ASAN - Smartsheet: Once A Highly Valued Highflyer Now A Profitable GARP Story

2023-09-16 04:15:50 ET

Summary

• Smartsheet has become a GARP story as its growth has decelerated and valuations have compressed.
• The company's Q2 earnings release should have alleviated investor concerns, with reaffirmed billings growth and strong profitability.
• Smartsheet is gaining market share in the workflow management space and is expected to continue growing in the future.
• The company's AI releases have reached general availability and should start to become a tailwind to revenue growth next quarter.
• The company's business model has shown substantial improvement as expense discipline has significantly improved, and gross margins have remained above 80%.

Smartsheet: Putting some investor concerns to rest:

It may hard to accept that Smartsheet (SMAR) has now become a GARP story. Like many high growth IT companies it started its life as a public company valued stratospherically. As percentage revenue growth decelerated and valuations of most high growth IT companies compressed, Smartsheet valuation fell substantially . I don’t purport to know the interstices of reading charts; that said, this chart shows a triple top , and then a decline of about 50% to current share price levels. The shares have traded in a range for most of this year. The company’s business has continued to grow and the company took a decided turn to non-GAAP profitability and free cash flow generation a little more than a year ago. Most recently, in the wake of the quarter reported in May, investors and traders concluded that its growth wasn't good enough and that its billings forecast was aggressive. While the company achieved its guided headline results, calculated billings were considered to be disappointing , and the company management described macro headwinds as a challenge during the call . The company didn’t raise its guidance for revenues and analysts questioned its full year billings guidance of 20% even though that has been unchanged since the start of the current fiscal year.

The result of the Q1 earnings release was to send the shares down by almost 30% in a couple of days. The shares, so far this year, are up just 10%, quite a bit below average for software stocks, and certainly for software stocks with such a steep positive ramp when it comes to earnings.

The quarter reported late last week was one in which the results should have ameliorated a host of investor concerns. That said, the company hasn’t seen a return to a “normal” buying cadence. But it did talk about macro stabilization particularly for enterprise customers, it did raise guidance for revenues and EPS, and it did reaffirm its billings forecast. Given the valuation of the shares, and the skepticism many had felt about billings that has turned out to be good enough. The CFO, on multiple occasions talked about why billings guidance was actually conservative, and perhaps less than might be attainable. Parsing the numbers carefully, and looking at the track record this company has relative to its forecasts, it is difficult to be terribly concerned that the current billings forecast is particularly aggressive.

This is a recommendation to buy SMAR shares. I am writing this article at this point, less than 3 months after my prior article covering the company, basically because the shares have yet to reflect, at least entirely, either demand growth stabilization trends or the strong increase in both profitability and free cash flow generation. In some ways, the shares are less highly valued now than was the case back in June despite better visibility and stronger profitability.

I frequently recommend to subscribers to Ticker Target that they construct a high growth IT portfolio based on segments as much as individual companies. Workflow management is expected to have one of the strongest growth rates of any sector in the enterprise software industry over the next 5+ years. The study linked here suggests that the CAGR of the space will be greater than 30%. The current economy is creating significant headwinds to that growth and SMAR is forecasting full year revenue growth in the mid-20% range. The outlook for the economy is, no doubt, murky at best, and commentators and analysts seem to change their outlook as often as they enjoy hot dinners-as I complete the editing process the soft landing outlook seems to have returned as the favored scenario. Most businesses have to modernize processes and workflows in order to achieve reasonable gains in productivity and to create an acceptable environment for their employees. For the most part, workflow management solutions facilitate transformations that customers are trying to achieve.

That said, it should be clear that workflow management is not the absolute priority for users. In an environment in which economic conditions seem unsettled, it is not terribly surprising that there are macro headwinds in terms of demand for workflow management solutions. Users are reluctant to add seats, when they are trying to restrict their own expense growth. I expect the CAGR of Smartsheet to bounce up when economic conditions cease to present significant uncertainty.

Enterprises of all sizes use workflow management. My own anecdotal checks suggest that the larger the enterprise, the more essential the workflow management tool. I am not likely to be some kind of luminary source with regards to the kind of landing the economy will have; soft, medium, hard or something else. What I think I can say is that when that landing is in place and fully recognized, SMAR, along with competitors is likely to experience a significant positive growth rate inflection and that is most certainly not priced in to these shares at the current time.

