GTLB - GitLab: Rating Upgrade As Growth Remains Strong And Valuation Is Now Reasonable

2023-10-12 00:08:33 ET

Summary

• GitLab's revenue growth exceeded expectations in 2Q24, with a 37% increase and improved operating margins.
• Customer spending patterns are stabilizing, and the adoption of GTLB's Ultimate tier is increasing.
• Macro conditions are stabilizing, and GTLB is gaining traction in high-value deals, positioning the company for continued success.

Overview

My recommendation for Gitlab ( GTLB ) is a buy rating, as I expect growth to exceed my previous expectations and valuation to sustain at these levels. Note that I previously rated a hold rating for GTLB because my concern is that valuation will compress back to 9x forward revenue given that the business growth rate did not deserve such a high premium. Since my last rating, valuation has gone the way I expected, compressing to 9.5x today.

Recent results & updates

GTLB's 2Q24 results exceeded my expectations, with revenue growth of 37% (higher than my 30% expectation for FY24e) and an operating margin of -3% (much higher than the consensus expectation of -5%, by 500 bps). It's important to address the concerns that potential GTLB investors may have before discussing the company's positive outlook. To begin, the net retention rate decreased by 400 bps between the first and second quarters of this year, falling to 124% in 2Q24 from 128% in 1Q24.

However, the fact that customer spending patterns in the quarter stabilized when compared to previous quarters indicates that contractions have levelled off. Notably, there appears to be less of a contraction volume than in 1Q24. Furthermore, GTLB's Ultimate tier is experiencing robust adoption due to customer victories in security and compliance applications, now making up 42% of ARR compared to the 39% it represented in the second quarter of 2023 last year. As such, I would not focus too much on the reduced net retention rate and ignore other good parts of the business (as I discuss below).

I expect GTLB to exceed my previous growth expectations in the near term, as the macro environment seems to be stabilizing for GTLB and it is gaining strong traction in winning deals with high unit economics (as seen in the Ultimate Tier adoption). At the San Francisco conference , management stated that macro conditions were stabilizing sequentially. However, GTLB should see a slower rate of deceleration in FY25 as the company laps more difficult gross retention rates over the next quarter or two. They also mentioned that, following a period of excess seat commitments paid in advance, companies are now being less lavish with money. In other words, any potential slowdown in the near term is simply because of demand pulled forward previously, which is not structural to the business.

The fact that GTLB's customers can increase their return on investment by more than four times and decrease the time it takes to create new software by 7x compared to when they used individual point solutions is a huge selling point for me, and I expect the company to continue to be successful. These are staggering numbers that highlight the value of using GTLB and further persuade me that it has a bright future ahead of it. As evidence, consider the fact that GTLB is luring customers away from Jira.

The customer wanted to drive greater efficiency by integrating an enterprise agile planning solution with the rest of their software development practices. They moved thousands of business users from Jira to GitLab. AI continues to be a key area of product innovation.

And what's happening is that people are moving from point solutions to a platform because you can get the cycle time up. And our enterprise portfolio management is good enough to replace Jira in many instances. From: 2Q2023 earnings call

Additionally, with GTLB's suggested code review tool, customers can cut down on the time needed for reviewing code - a lengthy process that slows down code deployment. I think GTLB is a good fit for businesses that are looking to maintain a lean budget, streamline their spending, and improve their operations. If management keeps expanding the breadth of the company's offerings through the release of 10 new artificial intelligence features, I have no doubt that product innovation will remain a key growth driver in the years to come. In my opinion, these updates can boost developer productivity and serve as yet another example of GitLab's domain expertise and product breadth.

With GTLB's continued success at converting its free users to paying customers (via the enforcement of new user limits), growth should be sustainable for the foreseeable future. Growth can also be expected from price increases brought about by the introduction of Gen-AI services (at a cost of $9 per user per month) and the Premium tier's subsequent price increase. These factors contributing to growth, combined with the stabilization of demand when compared sequentially and a reduction in the contraction of deals, are expected to result in a resurgence in growth once the demand environment improves.

Valuation and risk

According to my model, GTLB is valued at $53.86 in FY24, representing a 13% increase in the short term. This target price is based on my growth forecast of 35% over the next two years, 500 basis points higher than my original 30% expectation. The increase in growth expectation is because of the various pricing upside growth drivers (mentioned above) and the stabilization of macro conditions.

GTLB is now trading at 9.5x forward revenue, which I believe will remain at this level in the near term as the business should continue to grow at the current pace. I previously expected 9x, as I believe growth will slow down to 30%; however, 2Q24 results and management's comments have proven me wrong. When compared to other application software peers, it is also clear that GTLB growth is at a premium (30+% growth vs. 20% growth). Coupled with the point that GTLB is improving its profitability (-3% EBIT margin in 2Q24, which means it is going to be profitable soon), I expect the GTLB valuation premium vs. peers to sustain.

The risk is that GTLB's near-term growth drivers depend on the company's success at turning its free users into paying customers in exchange for more of the same. If these users are content with the free version or come to the conclusion that they do not need to convert, GTLB's expansion could be stunted.

Summary

I upgraded my rating to a buy rating for GTLB as the company has shown impressive growth that has exceeded my previous expectations. While I initially had concerns about a potential compression in valuation, GTLB's current valuation at 9.5x forward revenue seems reasonable given its growth trajectory. The recent 2Q24 results, with revenue growth at 37% and improved operating margins, indicate the company's strong performance. Despite a slight decrease in net retention rates, it's important to note that customer spending patterns are stabilizing, and the adoption of GTLB's Ultimate tier in security and compliance applications is on the rise.

Furthermore, macro conditions appear to be stabilizing, and GTLB is gaining traction in high-value deals. Management's expectation of a slower deceleration rate in FY25 is encouraging. GTLB's ability to offer substantial ROI and efficiency gains to its customers positions it for continued success.

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