HCP - HashiCorp: Growth Should Return To Historical Average Eventually

2023-12-28 05:28:26 ET

Summary

• HashiCorp's revenue growth exceeded expectations, with subscription revenue growing by 18%.
• The drop in share price post-Q324 results was likely due to revised FY24 guidance and uncertainty about future growth rates.
• Despite concerns about certain metrics, the long-term growth potential for HashiCorp remains positive due to multi-cloud adoption and continuous innovation for developers.

Investment action

I recommended a buy rating for HashiCorp ( HCP ) when I wrote about it the last time , as I expected growth to reaccelerate as HCP moves towards FY25, where the economy should start to recover. Importantly, I believed that the long-term secular tailwind for HCP remained strong and that HCP was well positioned to ride on it. Based on my current outlook and analysis of HCP, I recommend a buy rating. My view remains the same for HCP, in that the secular tailwind remains strong and HCP is poised to return to 30+% growth eventually. I don’t think the weak 4Q24 revenue guidance is a good representation of long-term growth potential, as I believe management is being conservative due to the macroeconomic situation.

Review

HCP reported 3Q24 revenue growth of 16.6% to $146.1 million, beating the consensus estimates of $143.2 million. The bulk of HCP’s revenue, subscription revenue, grew 18% to $141.9 million. Better-than-expected top-line growth was accompanied by an expanding margin profile. Wherein, non-GAAP gross margin expanded by 61bps to 85.8%, and non-GAAP operating loss came in at -$10.5 million (-7.2% margin), which was well above management's guidance for -$23 to -$26 million and a -17% operating margin.

The burning question to address is why the HCP share price dropped by 20% post-Q324 results. I believe it was primarily due to the revised FY24 guidance. While FY24 guidance was revised upwards, the 4Q24 revenue growth painted a weak growth outlook for FY25. Specifically, 4Q24 revenue was guided to $149 million, or 10% growth at the midpoint, while FY24 was guided to grow at 21%. Naturally, the bugging question would be, “Is the base growth rate 21% or 10% for FY24?”. I believe this uncertainty has led to many investors pulling their capital out of the stock as they await further validation. Suppose 10% is the base growth rate to think about when modeling HCP FY25 performance. It is likely that consensus will start to revise their estimates downward, impacting valuation. FY24 exit growth rate aside, HCP also reported certain metrics that are quite negative. For instance, pro-forma CRPO is essentially flat sequentially at $420.8 million in 3Q24 vs. $420.3 million in 2Q24, which is a degradation in performance when compared to the 5% sequential growth last year (3Q23 vs. 2Q23). Cloud platform subscription revenue sequential growth also decelerated by 300bps to 8%, reflecting a weaker sales trend for HCP’s cloud-based business. The last nail in the coffin, in my opinion, was management's decision to hold off on making any remarks—directional or otherwise—about FY25 revenue guidance until its Q4 earnings call.

That said, I am willing to play devil’s advocate and believe that the weak 4Q24 guidance is likely due to the current macroeconomic environment, which is still murky in outlook. My take is that management is most probably being conservative in their estimates. Once the macroeconomic environment recovers, which seems like it is stabilizing, growth should bounce back to HCP’s historical 30+% growth rate. Even though the macro environment will probably slow growth in FY24, new customers are paving the way for reacceleration in the future as HCP executes its land and expand strategy. Indeed, overall customer additions increased from 64 in 2Q24 to 137 in 3Q24, with a particularly noteworthy improvement in HCP additions of customers with more than $100,000 in ARR, which increased from 21 in 2Q24 to 26 in 3Q24. If we layer these datapoints with management commentary that they are seeing higher deal volumes offset by smaller land and expand activity, it suggests that there is still a long runway for growth as HCP “expands” in these newly acquired customers.

Deal volumes, as Navam indicated, are as high as ever. Our win rates are as consistent as ever and we're not seeing any changes to the discounting behavior in our field. We're just seeing smaller land and expand activity from our customers. 3Q24 call

I would also emphasize that the growth runway (customer additions) is still incredibly long for HCP. There are multiple tailwinds at play here. Firstly, my view is that more and more companies are going to adopt multi-cloud infrastructures , and this should drive demand for HCP products. Secondly, as the penetration of object storage services [OSS] increases, it bodes well for HCP as it will make HCP stickier, putting it in a better position to raise prices.

The Accenture folks, the GSIs is a good proxy, they have a very focused hybrid cloud and automation practice that, again, continues to think HashiCorp. Because the OSS is everywhere, they will build a practice around our technology, which will help us with large customers. HCP Financial Analyst Day

Thirdly, I believe HCP can continue to churn out new solutions to make the lives of developers and coders easier. This goes back to the roots of HCP, which is a developer-centric company with deep knowledge of the user community. Given the growing influence of developers in corporate strategy and operations, I see this as a significant advantage. As HCP occupies more and more mind share among developers, they will be one of the few vendors of choice when businesses need to deploy any related solutions. Take, for instance, the new product, Boundary (HCP’s Privilege Access Management), which is already gaining recognition and is adding new revenue streams to HCP’s platform. Furthermore, the more HCP products businesses use, the sticker HCP becomes as it is more tightly integrated with the business workflow processes. In short, HCP becomes even more mission-critical.

Valuation

The management reiteration of FY24 guidance pretty much solidified my view that HCP will grow revenue by a low-20% percentage in FY24. However, I revised my FY25 growth to 15% (half of the 30% historical growth rate) to reflect the macroeconomic uncertainty (management-guided 4Q24 exit growth rate of 10%). My view of growth recovering to 30% remains the same for FY26, as I believe the strong secular tailwind will continue to drive growth once the economy recovers. A slight adjustment to my model is that HCP should trade at 7.3x forward revenue. With 3Q results out, the market has adjusted infrastructure peer valuations upwards to a median of 7.3x. Comparing HCP's operating metrics to peers’ medians (revenue growth, gross margin profile), I believe HCP should continue to trade at the same multiple.

Risk and final thoughts

LTM net dollar retention rate came in at 119%, which is a 500bps deceleration from the 124% we saw in 2Q24 and 134% last year. While I mentioned that this is likely due to the weaker “expand” motion, it could be an emerging red flag of customers churning for unknown reasons. If this metric continues to decline, it would impact growth as it suggests HCP is not able to upsell or cross-sell or that more and more customers are churning. My concluding thoughts are that HCP remains a buy despite the recent market reaction to the weak 4Q24 guidance. Despite concerns regarding the deceleration in certain metrics, I maintain a positive outlook on the long-term growth runway, driven by multi-cloud infrastructure adoption, increased OSS penetration, and continuous innovation for developers.

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