GTLB - GitLab: Strong DevOps Player However Patience Advised

2023-10-12 00:20:47 ET

Summary

• GitLab exceeded expectations in Q2, raising its full-year revenue and margin projections.
• The demand for digital transformation remains strong, driving the need for software solutions like GitLab's platform.
• GitLab plans to expand its base of enterprise customers and increase revenue, but faces competition and economic pressures.

Investment Thesis

GitLab Inc. ( GTLB ) is a software company specializing in open-source solutions that provide a comprehensive platform for developers to support various aspects of the DevOps lifecycle, from software development and continuous integration to testing, deployment, and monitoring. GitLab's robust single codebase architecture is well-suited to assist businesses in addressing crucial DevSecOps requirements, and I see the company benefiting significantly from vendor consolidation in the long run. However, despite my liking for the company's platform, challenging macroeconomic conditions seem to be disproportionately affecting GitLab. Although I hold a positive view of the company and believe it is well-positioned, benefiting from various favorable trends that could drive sustainable growth in the medium term, I assign a hold rating to the stock primarily due to valuation considerations.

FQ2 Review and Outlook

GitLab delivered strong results in its second fiscal quarter, surpassing expectations in key performance metrics and raising its full-year revenue and margin projections, indicating better-than-anticipated business trends. The company's revenue exceeded consensus estimates, growing by 38% year-over-year, and its profit margins outperformed expectations. Although the net retention rate decreased from the previous quarter, GitLab noted that customer purchasing patterns stabilized and contractions reduced compared to previous periods.

Looking ahead, GitLab showed robust growth in its Remaining Performance Obligation ((RPO)), with a 37% year-over-year increase and substantial sequential additions, primarily driven by significant deals. However, the growth rate for Committed Remaining Performance Obligation (cRPO) slowed to 34%, a 9-point deceleration from the first quarter, with sequential dollar growth in cRPO and Deferred Revenue in the second quarter slightly lagging behind the first quarter.

Regarding the impact of a price increase, GitLab reported positive results after four months of data, with bookings surpassing expectations and lower-than-expected customer churn. Looking forward, the company raised its full-year revenue and operating margin guidance while reiterating its goal to achieve free cash flow breakeven in fiscal year 2025.

Software Plays a Key Part in a Digital World

In today's increasingly digital world, software remains a crucial driving force. Despite economic conditions, organizations are unwavering in their commitment to prioritize ongoing digital transformations. These transformations empower organizations to offer greatly enhanced and personalized customer experiences, which are now expected and demanded by customers in a world that prioritizes the cloud, mobile, and interconnected devices. This heightened customer experience consistently leads to increased engagement, customer retention, and opportunities for upselling. Digital transformation is motivating companies in all industry sectors, even those traditionally less agile, to invest more in IT. These investments are aimed at generating additional revenue and enhancing operational efficiency.

Nearly all organizations are becoming increasingly dependent on software, and this trend is only strengthening. Agile software development and continuous deployment practices are making organizations more competitive, enabling them to operate with greater efficiency and speed. While macroeconomic challenges may lead to longer sales cycles and the need for optimizing workloads in the public cloud, I expect the overall demand for digital transformation to remain strong in 2023. This is because companies are continuing to rely more on cloud technologies as an integral part of their operations.

Enterprise Push Crucial for GitLab's Path to Revenue Growth

GitLab has the potential to increase its revenue to $1 billion and capture additional market share by fiscal year 2028. This can be achieved by focusing on improving the customer mix, enhancing client outcomes, and increasing cross-selling and upselling. Additionally, a higher proportion of large enterprise customers could contribute to improved operating profits and margins. To expand its base of enterprise customers with annual recurring revenue exceeding $1 million to over 100 by fiscal year 2025, GitLab plans to grow its direct sales team, forge strategic partnerships, and collaborate closely with hyperscale and cloud providers. Although GitLab currently lags behind its competitors, it managed to increase the number of such large enterprise customers by 60% year over year, reaching 63 by the end of April, up from 39.

Valuation & Financial Outlook

GitLab's rivalry with best-in-class, better-resourced tool providers will be challenging. What's more, its focus on expanding the base of large enterprise customers could entail additional upfront investment and a longer sales cycle. With more than 150 companies vying for a share of the DevOps market, competition remains intense. GitLab spent almost 70% of its revenue on sales and marketing in the past 12 months. Though getting bigger may reduce that ratio, I do not see it going down significantly through 2027. GitLab's profitability faces a threat from the slowing global economy and the effect it could have on sales.

GTLB trades at a forward EV/Sales multiple of 11x, at a substantial premium to the sector median. Despite my enthusiasm for the GTLB platform and belief that the company should benefit from a number of important secular trends, its ability to execute at a fairly high level in the near-term remains far more uncertain. Hence, I think there are limited chances of upward multiple re-rating in the near-term and, hence, assign a hold rating to the stock for now.

Investment Risks

GitLab has established itself as a leading player in its category, offering impressive capabilities across the entire DevOps process and boasting a strong portfolio of enterprise clients. Nevertheless, the ongoing competitive rivalry from Microsoft, particularly in the context of their broader DevOps strategy, could impact GitLab's ability to acquire new customers, maintain revenue growth, and enhance profit margins. Furthermore, the growing maturity of other DevOps platforms, like those provided by JFrog or CircleCI, among others, could intensify competition in the future.

If economic pressures worsen, GitLab's ability to close larger deals and maximize its existing customer base may be negatively affected. Moreover, due to the macro environment, businesses might choose to allocate their IT budgets elsewhere or delay such initiatives due to an increased focus on cost-saving measures.

The inability to expand its customer base could hinder GitLab's growth. While gaining new customers contributes to the company's growth, a significant portion of GitLab's expansion relies on monetizing its existing customer relationships, particularly by increasing and sustaining its dollar-based net retention rate. If GitLab cannot demonstrate a strategy for growth within its current customer accounts, it may experience a negative impact on revenue growth and its stock performance.

Conclusion

GitLab's strong single codebase architecture is well-suited for helping businesses address essential DevSecOps needs, and I believe the company can gain significant advantages from industry consolidation in the long term. While GitLab's platform and its alignment with important industry trends are promising, its near-term execution remains uncertain, leading to a hold rating due to its high valuation and limited potential for multiple re-rating in the short term.

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