MNDY - Market Trends Favorable For Smartsheet's Upmarket Strategy

2023-04-24 05:02:04 ET

Summary

• Smartsheet is a cloud-based platform for managing unstructured or ad hoc projects.
• Smartsheet Advance has contributed to consistently high DBNRR rates of over 120% in the enterprise market.
• The upmarket sales motion is gaining traction, and there is a significant greenfield opportunity for growth.
• I assign a buy rating to SMAR stock with an end-of-year price target of $51.8.

Thesis

Despite consistently exceeding expectations and providing an optimistic outlook for the future, Smartsheet Inc. ( SMAR ) shares have underperformed compared to NASDAQ over the past year. The likely reasons for this are concerns about the company's enterprise go-to-market strategy, which has not been consistently executed, and competition in SMAR's core work management market. However, recent market trends suggest that there is an opportunity for multiple companies to succeed, and SMAR's improving upmarket strategy is a positive factor. Therefore, my view is turning more favorable, as I believe that the current market conditions provide an opportunity for multiple companies to succeed. I assign a buy rating to the stock with an end-of-year price target of $51.8 based on a forward EV/Sales assumption of 6x applied to a consensus revenue estimate of $1.15 billion for 2024.

Smartsheet Advance Remains Key for Growth

Investors have been concerned about Smartsheet's lack of a mature enterprise go-to-market strategy. However, Smartsheet Advance, launched in June 2021, has gained significant momentum and has been instrumental in driving the company's accelerating DBNRR (dollar-based net retention rates). In Q4, DBNRR stood at 125% and has consistently remained over 120% over the past year.

Although Smartsheet has faced challenges in its enterprise motion since its inception in 2018, including restructuring and high turnover in 2020, Smartsheet Advance remains a key contributor to recent success. The upmarket sales motion is gaining traction, and with penetration still low within enterprise accounts, there is a significant greenfield opportunity for growth, particularly as Smartsheet Advance replaces manual processes. Investors have also expressed concerns about the highly competitive and fragmented market, but with Smartsheet's improving upmarket motion, product positioning, and greenfield opportunity, there is increased confidence in the company's ability to capture share. Overall, despite past challenges, Smartsheet's recent success with its Advance offering suggests promising growth prospects in the enterprise market.

Focus on Profitability in FY 2024

Looking ahead to the fiscal year 2024, there are several factors that make me optimistic about Smartsheet's potential improvement in profitability and cash flow. Firstly, there has been a slowdown in hiring, with headcount growing around 21% year-on-year ending February, aligning with comments from the company about adjusting the pace of hiring going into this year. Secondly, Smartsheet is entering this fiscal year with an incrementally higher number of ramped quota-carrying reps, driving potentially one of the best quota capacities entering a new fiscal year, which should help with productivity per rep. Thirdly, the focus on a higher level of digital selling should help with efficiency, although it may not be a material contributor in FY24. Fourthly, management has characterized its FY25 (or CY24) free cash flow margin target of +10% as a "low watermark," which I think speaks to the potentially higher profitability in outer years.

Expansion opportunity within the existing customer base

SMAR's platform is initially used by customers for a single project or process, but they tend to expand its usage across their organization. This trend is evident in the increase of SMAR's average annual contract value ((ACV)) over the past eight quarters. This growth presents a positive long-term outlook, especially with the rise in customers with an ACV greater than $100K, which has grown by 44% over the past year. SMAR's "expand" strategy provides a strong revenue growth opportunity as the company continues to acquire new customers who find new use cases for the platform. Management cited that thousands of use cases exist, which could support SMAR's continued expansion.

In 4Q22, management noted that the number of customers with annual recurring revenue ((ARR)) greater than $50,000 increased by 36% to 3,206, while the number of customers with ARR over $100,000 grew by 45% to 1,484. This presents a significant opportunity for SMAR to increase its revenue, given the company's evidence of upselling success in this cohort.

Easy-to-use platform enables broad-scale adoption

The Smartsheet platform is versatile and can be used by businesses of any size and by any type of user. The management has noted that most bookings start with small transactions, typically under $5K in annual contract value. The platform's unique offerings, such as customizable APIs that integrate with various business systems and partnerships with leading software companies such as Atlassian Corporation ( TEAM ), Salesforce, Inc. ( CRM ), and Teams, give it a competitive edge and make it less vulnerable to competition in the small transactions segment. Additionally, once customers reach a certain level of success or growth, it is rare for them to look for alternatives in the market, which demonstrates the strength of Smartsheet's competitive advantage or moat. This provides opportunities for cross-selling and could support Smartsheet's position in the market during more challenging macroeconomic conditions as sales cycles lengthen.

Valuation

SMAR shares have underperformed the NASDAQ on a TTM basis, as the company has recovered from its recent troughs and emerged as a beneficiary of a move towards hybrid/remote work and increased demand for productivity-enabling solutions.

On an EV/NTM revenue basis, SMAR's current multiple of ~5.6x is below peers with a similar growth profile. I do see a strong correlation between revenue growth and EV/revenue multiple for software more broadly; however, suggestive of the potential for multiple expansion should SMAR sustain growth rates in the high 30s to low 40s. Similarly, SMAR's current multiple of 5.6x is well below those of its direct peers like monday.com Ltd. ( MNDY ). Based on my favorable views of the market and SMAR's improving positioning in the enterprise, I view SMAR's current valuation as an attractive entry point, with potential for multiple expansion over time. I keep an end-of-year price target of $51.8 based on a forward EV/Sales assumption of 6x applied to a consensus revenue estimate of $1.15 billion for 2024.

Risks

Smartsheet has emerged as a leader in its category, with a strong client base over the past decade. However, the company faces significant competitive pressure from smaller players, which could impede its top-line growth, margin expansion, and customer retention. Furthermore, the emergence of deep-pocketed mega-vendors such as Microsoft Corporation ( MSFT ), Google, and CA Technologies could pose a threat to Smartsheet if they develop similar functionality and offer them at discounted prices or as part of a broader customer engagement package. While new customer acquisition is important, much of Smartsheet's growth story depends on its ability to expand within its existing customer accounts and maintain a dollar expansion rate of over 120%. Failure to achieve this could affect revenue growth and gross margin leverage, impacting the company's stock.

Final Thoughts

Smartsheet is a popular platform for managing unstructured or ad hoc projects using the cloud. The platform's licensing model is straightforward and designed for easy adoption within organizations, making it a valuable tool for businesses. SMAR has experienced significant success in the enterprise market with the launch of its Smartsheet Advance offering, which has contributed to consistently high DBNRR (dollar-based net retention rates) of over 120%. While Smartsheet has faced challenges in its enterprise sales motion since its inception in 2018, the upmarket sales motion is gaining traction, and there is a significant greenfield opportunity for growth as Smartsheet Advance replaces manual processes. I have a buy rating on the stock with an end-of-year price target of $51.8.

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