SEMR - Semrush: Reiterate Buy On Growth Trend Pivoting Back To Historical Levels

2023-06-22 11:20:34 ET

Summary

• SEMR shows signs of recovery, with a return to more typical levels of net new paying customers in 1Q23, indicating potential for further growth.
• Strong unit metrics, including increased ARR per paying customer and a growing customer base, support my bullish thesis.
• The App Center presents opportunities for up- and cross-selling, and as the economy recovers and market sentiment favors growth tech stocks, I expect SEMR's valuation to improve.

Overview

I reiterate my buy recommendation for Semrush Holdings ( SEMR ). My belief remains that following COVID, there has been a significant global shift toward online business. This shift has resulted in a rise in digital marketing solution providers to serve the growing number of online businesses, and the spike in the digitization of businesses translates to a greater market opportunity for SEMR. Sentiments have been bad for the stock as the number of paying customer adds started decelerating from the usual 4 to 5k adds to just 1k in 4Q22, which kickstarted a series of sell-off. In 1Q23, however, the number of net new paying customers has returned to more typical levels. Unit economics, including ARPU and operating margin, improved sequentially despite a slowdown in growth and NRR. The latter doesn't concern me too much right now because it may indicate that seat increases at existing customers are slowing down as a result of the macro backdrop. As a whole, I anticipate growth to continue recovering to previous levels (pre-2H22), given that management has now focused its investments to increase its up/cross-sell capabilities. This should increase the number of users who upgrade from free to paid in the next few quarters, which will boost growth in the near future.

Strong unit metrics

First-quarter ARR came in at $293 million, an increase of $18 million vs last year. Although the $18M of net-new ARR in Q1 is $5M less than the $23M in 1Q22, it is still an improvement over the $8M in Q4. Although Q1 is typically a stronger quarter for net-new ARR, and ARR is still slowing on a y/y basis, I believe it reflects strong execution in that management managed to hold the ship steady. Importantly, the number of new paying customers recovered to 5k, bringing the total to over 100k, and furthermore, 20% of customers are purchasing >2 products, which I see as an implicit increase in retention rate, and unit economics. Based on my read, I think there is still a lot of room for SEMR to improve its ARR per paying customer ($2.9k as of 1Q23), and management pointed out in the JPM TMC Conference held on 19th May that their average ARR per paying customer is around $3K lower than peers. This difference is, in my opinion, primarily attributable to the fact that its customer mix consists of a large number of very small businesses, thereby decreasing the ARR generated from each customer. Continued progress in SEO and SEM, a cross-sell and upsell motion that includes 55 applications that broaden offerings beyond its core, and the app center, which presents yet another cross-sell opportunity, are all ways in which I anticipate increasing ARR per paying customer.

App Center

I believe the App Center will help SEMR increase its up-and cross-selling. With the addition of new apps and features, the App Center should broaden SEMR platform and increase customer stickiness, in my opinion. By incorporating apps created by outside developers, SEMR can also quickly and cheaply test product hypotheses and gauge customer interest, resulting in cost savings and a sped-up time to market. I anticipate that management will continue allocating resources to the development of the App Center, which may affect near-term financials due to investments (R&D and also S&M to find partners). The way I would monitor this is by the number of apps it is hosting (right now at 51).

Long-term guidance

Despite a difficult macro environment, management has reaffirmed its commitment to achieve its long-term margin targets, which lends credence to my bullish thesis. With a reported margin of 82% in 1Q, SEMR is well on its way to achieving its gross margin goals. In the long run, I anticipate that margins will continue to grow so long as SEMR keeps their investment focus on growing their product line to increase scale and revenue. There will still be spending on R&D, but management expected it to grow at a slower rate than the company's top line, which I expect will allow for profitability improvement in the coming quarters.

Valuation

I believe SEMR's upside will be more backloaded as the economy recovers and the market begins to favor growth tech stocks, particularly unprofitable ones. This applies to SEMR, and when it does, I believe valuation will begin to return to historical levels (not pre-2022 given the interest rate environment), such as those seen in 1H22 when SEMR was still adding paying customers at the 4 to 5k level (normalized). Specifically, I have modestly tampered my growth assumptions to reflect my conservatism in the near term until FY25, but believe that holding through FY25/6 would allow an investor to benefit from the potential multiple re-rating (back to when SEMR was adding 4 to 5k customers) as the valuation paradigm rolls forward from focusing on FY25 numbers to FY26 numbers. SEMR should be worth more than $20 per share in FY25 at that valuation.

Risks

SEMR's platform, products, and solutions rely partly on access to third-party data sources to produce well-informed insights for their customers. They collect third-party data using their own proprietary data collection techniques. If, by any chance, they lose access to the third-party data, their business will suffer.

If search engines, social networking sites, and other third-party data sources change their technology configurations and/or policies regarding the use of their platforms for commercial use, SEMR's products that use this data will be less efficient.

Conclusion

I maintain my buy recommendation on SEMR as I continue to believe in the global shift towards online business and the growing market opportunity for digital marketing solution providers. Despite concerns over customer adds deceleration in the past, SEMR has shown signs of recovery, with a return to more typical levels of net new paying customers in 1Q23. Strong unit metrics, including increased average revenue per paying customer and a growing customer base, indicate potential for further growth. The App Center presents opportunities for up-and cross-selling. As the economy recovers and market sentiment favors growth tech stocks, I expect SEMR's valuation to improve.

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