GTLB - GitLab: Looking At Its Growth Potential In An Era Of Generative AI

2023-06-14 00:49:39 ET

Summary

• GitLab's shares have experienced significant volatility, but the company remains a technology leader in the DevSecOps space. The space has a projected TAM of $23 billion.
• The company has introduced AI and machine learning features to its platform, which could drive growth and improve its competitive position in the market.
• GitLab's valuation depends on its estimated multi-year CAGR, and while the current valuation may deter some investors, I think its growth opportunity is underappreciated.
• GitLab is rapidly improving its profitability profile, and one or more quarters in the current year may achieve positive free cash flow.

The winding course of GitLab's Outlook

No one who follows the IT space can ever complain about boredom or more than a couple of dull moments. Trends are fads that last for more than a few days. The concept of secular trends can be more honored in the breach than in the observance. I first wrote about GitLab ( GTLB ) soon after its IPO i n the fall of 2021. Initially the shares reached the stratosphere. My initial r ecommendation, in February, 2022 came after the shares had fallen by more than 40% from their high point set soon after the IPO. I liked the company then and thought the valuation implosion was adequate to provide some margin of safety for investors. Was I wrong!

Subsequently the shares went on to fall another 46% by the end of 2022, before rallying noticeably to a high of $52 at the end of February, just before a disappointing earnings release that featured the announcement of a layoff, and a sharp guide-down in terms of expected revenues. From that point, the shares fell by 48%. Now, after spiking by over 30% in the wake of a beat and raise quarter, the shares have reached to within just about 10% of the high they set at the end of February. Even by the standards of the IT space that is a lot of volatility. The question now is whether the shares are at a reasonable valuation for long term investors.

One of the harder undertakings in this current economic phase is to try to establish a baseline growth estimate for GitLab or most of the other high growth IT vendors. While there has been endless debate about a recession or a soft landing, there can be no debate that IT growth rates have receded below recent levels as enterprises, faced themselves with declining demand, have looked to more carefully manage IT spending. Into that mix, investors want to add some projections for the potential of AI to increase percentage growth. Some brokerages such as Goldman actually have had the temerity to forecast the impact of AI on the fair value and earnings for the S&P over the next 20 years. I personally find it more than a little difficult to estimate the impact of AI on the outlook for GitLab in the next year or 2, let alone the next 2 decades. It leaves analysts, investors and industry consultants with a host of problems in determining an appropriate CAGR for companies in this space.

I certainly don’t claim prescience-anything but. But of course it is necessary to have some estimate of CAGR in order to develop a valuation framework. GitLab’s most recent call while very upbeat overall, added a further component of murkiness to the stew in determining a realistic CAGR for this company more than 1 quarter at a time.

Should investors take a leap into the dark and consider initiating positions in GitLab after the recent share price spike? I am a long-term investor, which makes the question much easier. GitLab is probably the technology leader in DevSecOps space, and that is a space likely to enjoy a CAGR of about 25% over the next 5 years, with an estimated market size reaching more than $23 billion by the end of the decade. Given that the current revenue forecast for the company is forecast to be less than $550 million for the current year that suggests plenty of potential growth runway.

Should you buy the shares at this point? It really depends on time horizons, risk preferences and portfolio construction. My guess is that the shares are going to consolidate at this point; they are up by 70% since May 4th , and by any standards that is quite a move. Almost certainly, there will be reversal days, perhaps several of them, and that will provide an entry point that is less risky than the current share price. For those readers with a longer term perspective, the best strategy, at least to me, would be to scale into the shares, with some understanding that the demand picture hasn’t completely reversed in the last 90 days. The quarter that was recently reported was a better quarter than anticipated; it wasn’t a halcyon quarter.

One thing I can safely assert is that GitLab shares will need a continuation of the rally in IT shares to work from this point. For GitLab’s shares to work as an investment a bull market in tech shares is a precondition. In any other environment they are unlikely to show substantial relative outperformance. In that environment, after a consolidation, the shares, in my opinion, have significant upside.

