only uses equity financing while continuing to remain focused on growth, it will basically issue what it needs to in order to operate. On the other hand the firm has a very healthy cash balance of 20% of its market cap.

The caveat here is that the company has continued to issue common stock even though it has consistently had the cash on hand to continue operating. While this may buoy its cash balances further, it doesn’t appear particularly sensible for it to be doing this with its share price having declined so much. This is likely due to the firm’s relatively expensive valuations relative to the IT sector as a whole; management likely thinks they are still getting good numbers for their equity financing.

Contextualizing this with the company’s impressive growth, I still don’t find this current scenario to be investable. Ongoing variable dilution is a tough thing to accept as an investor. I believe the trendline here of continuing to issue shares in excess of operating requirements also makes it starkly clear that it is not focused on shareholder returns. The risk is very clear: this business can continue growing quickly and potentially even gain traction on profitability, but it will continue diluting shareholders at a variable rate.

Conclusion

I think GitLab is worth keeping an eye on but is not worth investing in at this time. Given the way that the company is being managed I would also advise against continuing to hold shares. What I would be looking for in the future with this stock is for it to achieve positive operating cash flow while also concluding its ongoing share issuance/stock-based compensation. While the growth rate here is impressive, these dilutive factors make this stock conclusively a hold.

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