Measuring market share in workflow management is not the same as measuring market share in the auto industry. Definitions as to what is a workflow management tool vary, and even the number of domains using a tool means less when much growth is coming from strong increases in average revenue per domain. That said, Smartsheet is one of the leaders in the space with ARR approaching $1 billion, and I think that its share is increasing and should continue to increase for the foreseeable future. I will come back to my expectations with regards to market share later in this article.

Simply put, my investment thesis for Smartsheet is that their space, workflow management, is large, under penetrated and is amongst the fastest growing segments of enterprise software. I believe that Smartsheet is most likely a share gainer and consolidator, and its rapid improvements in its business model are impressive. While all that has been happening or is likely happen, valuation has compressed making the case for the shares more emphatic, I believe.

One significant concern had been that Cisco (CSCO), a major customer of Smartsheet was thinking of migrating to an alternative solution-Asana (ASAN), actually was the rumor. That didn’t happen and indeed Cisco signed a large multi-year, multi-million contract extension. Smartsheet, as the company name implies, started life as a vendor selling collaborative spreadsheets to thousands of smaller users. It pivoted hard to the enterprise some time ago, and that pivot has included a focus on the performance of its platform. The company has released technology that allows for substantial scale and high performance, and companies like Cisco have found it useful to grow their SMAR commitments substantially. The 3 principal competitors in the space have recently announced substantial performance enhancements for their core technology. Trying to make a judgement about buying a position in the workflow management space based on the performance of the different products is basically a bootless undertaking.

There are many competitors in the workflow management space. It is almost inevitable that an application which is basically concerned in managing and automating workflows and projects would be correlated in whole or in part with macro conditions. Trying to judge which competitive solution offers users a greater value is probably a dead-end so far as determining which the best investment in the space is. I have linked here to the Gartner review of the company’s capabilities, but realistically it isn’t substantially different from reviews of many other vendors in this space.

What has been important for Smartsheet is its “Advance” bundle and its “capabilities.” I often write about platforms and consolidation. That has been the most significant factor driving this company’s success. In particular, the company’s growth has been primarily a function of what it calls its Advance bundle. It isn’t so much that SMAR is offering a particular unique capability, as it is that the company offers all of the workflow management capabilities that are important for users on a single platform at a reasonable price. There are several pricing levels of Advance as can be seen here; the basic tier cost $25/user/month, but the Enterprise tier is the fastest growing. Overall, much of the growth of the company is coming from users moving to add more functionality to their deployment as well as more seats. The average ACV per customer rose by 17% year on year and by 4% sequentially.

Generative AI capabilities are a natural fit for an overall workflow management solution. They will improve the productivity of the app and decrease time to benefit. At this point, Smartsheet is not pricing most of its AI capabilities on a standalone basis, but is making them available only to paid users on enterprise plans. I don’t think it is possible, currently, to quantify the impact, if any, to the company’s growth or to its forecast. The CFO indicated that at this point, Smartsheet guidance didn’t include any incremental revenues from its AI features that are now in private beta test, but did include some costs related to the expenses of introducing the technology. There will almost certainly be some revenue benefits through upgrades that impacts Q4 results that is not baked into the consensus expectations as depicted by 1st Call.

Despite the modest share price spike in the wake of the company’s earnings and guidance, SMAR shares have a very undemanding valuation. Based on using a 4 quarter revenue forecast of $1065 million, and a 13% free cash flow margin projection, the projected EV/S is just greater than 4.9X and the valuation is now more than 20% below average when considering both the free cash flow margin and growth.

Smartsheet: a market share gainer

As mentioned, I believe that Smartsheet is gaining and will continue to gain share in the workflow management space for the foreseeable future. Here is a link to which shows most of the leading competitors in the space. Amongst the public companies, Monday (MNDY) and Asana (ASAN) have a similar focus on this space. Atlassian ( TEAM ) is also thought of as a competitor with both Trello and Jira being considered as tools to manage workflow. Microsoft ( MSFT ) has a project management tool, as does ServiceNow ( NOW ). Just looking at revenues, and revenue growth, the position of Smartsheet is pretty evident.