This is not an article about the market. Many readers and commentators have been surprised by the recent tech rally. Many commentators suggest that it is just another bear market interlude. The interest rate outlook, at least in the short term, is as murky as ever, with most observers calling for a Fed pause, but some forecasters expecting additional rate hikes in July and beyond. There have been some signs of a soft landing, and other signs that are far less positive. Right now headline employment metrics seem benign, but other metrics regarding jobs are far less positive. I will reiterate, that at least in my opinion, from this level, GitLab shares need a risk-on market to provide significant further appreciation.

The company used the occasion of the earnings release to announce several products/enhancements to its platform, mainly based on AI. I have said in other articles-going back a long time, years actually-AI is real and it has the effect of improving the ROI of software and hence, presumably the willingness of users to buy more. That premise has now reached wide scale acceptance. But I would not recommend GitLab, or most any other software company just because their solutions are based on AI and machine learning. The adoption of AI is, no doubt, a revolution, but a revolution that plays out over years, not quarters, and does not immediately impact productivity or revenue to any significant degree. In that regard, companies such as NVIDIA ( NVDA ) and perhaps Pure Storage ( PSTG ), whose results are already seeing the impact of AI and Generative AI on their demand, are outliers and not the norm.

The guidance GTLB provided included its new AI products. It did raise revenue guidance by slightly more than its 1 ^st quarter beat, and that was in stark contrast to the guidance it had given 90 days before, but at least in terms of the specific numbers in the current year, the impact of AI is not expected to be a huge factor in the likely growth of the company. That's not terribly surprising as the AI extension service is still in beta, and isn't scheduled for general availability for a few more months. Most likely, the guidance it has just given was a de-risked forecast that tries to account for continued macro headwinds. But I would be remiss in not commenting that there has been a lot of froth and speculation regarding AI, and while it is a revolutionary productivity tool, it is not going to solve all the problems of the world or of software developers in one fell swoop.

GitLab, despite considerable progress toward profitability is still likely to report losses, at least through the end of this fiscal year. That said, it is possible that it will attain break-even free cash results in one quarter by the end of the fiscal year.

What exactly did GitLab report and how did it guide.

GitLab reported revenues for the quarter of $127 million, non-GAAP gross margins of 91% and a non-GAAP operating loss margins of 12%. Revenues rose 45% year over, and by 3% sequentially from the company’s fiscal Q4. The company had forecast Q1 revenues of $118 million, and a non-GAAP operating loss margin of 22%. So, the beat was impressive in percentage terms, and reversed, in part, the prior guide down.

The company is now forecasting full year revenues of $542 million and a non-GAAP operating loss margin of 8%. Its prior forecast had been for revenues of $531 million and a non-GAAP operating loss margin of 12%. So its revenue guide is marginally greater than the amount of its Q1 beat, although its margin improvement compared to prior guidance is quite noticeable.

The company’s RPO balance grew by 37% year on year and by 7% sequentially, a reasonable progression for a fiscal Q1. The company’s net expansion rate was 128%, down from 133% the prior quarter, and reflecting the macro uncertainty in which customer expansions have been curtailed. The company’s free cash flow burn was about $11 million for the quarter, compared to $30 million, the prior year. The company has projected it will reach full year free cashflow breakeven in fiscal year 2025 (starts 1/31/24) and it reaffirmed that commitment on this current call. Given the seasonality and fluctuations of cash flow metrics, I would not be surprised to see at least one quarter this year reach positive free cash flow generation.

The company CFO spoke about a better line of site on bookings during the quarter. Apparently deals scheduled to close, wound up closing, a different paradigm when compared to the prior quarter. The company also saw less seat contraction in the quarter, with minimal enterprise churn. The company raised prices in early April so far without any customer pushback. Given the mechanics of the price increase, most of the impact will be seen beyond the current quarter, and will be most noticeable in the following fiscal year.

The company CEO, Sid Sijbrandij provided a great deal of color and granularity on GitLab’s approach to AI. That being said, however, the CFO really focused on how the company's emphasis and concentration on accelerating AI development could be contained within the company’s expense structure. I would have been hopeful of some discussion of how AI might impact revenue growth, but thus far that hope remains unfulfilled.

