HCP - HashiCorp: Profitability Timeline Pulled Forward

2023-04-18 10:36:02 ET

Summary

• HCP has shown progress towards its goals with both revenue and operating margin increasing and a positive outlook for 1Q24.
• The macro environment is causing some apprehension for management, leading to cautious revenue projections for FY24.
• HCP has made significant strides in improving margins and providing a path toward eventual profitability.

Thesis update

This is an update to my previous post . I still think of HashiCorp (HCP) as a top open source infrastructure software vendor, poised to reap the benefits of the public cloud's surging popularity and drive steady expansion over the next few years. The most recent financial report ( 4Q23 ) shows that HCP is making progress toward its goals, with both revenue and operating margin increasing and a positive outlook for 1Q24. However, management has shown general apprehension about the worsening purchasing climate by being more conservative than usual with their revenue forecast for FY24. Given the persistent threat of a difficult and potentially deteriorating macro, I do respect management's cautious approach to its initial guidance. This cautious guidance has, in my opinion, reduced expectations and illuminated a more direct path toward reducing losses, both of which should aid the consensus in more accurately modeling the business going forward.

1Q24 guidance is better than expected

Revenue growth in 4Q23 remains robust, up 41% year over year. Specifically, the $135.8 million in revenue is $12 million more than the midpoint of HCP's 4Q23 guidance. Thanks to higher-than-expected revenue in 4Q23, operating margin came in at -20%, which was significantly better than expected. This reassures me that HCP's operating leverage is solid, and it opens the door to the possibility of a profit within the next year to 18 months. Importantly, 1Q24 guidance also beats expectations, coming in at 32% revenue growth versus the consensus estimate of 28% and an operating margin of -30%.

Macro worries

While the outlook for 1Q24 is encouraging, there are a couple of warning signs on the other end of the spectrum. Subscription revenue growth among HCPs, for example, slowed to 10% sequentially which is much lower than a typical 4Q. In addition, the growth rate of support revenues slowed from 38% in 3Q22 to 35% in 4Q22, and the growth rate of cloud revenues slowed down as well to 12.7% sequentially in 4Q22. In addition, net new customers dropped from 323 in 4Q21 to 232 in 4Q22. I'm even more concerned by the fact that, compared to a year ago, only 38 customers have reached $100,000 in annualized recurring revenue. When taken as a whole, I think these various signs of slowing suggest that HCP is feeling the effects of the worsening macro environment.

Therefore, I agree with management's decision to be more conservative with FY24 revenue projections. HCP's midpoint revenue guidance for FY24 is $593 million, which is roughly in line with consensus on a dollar basis but falls short in growth, with 25% implied at the midpoint compared to the consensus estimate of 28%. While it is true that the management has observed a surge in transaction count during 4Q22 due to customers opting for shorter deals and smaller purchases, I want to advise investors to be cautious as many procurement departments are becoming more vigilant. This increased scrutiny is likely to prolong the deal cycles and delay growth. It's also unclear to me whether HCP's 32% Q1 growth forecast and 25% FY24 forecast reflect increased risk or is it to provide more room for management to wriggle around such that they will not disappoint. As such, I think the stock price is unlikely to surge in the short-term due to this uncertainty.

Margins outlook

I think HCP has done a fantastic job fundamentally in improving margins, even if we discount the macro weakness I mentioned above. Importantly, management made a series of comments that help provide directional clarity for a path toward eventual profitability, bringing the midpoint operating margin forecast for FY24 to -23%. For instance, operating margin is expected to exit 4Q24 in the -14 to -12% range, and free cash flow margin is projected to be -10% for FY24, compared to -20% for FY23. The final and most significant remark concerns the preemption (from 2H26 to 2H25) of long-term breakeven operating margins. Many investors, I believe, have updated their models as a result of the latter commentary, and this has the potential to drive a positive narrative and share price reaction if HCP performs as guided. I think the market will pay more attention to FY25 figures, so the impact of these comments won't be reflected in the share price until after FY24 ends. Meanwhile, leadership should take precautions to prevent a decline in profits.

Strategy update

HCP's Boundary, a security management tool based on identity, became commercially available in late 2022. A US-based retailer, who had already adopted Terraform enterprise and added Consul enterprise and HCP Boundary to their zero trust bundle, was among the first to use Boundary. This not only demonstrates the success of Boundary but also shows the comprehensive capabilities of the HCP platform as it expands and introduces innovative solutions.

Conclusion

In conclusion, HCP remains a top open source infrastructure software vendor with a positive outlook for 1Q24 and progress toward its revenue and operating margin goals. However, management's cautious approach to its initial guidance, due to macroeconomic concerns, has reduced expectations and highlighted a more direct path toward reducing losses. While there are some warning signs of slowing growth, such as slower subscription and support revenue growth, HCP has made significant strides in improving margins and providing a path toward eventual profitability. Despite uncertainty surrounding HCP's revenue and growth forecasts, I believe the market will likely pay more attention to FY25 figures once we get closer to FY24 and the potential impact of HCP's strategic initiatives on future growth and profitability - which will drive share price upwards.

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