GTLB - GitLab: Growth Can Sustain At The Current Level

2024-01-09 08:00:03 ET

Summary

• GitLab's strong performance in 3Q24 supports my expectation of sustained growth at 35% level.
• Subscription revenue, calculated billings, and remaining performance obligations indicate positive growth ahead.
• The stabilization of the enterprise segment and increased penetration of the Ultimate tier are positive indicators for future growth.

Overview

My recommendation for GitLab ( GTLB ) stock is a buy rating as I expect growth to sustain at this 35% level as macro conditions appear to be turning for the better, and GTLB has a couple of internal growth drivers that support growth. Note that I previously rated buy rating for GTLB as the business was a lot better than I originally expected, and I believe growth could continue to sustain itself at >30% levels for the foreseeable period. If true, the market would likely re-rate GTLB’s valuation upwards to reflect its sustained growth profile.

Recent results & updates

As I expected, GTLB performed very strongly for 3Q24 . GTLB 3Q24 revenue beat consensus again by 600 bps, growing 33% to $150 million. The strong growth was mainly due to the strength of subscription revenue growth, which came in at 33%. Other operating metrics also continued to reflect strong underlying demand and a forward growth outlook. For instance, calculated billings grew 24% y/y and RPO (remaining performance obligations) grew 40% y/y. I understand some investors are not fans of using the calculated billings metric because it is easily impacted by deal sizes and timing, but I remind these investors that calculated billings have been acknowledged by management as being directionally correct. As for RPO, I personally think it is a better forward-looking metric, and it has shown slight acceleration vs. the 37% growth last quarter. One thing that should be highlighted about the strength of RPO growth is that the average contract duration has increased from 14 months in 2Q24 to roughly 15 months now.

“And so, to me, I would look at revenue growth, even though it is backwards-looking. cRPO is directionally correct. Short-term calculated billings is directionally correct by the nature of what they are.” Piper Sandler Growth Frontiers Conference

“So it's similar to what we walked through before, where we took a certain amount of bookings, we saw when they're coming up for renewal, what the stage would be with the one year for existing customers and then the price increase for new customers, and then taking an average of -- our average contract term right now is roughly about 15 months and in building that waterfall model.” from: 3Q2024 earnings call

Recall in my previous post that the weakness in the macroeconomy was a major concern as it has impacted the GTLB net retention rate [NRR] previously, although the situation appeared to have turned for the better in 2Q24. I am glad to know that this positive recovery has continued to 3Q24, as GTLB reported an NRR of 124% in 3Q24. The fact that it stopped short of falling further indicates a potential "trough" in this cycle, even though it is flattish compared to 2Q24. The comments from management support my viewpoint, as they pointed out that the enterprise segment's sales patterns have stabilized for the quarter. Win rates for GTLB have also improved, and contractions have improved for three consecutive quarters. What's even more noteworthy is that customer successes in security and compliance use cases have led to continued strong adoption of GTLB's Ultimate tier. For reference, GTLB ultimate tier as a percentage of total ARR bookings was over 50% in the 3Q23 and now contributes 43% of ARR. Achieving 43% was a feat, as it marked a 100 bps acceleration vs. 2Q24 and also showed that this >40% level is sustainable. However, compared to last quarter, sales cycles have generally lengthened, and mid-market and SMB customers continue to be cautious. I believe the recovery in GTLB’s enterprise segment is a good precedent for the recovery for mid-market and SMB customers, as it shows that underlying demand for GTLB remains healthy, despite the macroeconomy not being fully recovered yet. Another supporting fact that demand remains strong is that the recovery in enterprise demand came in despite the price increase that management implemented earlier in April this year.

Consequently, management revised their FY24 guidance upwards, raising FY24 revenue guidance by $17.5 million, which is above the $9 million beat relative to its 3Q24 guide. This is very positive, as it means that the strength seen in 3Q24 is going to follow through to 4Q24 (4Q24 revenue to perform $8.5 million better than originally guided). From a full-year perspective, growth is now guided to be 35%, in line with my previous post’s expectations.

Overall, GTLB's execution has given me increased conviction in its product’s value proposition, which should continue to support a strong top-line growth rate. This strong value proposition should enable GTLB to continue penetrating the $40 billion TAM. Aside from that, other growth drivers include:

1. Recovery in NRR is supported by increasing free-to-paid conversion as GTLB implements a user limit in the free tier.
2. Increased mix of Ultimate Tier as a percentage of total ARR, which carries a higher ARPU, thereby benefiting growth. Execution so far has shown that GTLB can continue driving penetration here.
3. Lapse of renewal discount provided by GTLB when they rolled out the pricing tier changes in January 2021. Note that the renewal discount provided previously was for 3 years, and it is going to end in 2024. This should provide a sizable uplift to ARPU.

Valuation and risk

According to my model, GTLB is valued at $86.81 in FY25, representing a 52% increase. As management has revised its guidance to 35% growth in FY24, I am now even more confident that GTLB can sustain this growth over the next 2 years. I have already mentioned a few growth drivers above, and I would like to reiterate a major macro-growth driver that will be very positive for GTLB. If the Fed were to really cut rates, I believe it will spark a strong recovery in IT spending as businesses that have shored up cash in their balance sheet (from delaying IT investments and deployment) will feel more comfortable deploying cash. The reduced cost of capital will also benefit mid-markets and SMEs. Given that GTLB is already expected to grow at 35% today, with all the positive growth drivers coming GTLB’s way, I think it can easily sustain 35% growth.

Sustained growth, a better macroeconomic condition, and lower interest rates should support GTLB’s current valuation as the market looks forward to FY26 (CY25). The past 2 years average was about 11x, and I expect GTLB to remain trading at that level.

Where things could go wrong is that macro conditions could flip for the worse. Given that valuation has rerated back to ~11x, market expectations are that growth can sustain itself at >30% for the foreseeable future. If growth does not sustain itself at this level and NRR falls further, the market could rerate valuation downward.

Summary

In summary, I am recommending a buy for GTLB. GTLB's robust performance in 3Q24 reinforces my view that growth can sustain at 35% level for the foreseeable future. Strong subscription revenue, growing calculated billings, and RPO are also pointing to positive growth ahead. Despite some caution in mid-market and SMB segments, the enterprise segment's stabilization and improving win rates are also positive. Notably, GTLB's Ultimate tier's also saw increased penetration.

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