Part of the company’s forecast includes the financial impact of its JiHu, the company’s Chinese joint venture. The company is consolidating the loss from the JV in accordance with GAAP, although the actual economics of the agreement are based on a sharing of losses and revenues. More than half of the operating loss projected by the company this current fiscal year is a function incorporating JiFu’s losses into the GitLab financial statements. There is some hope that JiFu’s results will be deconsolidated from published GitLab earnings over the next year.

AI and GitLab-Disentangling the hype from the opportunity

I don’t want to come across as a curmudgeon shouting bah humbug at AI. AI is a big deal. Generative AI will have a noticeable impact on productivity. Most readers of this article will start to see benefits in their own personal sphere from Generative AI in the next couple of years. But investors are still going to look at financial statements and growth rates and that is true for GitLab as much as any other company and will be the case regardless of how many AI products and features are becoming part of their stack.

For those readers unfamiliar with GitLab, it is one of the leading companies in what is called the DevSecOps space. Its largest competitor by far, is GitHub , which is part of Microsoft ( MSFT ). The term is an outgrowth of DevOps, with more of an emphasis on security. I have linked here to a fairly recently updated article that describes some of the features of the technology and some additional metrics that may be of interest. At the end of the day, the technology is about improving the efficiency and the speed of the software development process and doing it in a secure fashion.

GitLab has been one of the industry pioneers and it has been steadily adding features and capabilities to its product with a set of upgrades released every month. Although it is an industry leader, its estimated market share is still less than 12%, suggesting lots of competitive opportunities. It has a significant range of reference customers including IBM ( IBM ), Goldman Sachs ( GS ), Sony ( SONY ) and NASA.

The company’s core AI offering at this time is called Code Suggestions. The offering is only in beta at this point. It is built with a privacy first foundation. As the name implies, Code Suggestions provides developers with…well you guessed, suggestions as they type lines of code.

The Microsoft/GitHub alternative is called Copilot . There is a perception these days that everything that Microsoft does in AI is “better.” I am hardly in a position to evaluate that notion in terms of specific product comparisons. The CEO, when asked about competition between Copilot and Code Suggestions, made several telling points centering around security, partnerships with hyperscalers (of course other than Microsoft) and a platform approach. Interestingly, in the wake of Oracle ( ORCL ) earnings, just reported, that company was called out as a particularly effective partner. I think at this juncture it is really impossible to evaluate whose Generative AI is better when it comes to developing apps. I don’t really think it necessary to make that kind of a call in order to recommend GitLab shares at this point. It is really too early in the evolution of the use of AI technology for developing code, to declare there is a single product standard, and a single winner.

I think, however, it is fair to project that GitLab will be one of the leaders with this technology, just as it has been over the course of the evolution of DevSecOps.

At this point, there is no available data regarding just what kind of productivity enhancements can be achieved with the new offering. Overall, at this point, the company has announced 10 AI features. In addition to the basic use of Code Suggestions to create new code, the AI features can do code review, identify vulnerabilities and suggest vulnerability remediation and forecast value streams to predict future team efficiency. Doubtless there will be additional Generative AI functionality that will be included in the company's AI extension over future time periods, especially as Generative AI is now the focus of the company's development efforts.

The CEO spoke to these features bending the demand curve with customers who had not planned to purchase DevOps functionality until sometime in the future, becoming potential prospects this year. The thesis presented by the CEO is that with an automated process to write code, the potential size of the developer community will expand, as less highly skilled developers can now be productive in creating new applications. In turn, this will reduce the expenses of creating software, and with lower project expenses, businesses will decide to develop more software, further augmenting the demand for developers. A self-evident virtuous cycle compounded by market share gains based on GitLab’s expertise in building machine learning modules. When questioned during the call, the CFO glided around any forecast that guidance might be overly conservative because of this potential.

GitLab has recently introduced some unique machine learning algorithms into its stack. This is called ModelOps, and I confess I have only recently become familiar with how it works to provide developers with better outcomes. I have linked here to a blog post that better explains the process than I can, although it may befuddle some readers. This is a very nascent component of GitLab’s business; it expands the company’s TAM, and at some point will be a revenue growth driver-but that some point is probably not encompassed within the next year. GitLab now offers a machine learning model experiment tracking tool . It is based on an open source solution but as is most often the case with products built on open sourced, the GitLab offering is far easier to use. Based on what I can determine, ModelOps and GitLab’s version of that technology called MLflow will represent significant untapped opportunities for the company. I have linked to a more complete description of the GitLab MLflow feature.

