GTLB - GitLab: Bundling DevOps Tooling Snowballing Growth

2023-07-24 14:10:15 ET

Summary

• GitLab, a competitor to Microsoft's GitHub, is a code repository platform that has seen substantial growth, despite being unprofitable. It recently had an IPO in October 2021.
• GitLab's revenues are growing fast, but its operating expenses are high, accounting for 91.1% of revenues. However, it has a robust capitalization with almost $1B in cash and short-term investments.
• GitLab's total addressable market is estimated at around $40B, indicating significant room for growth. However, it may not achieve profitability until FY25 or FY26.

In 2018, Microsoft ( MSFT ) acquired GitHub for a notable $7.5B price tag . Although GitHub sits atop the throne in the code-repository realm, it doesn't go unchallenged. Several competitors vie for supremacy, one of which - GitLab ( GTLB ) - will be our focus today.

Recently, GitLab's fundamentals have experienced substantial growth, and intriguing investors tend to seize the opportunity to snap up more stock with every market dip. But, before we dive deeper, let's begin with an overview of GitLab.

What Is GitLab?

Readers who know me know that I'm a big fan of analogies. Following a recent visit to a LegoLand Discovery Center (an impressive place, by the way), I've cooked up a perfect comparison. Let's mix things up!

Think of GitLab as a specialized Lego kit for software developers. Just as regular Lego allows anyone to construct physical structures, GitLab offers the bespoke pieces that programmers need for collaborative software building.

At its heart, GitLab facilitates source code management, much like Lego provides the bricks and baseboards for your architectural endeavors. Developers can store, monitor, and modify their code using GitLab. It also allows multiple programmers to work simultaneously on the same codebase, echoing a team of Lego enthusiasts constructing a shared masterpiece.

But GitLab offers more than just this: think project planning boards, code review mechanisms, testing tools, and deployment procedures for the finished software. These elements integrate seamlessly, much like specialized Lego pieces snapping together to form a comprehensive development environment.

Just as a Lego kit provides every unique piece needed to build a spaceship or castle, GitLab collates the crucial tools developers need to manage, construct, test, and launch applications. Large tech teams harness the power of GitLab to efficiently put together complex software - akin to assembling intricate Lego sets. So, while the average consumer might not be familiar with GitLab, it fuels a lot of the software that underpins the products and apps we use daily.

It's crucial to note that you could swap GitLab with GitHub in the above description, and it would still ring true. Of course, the specific functionalities vary significantly, but the main point of difference between these two largely hinges on name recognition and user familiarity.

The Financials

GitLab's journey mirrors that of many unprofitable tech companies that have graced the market in recent years. An exuberant IPO in October 2021 quickly gave way to prolonged investor discontent.

Suppose you had purchased shares a couple of weeks post-IPO, at its peak of $130. In that case, you'd now be nursing a 50% loss. Although I'm not suggesting GitLab will promptly rebound to $130, I believe there's an array of financial positives that deserve our attention.

Fast Growing Revenues

As you'd anticipate from a company yet to hit profitability, its top-line growth is brisk. However, as we've witnessed with numerous SaaS firms recently, this rapid growth shows signs of deceleration.

As illustrated above, GitLab enjoyed a sustained period of double-digit Q/Q growth, but it tapered off to a mere 3.3% in the last quarter.

While year-over-year growth paints a more optimistic picture for the company, it too has slowed down in recent quarters, settling at a respectable 45.2% according to the company's latest report.

Stable Gross Margins

The gross margins have demonstrated remarkable stability, even hinting at marginal improvement in recent quarters, inching towards 90%. While achieving a 90% gross margin is undoubtedly impressive, it offers limited scope for further enhancement or areas for GitLab to make cuts.

But Really Heavy on Operating Expenses

Shifting our focus to areas where the company undoubtedly needs to boost efficiency, we land on spending.

At present, Selling, General & Administrative (SG&A) expenditure accounts for a hefty 91.1% of revenues. This means that even with a stellar 90% gross margin, GitLab still falls short when it comes to covering its SG&A costs.

On the upside, SG&A is decreasing as a proportion of revenue, which is certainly encouraging. Additionally, the business boasts robust capitalization, with almost $1B in cash and short-term investments on its balance sheet. This reserve will be a significant aid until the company achieves profitability.

Potential For GitLab Growth

GitLab projects its total addressable market to be around a sizable $40B. This market, however, is dependent on the consolidation of toolchains, which could be a tough proposition for many development teams (thereby justifying the high SG&A that's likely to remain unchanged).