Last quarter Smartsheet reported revenues of $236 million, and revenue growth of 26%. Monday reported revenues of $176 million , and revenue growth of 42%; Asana reported revenues of $163 million and growth of 20% and Atlassian reported revenues of $939 million with revenue growth of 23%. Many readers will recognize that a substantial component of Atlassian’s revenue does not come from workflow management, regardless of how it is defined, and that its numbers are significantly influenced by its migration of its user base to its cloud products. There are, no doubt, other ways of calibrating market share, but my belief is that the results of this latest quarter accurately reflect market trends.

I think most industry analyst accept that Monday and Smartsheet are the two leaders in this space. One thing about taking a sector approach to investing is that I don’t absolutely have to make a judgement between two well run, innovative companies in the same space. I own and recommend both Monday and Smartsheet and I can adjust weightings between the two companies if I feel it makes sense to do so.

Monday has been enjoying a growth spurt because of tweaking its tool to provide users with a very keenly priced Customer Relationship Management offering that has had a material impact on the company’s growth. This has been well recognized by investors and Monday has an EV/S of almost 9X, although one reason for that valuation premium is its 23% free cash flow margin.

Why do I think Smartsheet will continue to grow its share? It is mainly a function of the company’s functionality in terms of specific features, as well as its scalability. Enterprise users can get essentially all that is currently available in the workflow management space these days on a single platform, i.e. Smartsheet Advance. It is very easy to learn to use Smartsheet for almost everyone who has dealt with Excel. And it has tons of integrations which enhance the utility of the tool for enterprise users, particularly. The company suggests that it is able to scale its solution to encompass more users on a single platform than competitors. For example it is now able to link as many as .5 million cells per sheet, and that is up from 30K per sheet previously. It is in the process of increasing this limit another 10X.

Just how differentiated that might be from other tools is simply not something I know, and whatever is the case, I expect competitors to increase their capacity/scalability as well. It is the kind of claim that I find difficult to validate and a material change in capacity/scalability usually doesn’t show up in product reviews for at least another year or two. At the least, I think Smartsheet has been better able to penetrate the largest enterprise when compared to alternatives and it is in the enterprise segment that the largest percentage growth in workflow management will be found.

As mentioned, trying to go much beyond that in terms of analyzing who has a better solution based on features has the potential to create migraines for those susceptible that ailment. I am the last person to try to rank the utility of one set of Kanban boards compared to another set. And I have yet to read or understand why the task dependency algorithms or automation tools are better from one vendor compared to another.

One component of the Smartsheet solution that is resonating significantly with users is what is called the Data Shuttle . As the name implies, this is part of an integration solution that allows customers to upload and/or offload data between Smartsheet, their ERP solution, their CRM implementation and their database and to do so automatically and seamlessly. Competitors advertise comparable functionality but apparently Data Shuttle has the most advanced capabilities that customers find most useful-although again, I wouldn't like to try to prove that.

At the moment, Asana is struggling to reignite demand outside what had been its core vertical, the tech space. Asana has a new chief revenue office r and it has pared its losses. Its conference call featured comments about-well most readers will guess, but for those wanting some confirmation-scalability and an equivalent to Smartsheet’s Data Shuttle that is called Work Graph.

Just how much will new generative AI solutions enhance demand growth? I don’t want to come across as a “nattering nabob of negativism” as a disgraced former vice president once talked about referring to the journalists of his era. He was better with witty phrases than integrity, as it turned out.

I believe that generative AI is creating more productive use cases for many, probably most, and IT applications. And that certainly is true for Smartsheet. The company has announced 3 products for users: AI Formula Builder , AI Content Generation and AI Insights. These 3 features will be generally available this month, but can only be accessed by Enterprise users on paid plans. The company has forecast that upgrade activity will accelerate, and that the company will sell users higher usage based tiers. The question is just how much this is going to add to revenue growth and at what cadence.

The company is forecasting Q3 revenue growth of 20%-21%. It is forecasting Q4 revenue growth of about 21%. So, the initial quarter of generally available generative AI products isn’t expected to have a huge impact-although my guess is that this "forecast" was deliberately designed to exclude AI impact because trying to quantify this would be just a guess. More of the impact will probably be seen in FY '25, and depending on macro influences, the current 1 ^st Call consensus revenue growth forecast of 21% seems to be unduly pessimistic.