The company is going to introduce a specific add-on to its core platform with a cost of $9/mo./user. As of last month, GitLab had about 31 million registered users, so $9/mo. potentially would be a substantial new stream of revenue. Just to be clear, registered users are not the same as paying users, and even in the cohort of paying users, the percentage of Generative AI penetration is something of a guess at this point. But that being said, even a couple of million users at $9/month would be a big deal for the company. I do believe the AI extension will be a big deal, and I certainly think it should be considered in evaluating Gitlab as an investment.

Just as a reference point, GitLab recently raised its list price for its premium tier to $29/month, up from $19/month (premium in this case is less than Ultimate). As pointed out earlier, besides the $9/month, the expectation the CEO expressed during this last conference call is that introducing an AI extension is going to significantly speed up user expansion. The company’s count of large users rose by 6% sequentially last quarter; it will be a few more quarters until investors can effectively track how AI is actually increasing the company’s count of users and customers.

While the CFO indicated that the costs of creating Generative AI were included in guidance for the current fiscal year, the expected impact of the AI extension is going to be fairly minimal especially since the product is still in beta. When asked about any forecast incorporating the contribution from the extension in FY ’25, the CFO ducked.

Currently, the published consensus revenue estimate for GitLab for FY’25 shows growth of 28%, essentially equivalent to the forecast growth rate this current year. The forecast calls for marginal positive non-GAAP EPS for the year, compared to a relatively small loss forecast this year. I have forecast revenue for the next 4 quarters of $599 million which is marginally greater than the consensus; just how much the extension will generate in revenue is a guess but I can say that the beta has seen such interest that the site is indicating that there could be unscheduled downtime for maintenance. My model does include a discrete item of $15 million for the price increase over the coming 4 quarters. I have also included $10 million of revenue from the early adaptors of the Generative AI extension, as well as an overall easier comparison, particularly in Q1-FY '25. I have not tried to include the impact of the company adding what the CEO described as "consumptive" elements to its pricing model. Based on the commentary by the CFO, my model holds opex at levels consistent with the projections in Q2. That produces non-GAAP break-even results by Q4 of the current fiscal year-and positive free cash flow is bolstered by a consistent flow of large, multi-year contracts.

Overall, I would be surprised that with a basic price increase, and the introduction of an AI extended service to not see some kind of percentage growth acceleration next year compared to Fiscal ’24. That is particularly true if the macro headwinds that have plagued almost all software vendors over the past 3 quarters start to abate, if for no other reason than easier comparisons. Were that to happen, then EPS and free cashflow estimates would see significant positive impacts.

The company has been adding what it describes as “consumptive” elements to its pricing format, and over time, and this seems more of a focus when it comes to the AI extension. Consumption growth can be a significant revenue growth driver. In the last several quarters, software vendors who have consumption based revenue models have seen their growth impacted to a significant degree. But users like consumption models, and over the longer term, consumption models really are profitable for software vendors. Given that GitLab gets minimal revenues from consumption pricing currently, adding consumption as part of a menu of offerings is going to be a positive for percentage revenue growth.

As indicated, I do have a model which calls for $599 million in revenues, and a free cashflow margin over the next 4 quarters with a free cashflow margin of -2%. I expect to revise the model significantly once there is some kind of forecast from the company as to the overall impact of the price increase, from consumption pricing acceptance, and most importantly from user demand for the AI extension; in the meantime, I think my estimate is more likely to be a conservative evaluation of the numerous growth drivers I see in the company's business outlook.

Competition in the DevSecOps space

For readers unfamiliar with “Git” it is a version control capability that is foundational for software development. It has been the leading version control system for several years-it is the system preferred by most developers, and obviously the foundation of the offerings from the 3 leading vendors in this space.

What is called the DevSecOps space is of recent origin, but overall vendors have been creating DevOps platforms for some time, and there are plenty of alternatives for users to consider. I have linked here to a listing of some of the competitors compiled by Gartner. This is the first year in which Gartner has provided a Magic Quadrant analysis for DevOps platforms. Not terribly surprisingly the two leaders are GitLab and Microsoft’s GitHub. Atlassian ( TEAM ) is in 3 ^rd place, with a bunch of other alternatives including IBM’s Red Hat and VMware ( VMW ) listed in lower positions.

