SPT - Sprout Social: Growth Should Continue At A Healthy Rate

2023-06-13 10:31:48 ET

Summary

• I rate SPT as a buy due to its strong growth potential, focus on the higher-end market, and partnerships like Salesforce.
• The company's push into the upmarket, price increases and improved unit economics contribute to a positive outlook for profitability and margin expansion.
• It is essential to monitor the impact of future price adjustments on customer retention and net new ARR growth, as churn among non-essential customers has been high.

Investment thesis

I continue to rate Sprout Social (SPT) as a buy rating because of its high growth, and importantly, its ability to sustain that growth rate due to its strong market position and push towards higher-end market. Management also guided to more than 30% growth through FY25. I have no doubt that FY23 is going to be a good year as 1Q23 continued to see benefits from the shift to upmarket customers and pricing increases with 2x new business deal sizes vs last year. The continuous strong growth in customers with >$50k ARR, >$250k ARR customers, and in enterprise net new ARR also further support my confidence. The partnership I mentioned with Salesforce earlier is also fruitful, resulting in an additional 96 customers (deceleration is just due to seasonality, in my opinion). As such, if we use 1Q23 as yardstick for FY23, things are looking great with greater enterprise customer exposure, pricing tailwinds and partnership contribution support management's guidance for at least 33% ARR growth in FY23. I also have high hopes for FY24 as a result of the price increase in FY23, which has led to positive momentum with large customers, the possibility of upside from a partnership with Salesforce, and the lapping of churns at the low end of the market. I reiterate my position to invest in SPT.

Margin

I am supportive of the price increase as now is the best time to raise prices given the inflation headline. The immediate benefit is an improvement in profitability and also a gush of cash inflow that management can deploy for reinvestments. We can see that management is doing a good job of balancing profitability and reinvesting as they raise the FY23 operating margin guide to 0.7%, implying a 225-235bps of annual expansion. As a long-term investor myself, I applaud this decision because it serves the "needs" of both the near and distant future. The short-term investors want results to show on the P&L immediately as it drives the stock, so an improvement in margin is preferred. The long-term investor would prefer SPT to invest as much as they can to ensure the business can capture a larger chunk of the market over the long-term. In addition to price hikes, I believe SPT's persistent push into the up market will help boost unit economics and, ultimately, profits. For perspective, there was an increase of 32.9% in customers with >$10K in ARR, which resulted in 455 net new adds and a total of 7,107 customers. In addition, the number of customers with an ARR of $50k or more also rose by 36, or 45.7%, during the quarter, bringing the total number of customers to 1,008. Total RPO also increased by 94% to $187.8 million, while Current RPO reached $143 million, an increase of 23.4%. I don't know about the short-term investors, but these metrics are telling a very strong story about the potential of SPT business as the mix shift more towards the larger customers that carry better unit economics.

Salesforce partnership

I believe SPT growth will continue to be healthy and strong as it finds support from partnerships form. SPT Social Studio gained 96 new logos thanks to the Salesforce partnership, down from 175 in the previous quarter but still a significant increase. While this may seem like a slowdown, I should remind readers that these ads tend to fluctuate with the seasons, and that management expects the first quarter to be the slowest migration period of the year. As a result, I anticipate significant growth in the partnership contribution throughout FY23.

Churn

While I am pleased with the results thus far, I am surprised by the high rate of churn among non-essential customers. SPT disclosed for the first time the total number of non-core customers (ARR $2k) and the contribution of ARR. Due to the price increase, the number of customers has dropped by 31% year over year to 10,350, and management has now revealed that this churn of $6 million in ARR is from the non-core customer segment. The bright side is that these customers accounted for less than 5% of ARR overall. In the big picture, I see this as a shakeout in which SPT is trying to improve the quality of its customer base by raising prices. Eventually, all but the most dedicated customers will leave, leaving only the "core" users among the non-core customer base. I believe that SPT will have a greater opportunity to up- and cross-sell other solutions to this remaining user base in the future to increase ARPU.

Valuation

Although the share price and valuation have fallen since I initiated a buy rating, I still believe the stock has an attractive upside. I continue to believe that SPT can grow at its historical rate of 30+% through FY25, aided by the push to up market and partnerships. However, I recognize that the strong FY23 performance may put some pressure on SPT performance in FY24 as it offsets the impact of the price increase and the surge in contribution from the Salesforce partnership. As a result, I believe it will be some time before valuation returns to the 9-10x level that I previously predicted. As a result, I valued SPT at 7x forward revenue multiple, resulting in an implied share price of $66.58.

Risks

The churn this time round due to the price increase is largely from the <$2K ARR group. If SPT decides to charge more to its other types of customers, the same thing could happen to them. Therefore, I believe it is critical to track future growth in net new ARR to evaluate the effect of price adjustments as they are implemented.

Conclusion

I maintain my buy rating on SPT due to its strong growth potential and ability to sustain that growth. The company's market position and focus on the higher-end market support its projected growth rate of over 30% through FY25. The partnership with Salesforce has already yielded positive results, and I anticipate further growth from this collaboration in the future. Although valuation may take time to return to previous levels, I still see an attractive upside for SPT. However, it is crucial to monitor the impact of future price adjustments on customer retention and net new ARR growth.

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