I believe the impact of generative AI on revenue growth for this company, and for others as well, will be more incremental rather than a step function, although over time it is going to be a very large increment. It is too easy to get enmeshed in hyper optimism when it comes to trying to validate the very earliest impacts of AI on the performance of software companies.

The use of generative AI to help build formulas, to generate content and to facilitate analytics are all mainstream requirements that should be adopted by most Smartsheet customers. I found it interesting that some “customers” who are using the company’s free tier, have complained that they actually will have to pay if they want to be able to access AI technology.

Measuring market share in a space with multiple definitions can be a daunting prospect. And while the workflow management space is supposed to achieve a multiyear CAGR of greater than 30%, the evidence that it is actually doing so is sparse. In looking at the company’s valuation, I have chosen to use a CAGR in the high 20% range, which I think will be consistent with gains in market share.

Smartsheet’s business model-some very favorable trends

In the last year+ Smartsheet’s non-GAAP profitability and free cash flow have shown some highly visible and strongly positive trends. That was particularly true in this latest reported quarter in which most of the benefit from the company’s recent layoff was realized. The company is still showing expense discipline and while there have no additional announced layoffs, individual stories about layoffs are still being reported.

Non-GAAP gross margin was 82% last quarter compared to 81% in the same quarter the prior year, and to 81% in the prior sequential quarter. As the company’s enterprise bundle, Advance, and its “capabilities” become a larger component of the mix, gross margins are likely to rise.

The company has shown significant expense discipline lately. In particular opex growth was just 5% year over year last quarter, and non-GAAP operating expense overall was 75% of revenues last quarter compared to 90% of revenue in the year earlier quarter. Operating expenses did tick up a bit in this latest quarter rising by 12% sequentially.

In particular, sales and marketing expense, which had declined by 4% year on year in the prior quarter, grew by 14% sequentially. Some of this was seasonal; on a year on year basis non-GAAP sales and marketing expense was 47% of revenue last quarter compared to 57% of non-GAAP revenue the prior year. While I don’t imagine the company will be able to show such substantial year over year improvements in operating expenses, given the still-elevated level of the sales and marketing expense ratio, there is plenty of room for additional improvement.

The company’s non-GAAP research and development expense last quarter was 17%, down from 20% in the year earlier period. I think this probably represents a low point for that expense ratio.

The company’s non-GAAP general and administrative expense ratio last quarter was just above 11% and that compares to 13% in the year earlier period. The company has forecast full year non-GAAP operating margins to be 7%; it was 8% last quarter. Like many other companies, I imagine Smartsheet is being quite conservative with its guidance at this point, providing a reasonable set-up for a quarter and a fiscal year that are likely to exceed expectations, particularly with regards to earnings and free cash flow margins.

Through the first half of the year, the company’s free cash flow grew to $82 million, far above the level of the prior year. This was mainly a function of the improvement in GAAP profitability, as well as better collections. The change in deferred revenues were a negative factor in free cash flow. Even though the company was booking a significantly greater number of large enterprise deals, there has been a tendency, perhaps because of higher interest rates, for companies to make fewer substantial prepayments and that shows up in the change in deferred revenues.

While RPO balances are showing substantial growth, the growth in deferred revenues is not likely to be a future factor in driving free cash flow. As mentioned, the company is forecasting free cash flow for the full year of $120 million. In part this reflects 3 onetime expenses that will constrain Q3 free cashflow to just $5 million according to the CFO's forecast.

In the most recent article I published on Seeking Alpha which reviewed the performance and outlook for SentinelOne (S), one commentator was particularly aggressive and incensed in commenting about the compensation of the CEO of that company and its use of stock based comp. I can only present the facts as I see them. I really have no particular emotional investment in the issue of executive compensation.

I will observe that CEOs get to make a variety of choices that dramatically impact the value of their companies. On the one hand, anyone with more than a passing familiarity with the software business is well aware of the poor choice made by the CEO of Oracle ( ORCL ) a dozen years ago when the cloud first emerged as a potential game changer-he didn't initially embrace the cloud to the long-term disadvantage of shareholders. On the other hand, just how much value will Microsoft shareholders get because the CEO of that company chose to make a stunning bet on generative AI? My point is only that choices made by CEOs can make or ruin a company.