GitLab has maintained for years that it is the most comprehensive integrated DevOps platform on the market. There really is no way for an analyst such as myself to validate that contention. I am not going to try to resolve the issue here-I am not sure that it is really resolvable since not one size fits all and users wind up evaluating the alternatives based on their own specific requirements and different use cases are best served by different vendors.

The Gartner analysis calls out GitLab’s unified platform and its built in security capabilities as strengths. It was compiled before the company began releasing its AI capabilities; at the time the report was compiled, Gartner identified Microsoft’s Copilot AI as a strength for GitHub. Microsoft essentially has two competing development environments; one created by the Azure team, and the other created by GitHub, which is really the flagship Microsoft offering in the space. GitHub has a huge market share/mindshare-in many ways, GitLab is the more modern, nimbler competitor in the space. In any event, I have linked here the Gartner MQ report for those interested in the details.

The latest data suggests that GitHub has 56 million users while GitLab has 31 million users according to data from 2021. GitLab has apparently been gaining market share for the last several years. Most GitLab users-at least in terms of number of users-wind up using their premium plan to get started and then migrate to the Ultimate tier. As mentioned earlier, pricing for GitLab Premium has recently gone from $19 to $29 per user/month. There will be a transitional tier for current users at $24/month. At this point, the company’s Ultimate tier, which accounts for 42% of ARR, has not had a price increase. On the call, the CFO indicated that the price increase hadn’t resulted in increased churn or loss of seats. Whether or not a 50% price increase on 40% of the business will lead to a 20% revenue uplift in FY ‘2025 has not been projected. Despite the vast price differential between Premium and Ultimate, Ultimate is growing significantly faster than Premium, and will probably continue to do so as many of the newest AI features are for Ultimate users and it really is the platform that offers the DevSecOps vision.

GitLab’s Ultimate tier is substantially more expensive than GitHub, although how that really works out at an enterprise level is not easy to determine. The review I have linked to here summarize the differences by opining that users can do more with GitLab without relying on 3 ^rd party integrations . Probably, the real price difference is far less than might be apparent just comparing list prices of the two solutions. Most 3 ^rd party integrations aren’t free, and the whole concept of GitLab is to offer users a platform that encompasses all of their development needs.

With the addition of AI features, I think it is probable that GitLab’s competitive positioning will improve. It has put most of its development chips on that part of the solution and I expect more deliverables at higher prices leading to stronger growth than has currently been forecast-at least in the published 1 ^st call consensus.

The GitLab Business Model: It is improving but isn’t yet at profitability and cash flow generation

When I wrote about GitLab initially it had a non-GAAP operating margin of negative 35% and it reported a non-GAAP loss per share of $0.16. Its cash burn that quarter was $53 million. The company’s non-GAAP gross margin was 89%. But revenue growth at that time was near 70%.

This last quarter, the non-GAAP gross margin had reached 91%, the company’s non-GAAP operating loss margin had fallen to 12% and its non-GAAP EPS loss was $0.06. Of course, rather than 70% growth, growth was 45% last quarter, and the company is projecting 3% sequential growth for the current quarter, compared to its projection back then of no sequential growth at that time. GitLab, over its time as a public company, has proven to guide very conservatively, and that is probably still the case.

Sales and marketing expense last quarter were 54% of revenues, non-GAAP, down from 69% on a non-GAAP basis the prior year. Sales and marketing expenses were essentially flat sequentially. Obviously this expense ratio still has a long way to fall, and the company’s recent layoff is likely to show up increasingly in this category.

The non-GAAP research and development expense ratio was 29% last quarter compared to 31% in the year earlier quarter. This was a modest improvement, and there is a huge amount of room to improve that expense ratio. Non-GAAP research and development rose by about 8% sequentially. The company has redirected much of its development spend toward AI functionality and the CFO was very clear that research and development spending overall would not exceed current levels.