This consolidation is a challenging proposition, especially for existing teams, because of the tightly knit nature of DevOps tooling. For instance, a company might use GitHub for code management, Circle CI for running tests and ensuring readiness, and yet another tool like Jenkins for code deployment.

These three tools integrate effectively. Sure, initial setup might be somewhat thorny, and occasional hiccups can occur, but once it's up and running, it operates smoothly. This is what GitLab is up against.

This is where I perceive a catch-22 for GitLab. GitHub positions itself as simple, accessible, and affordable. In contrast, GitLab targets large enterprises seeking comprehensive solutions. Engineers typically make the choice in this arena, and because GitHub has consistently been easy, accessible, and affordable for them, that's their go-to choice.

Therefore, GitLab's task is to attract companies struggling with their workflow or seeking to alter a system that their development teams likely find satisfactory. As I mentioned, that's a tough sell.

Nonetheless, it's a sell worth making because when GitLab lands a deal, the pay-off is substantial. As shown above, the company has managed to increase the number of customers paying over $100K annually at a steady pace.

Base customers, defined by GitLab as those paying >$5K annually, are also on the rise, and at a marginally faster rate.

The ratio of >$100K to >$5K customers remains steady from quarter to quarter at around 10.5%, indicating that the company maintains a healthy pipeline from small to large customers, which is another positive sign.

I'm convinced that GitLab can continue to onboard customers and upsell across their range due to the company's expansive coverage breadth. With continued R&D investment, I expect the chart above to expand even further as time advances.

The fact is, software engineers and DevOps teams are a tenacious group, and change is challenging. But the prospect of having an increasingly comprehensive set of tools under one roof, especially if they work seamlessly together, is an attractive proposition.

Valuation

As mentioned earlier, GitLab's Total Addressable Market is estimated at around $40B. Considering its less than $500M in trailing twelve months revenues, there's significant room for growth.

The company's own guidance projects $543M in revenues for the fiscal year, equating to a growth of 28%. While impressive, this represents a definite deceleration from previous years.

Without implementing cost-cutting measures, GitLab will conclude the fiscal year in the red. This implies that we may need to wait until FY25 or possibly even FY26 to see profitability, which could present an issue.

However, like all growth stocks, our focus must be on the long term, as the market values these companies based on their future potential. And in the realm of potential, GitLab is highly endowed.

Analysts generally believe the stock is currently trading at fair value, with an average price target of $54.79. On the higher end, Goldman Sachs values it at $70 per share, which seems a bit ambitious for the near term.

Another perspective on the valuation could be gleaned from GitHub's acquisition. Bought for $7.5B five years ago, one could argue that GitLab is in a superior position today than GitHub was then, albeit with a smaller user base. Given GitLab's current market cap hovering around $8B, this assumption holds merit.

Lastly, there's Google Ventures. Continually investing in GitLab during significant dips , Google Ventures now owns 2% of the company. One should also consider the potential for future acquisition by the likes of Google, possibly to challenge Microsoft more aggressively in the code repository market.

In conclusion, I believe GitLab's current trading price is around its fair value. If there were limited other opportunities, I might consider buying for the long-term. However, I'm hesitant to initiate a position today, as I don't foresee much upside potential in the next 6-12 months.

Risks

The most glaring risk lies in costs. Over the trailing twelve months, the company has expended 135.3% of its revenues on operating expenses, a practice that is clearly unsustainable.

With an anticipated 28% top-line growth this year, GitLab will likely remain submerged in operating costs, a factor that any potential investor should scrutinize closely.

I project that R&D costs will need to continue escalating into the mid-term future to ensure the product aligns with market demands. At the same time, SG&A expenditure, though challenging to cut back or curb growth, needs to be kept under control to prevent this success story from turning into a catastrophe.

The silver lining is the considerable deceleration in SG&A expenditure over the past year. In Q4 FY23, the company reported a 2.6% decrease in SG&A compared to the previous quarter. However, it rose again by 3.9% in the Q1 FY24 report.

Final Thoughts

GitLab operates in a sector rich with potential and itself shows promising growth. That said, I believe it is currently trading at approximately its fair value, and I do not anticipate considerable gains in the short term.

I plan to continue monitoring GitLab with the hope that the company can maintain control over its costs while striving towards profitability.

At present, I would classify this stock as a "hold." If you were fortunate enough to invest a few months ago when the shares were in the $30 range, it's probably worth maintaining your position for the long-term potential, as it's unlikely we will see a return to those levels in my opinion.

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