Currently, Smartsheet has a market capitalization of about $6 billion . The ability of the company’s CEO to influence that amount is substantial. I have made the case that Smartsheet is a share gainer. Gaining share in a market with the size and growth of this one is worth in the billions. Obviously the company’s CEO has been deeply involved in the choices that have recently enabled the company to achieve substantial profitability and free cashflow generation.

In any event, the company’s CEO, Mark Mader , received total compensation of almost $15 million last year. He has been the CEO of Smartsheet for more than 17 years. More than 80% of the compensation was by way of the value of his stock award which vests over multiple years and an additional 10% came from the value of the awarded stock options. Other executives received substantial awards of stock and options. I personally have no problem with executive compensation for companies that grow share and improve profitability. As long as Smartsheet can do that, I think executives are earning their pay.

Overall, stock based comp. expense came to 23% of revenue for the first half of the fiscal year, down from 25% of revenues in the first half of the prior fiscal year. Stock based comp. grew from $51 million to $53 million sequentially. I think dilution is a far better measure of the cost of stock grants and other forms of stock based comp, than the calculated values shown in GAAP income presentations. Last quarter, outstanding shares increased by 0.9% and they increased by 3.2% over the past year. In order to compensate for dilution, I use average weighted shares of 138 million over the next 12 months in calculating valuation metrics.

As of the close of trading yesterday, Sept. 14, 2023, Smartsheet had an EV/S of about 4.9X, a bit more than 20% below average for the company high 20% growth cohort. Given just how fast enterprise software companies are improving their free cash flow margins, Smartsheet’s discount to average when considering free cash flow margins and growth is a bit less than 20%.

Wrapping Up-The case to buy Smartsheet shares

Smartsheet shares are no longer within the category of highly valued IT shares. On the one hand, growth has continued steadily, despite macro headwinds and has been in the mid-20% range for the last several quarters. But in addition to growth, the company has achieved a significant level of non-GAAP profitability and free cash flow generation.

The company’s latest earnings release and conference call should have alleviated some investor concerns. The company reaffirmed its billings growth forecast and suggested it was actually unusually conservative. The company indicated that it had closed a large renewal with Cisco, when rumors had abounded that the customer was set to migrate to Asana. And profitability continues to surprise to the upside.

The company is one of the two leaders in an attractive space and it seems to be gaining share. Share gains are based on the scalability of the company’s technology as well as its many integrations facilitated by its Data Shuttle technology. A couple of years ago the company pivoted from its focus on selling new name accounts regardless of size and potential to a focus on the enterprise. The pivot has apparently worked. The company’s enterprise bundle, Advance is growing at 50%/year and its Capabilities offerings have grown to almost 1/3 ^rd of new ACV. This has helped the average ACV per domain rise by 18% this past year, and that trend has continued.

The pivot to the enterprise has been a factor in the ability of this company to achieve non-GAAP profitability. The non-GAAP sales and marketing expense ratio improved by 1000 basis points year over year. It is still elevated, at least compared to other IT vendors, and I expect it will be a continued focus of expense management.

The company has three AI offerings that will be generally available to customers this month. Monetization is basically a function of making generative AI capabilities only available to customers for the company’s higher paid pricing tiers. Essentially, the current forecasts do not include any tailwinds based on customers upgrading their pricing tier to take advantage of the new functionality. This is one case in which expectations haven’t been substantially influenced by AI hype, and indeed one reason why I expect results to exceed forecasts is the absence of any measurable expectations based on the availability of Generative AI functionality.

Smartsheet, unlike some other vendors, has suggested that macro pressures, at least at the enterprise level are easing. That differentiated commentary is part of the market share story, and given that the enterprise has been the focus of growth for the company, it probably suggests a bit better visibility into the potential results of the next couple of quarters.

GARP stocks, almost by definition are unlikely to be the most exciting of investments. That is perhaps the case for shares of Smartsheet. It doesn’t seem likely, at least to me, that Smartsheet can or will grow as rapidly as shares of Monday. That said, shares of Smartsheet are valued 40% + less than shares of Monday, at least on an EV/S basis, as investors recognize the likely differentiated growth rates when comparing the two companies.

While shares of Smartsheet initially jumped after the earnings release, they have yet to reflect the improvements in revenue growth metrics and in profitability. And expectations for future quarters are quite modest. I expect positive alpha for these shares over the coming year.

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