General and administrative expense was still at 19% of revenue last quarter, a very elevated ratio and one with lots of room for improvement. Overall the general and administrative expense ratio showed the least improvement; it had been 20% of revenue the prior year. Sequentially, research and development expense rose by 9%.

The company’s forecast for fiscal Q2 essentially incorporates a minor-$2.5 million-decrease in opex on a sequential basis. Given the 8% layoff that has taken place, and the likelihood of the maturation of other cost remediation initiatives, I think there is potential for a more significant decline in opex both next quarter, and over the balance of FY ‘2024 than is implicit in the company’s guidance. At this point, more than half of the projected full year non-GAAP loss is expected to be coming from the consolidation of expenses of its Chinese joint venture; the company is attempting to deconsolidate these results but there is no time line for this possibility.

Last quarter the company’s cash burn was about $11 million, down from $30 million in the same period the prior year. The company’s full year cash burn was $52 million for FY’23, compared to $74 million the prior year. The free cashflow metric is extremely variable on a quarterly basis. It is also quite sensitive to variations in revenue, and particularly deferred revenue. Just exactly how the company’s pricing increase, and subsequently the commercial release of its new AI offering might impact multi-year commitments is more than a bit murky at this point. I would not be surprised to see one quarter or the other reach breakeven cash flow this fiscal year. The company reaffirmed its commitment to reach full year cash flow break even in FY’25.

When companies have hyper-growth potential, as this one do, and when cash flow metrics are improving dramatically, my own experience has been that creating a price target is a misleading exercise. I simply don't know if it will take one year, or two, or longer for GitLab to reach a free cash flow margin of 25% or greater. With a gross margin above 90%, and a more disciplined expense structure, projecting rapid growth in free cashflow makes sense. But I absolutely don't want to pretend that I have the kind of visibility in an opportunity significantly predicated on new technology to produce an absolute price target. If the Gartner forecast of moving from 25% adoption to 75% adoption of a platform approach to DevOps is near right, then I am more than comfortable investing in GitLab shares, even at these levels, particularly as a long-term investor.

Risks to GitLab's Growth Potential

I think anyone familiar with this company and the software space recognizes that macro headwinds are a serious issue that has certainly not been resolved-not for GitLab, or for anyone else in the software business. Last quarter was better for GitLab than the prior quarter, but it certainly was not back to business as usual. GitLab's is navigating macro headwinds about as well as most high growth software vendors-which is to say that there is unusual uncertainty in any forecast.

Generative AI is a new capability that really has never been sold before. I am sure some readers, who are also developers, will have opinions about Code Suggestions. Not everyone is going to be happy with the initial outputs of Code Suggestions. And not all models are going to work as intended during their first pass. I remind readers at this point that the consequences of a flawed model are not insubstantial. Unity ( U ), for example, basically had to acquire ironSource to recover from its foray into the mediation space which failed because of problems of various kinds with its data model. Perhaps of more pertinence are the problems that Upstart ( UPST ) had with its model, and how that led to sub-optimal underwriting and serious business consequences.

This writer was once upon a time involved in model creation with a technology that was precursor of what we know of as AI these days. It is not easy to create, and iterations are a constant fact of life. So, the introduction of Generative AI is by no means guaranteed to proceed seamlessly although I assume that the leaders of GTLB, and in particular the CEO are far more knowledgeable about the specific risks of a flawed introduction than I might be.

Finally, any price increase, and certainly a 50% price increase always has to be considered a risk. I mentioned that in the initial weeks since the price increase took effect on 4/3, the CFO indicated that churn and seat compression hadn't changed. But there is plenty of negative commentary on various sites about how some users are upset with the price increase. I personally find it somewhat incongruous that professionals who certainly make well into 6 figures are upset about paying $108/year more for a seat in these inflationary times-but it is a consideration, and if I didn't have some concern, I certainly would have had a stronger growth forecast than what is in my $599 million revenue estimate for the next 12 months.

GitLab’s Valuation-Recapitulating the case to buy the shares.

GitLab shares, despite their recent spike, are no longer valued at levels that are out of bounds in the new valuation world. That said, it should be obvious that the shares will need at least a neutral risk environment in order to work from this point. I am not about to try to debate the course of the market for high growth IT names over the next several months, even though acknowledging just how much that course will mean to the progress of GitLab shares amongst others.

Not terribly surprisingly, GitLab does use share based comp. Last quarter share based comp. was 25% of revenue, and that compares to 20% of revenue in the year earlier quarter, and to 27% of revenues in the prior sequential quarter. Some of the increase in the recognized share based comp expense is a function of vesting; sometimes, depending on the specifics of a prior grant, options are vested due to a layoff, and that probably had an impact on recognized share based comp. last quarter.

I invariably use share dilution, rather than asses the reported stock based comp. to look at valuation. This company does forecast outstanding shares; outstanding shares are forecast to be 153 million in this current quarter, and 153 million for the full fiscal year, primarily, I imagine, because as part of the company’s cost containment efforts it isn’t giving out any dilutive share based compensation. I have used 154 million fully diluted average shares in my valuation analysis. With 154 million shares, the EV/S ratio is now 10.5X. That is somewhat above average for the company’s growth cohort, which I have estimated in the high 30% range. Given that it is not yet generating cash, its relative valuation is higher than average when considering the combination of growth and free cash flow margin.

I recognize that this kind of relative valuation may deter some investors. But just to provide some context, GitLab. MongoDB ( MDB ), Confluent ( CFLT ) and The Trade Desk ( TTD ) all have approximately equal relative valuations, although each one has different components in terms of its valuation. The fact is that valuation rests on an estimated multi-year CAGR, and that CAGR is at least in part a guess. GitLab’s had growth of greater than 70% during part of FY ‘23, and it forecasting growth of just 28% this year. 28% reflects an apogee of macro headwinds, and probably doesn’t include any substantial level of impact from the company’s AI initiatives or the full impact of its recent price increase. I have used a 3 year CAGR estimate of 38% in an abundance of conservatism given the many unknowns, and particularly the uncertainty about the cadence of adoption of Generative AI.

The basic tenets of a purchase recommendation include GitLab’s industry leading position in the DevSecOps space. GitLab has been a share gainer in its space for years, and despite macro headwinds, it is still a share gainer. The overall DevOps market is large and underpenetrated; Gartner’s latest report says that over the next 4 years, penetration of DevOps will rise from 25% currently to 75% of enterprises. According to Gartner and other 3 ^rd party analysts, users are increasingly adopting platforms that provide fully integrated capabilities to enable continuous delivery of software.

GitLab has announced 10 specific generative AI features as part of its platform. These are still in Beta-they ultimately will be packaged and separately charged as a feature at a price of $9/month. This company has 10s of millions of users-although many of those are not paying-so the potential revenue impact of this extension on revenue can be substantial.

Despite macro headwinds, the company saw demand show some resilience in the latest quarter, and it exceeded its forecasts for revenue and for bookings. Management believed that it had sufficient visibility to marginally increase its forecast for future quarters, but this is a fraught and murky environment for software demand-that hasn’t changed. The company began implementing a price increase a little more than 2 months ago; the price increase is not insubstantial for users in the company’s less enabled tier, but so far, the CFO is seeing little change in churn and user addition metrics.

After a difficult quarter that ended in January, the company implemented layoffs of about 8% of its staff. Some of those impacts were visible in improved operating expense ratios last quarter. More improvements are likely over the next couple of quarters.

Should investors buy the shares after the recent spike? Part of that decision will surely be a factor of reader expectations with regard to risk on/risk off conditions. GitLab needs a risk-on market to work well as an investment. The shares are going to be sensitive to macro trends, particularly including interest rate expectations and sentiment reversals.

That said, I believe the investment case for the shares rests on a growth rate that is now likely underestimated because of as a yet to be quantified opportunity to accelerate the company’s growth rate because of its Generative AI extension offering, a leading competitive position in its space and a rapidly improving business model that may produce a quarter or two of free cash flow this year, and which should produce a full year of free cash flow in FY’25.

I don’t always buy my recommendations immediately; it’s simply a matter of portfolio management and thus I do not currently own these shares. But I expect I will be a buyer of the shares at some point in the future. I like owning the shares of the leading company, with strong share gain trends in a rapidly growing space. On that basis, I expect GitLab to produce plenty of positive alpha over the coming year.

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