SPT - Sprout Social: It's Fall But Sprout Social's Results Are Coming Into Bloom

2023-10-07 04:47:09 ET

Summary

• Sprout Social held its 2023 analyst day, reiterating its free cash flow projection of $200 million by 2028 and a free cash flow margin of 20%.
• The company's shares have struggled due to higher interest rates and a transition to a focus on enterprise growth rather than customer count.
• Sprout Social is the leader in the social media management space and has competitive advantages, including its partnership with Salesforce and the recent acquisition of Tagger Media.
• During the analyst day, one slide indicated accelerating growth in ARR with strong sales performance in the enterprise and from the Tagger acquisition.
• The Tagger acquisition which has taken Sprout into the "influencer marketing" space seems likely to accelerate Sprout's already impressive success in the enterprise.

An analyst day with a bit more meat than some

Sprout Social ( SPT ) held its 2023 analyst day on Sept. 27 ^th . It had some competition for attention with Workday’s ( WDAY ) Rising event getting a lot notoriety. In some ways, the event reprised some themes and projections that the company had made previously, particularly on its last conference call. To me, however, there were a couple key metrics including a minimum projection for ARR at the end of Q3 which presaged, I believe, an upside quarter. In addition the company reiterated its free cash flow projection of $200 million by 2028, a free cash flow margin by that time of 20%. Many companies are getting the message these days that investors expect companies to generate cash. Investors are increasingly evaluating companies-even high growth IT companies-based on the discounted present value of cash flows. That is true for several companies that have recently presented revised and enhanced business models including CrowdStrike ( CRWD ) and Nutanix ( NTNX ) as examples. On the other hand, while many companies, including Sprout are in the process of pivoting to strong profit and cash flow performance, investors are far more fixated on long bond yields and the strength of the labor market.

Sprout Social shares have had a challenging trajectory so far in 2023 and that has extended to the time in which I have been writing this article as higher interest rates have taken their toll on growth stock valuations yet again. So far the shares are down 15% for the year , well below the performance of the WCLD ETF which has appreciated by 12% on a year to date basis. The problem for the shares hasn’t really been in the company’s operational performance which is exceeding guidance/expectations; the problem is that the company’s transition to a model focused on the enterprise, and ARR growth, as opposed to a growth in customer count hasn’t resonated with investors who have aggressively sold the shares after earnings reports whose results didn’t tick all the appropriate boxes. In addition, the shares have had to battle significant misinformation put into the market by an activist short seller Akram’s Razor. This is one factor that has probably caused the short interest ratio to reach an elevated level of about 14%. The Akram report has been dead wrong in most particulars, focusing on KPIs that are no longer relevant and ignoring some explicit metrics regarding the success of the Salesforce ( CRM ) partnership, the pivot to the enterprise, the rapid growth of backlog and ARR, and strong cashflow metrics, partially built on rising multi year commitments from enterprise customers.

I wrote an article recommending the shares of Sprout early in March . The shares have fallen 28% since that time, while the Wisdom Tree Cloud Index is down less than 3% since that time. I have chosen to review the recommendation at this point in light of the investor day at which the company presented its targets for the next few years. My conclusion is that the Sprout shares remain a buy, with even more attractive valuation and prospects than 7 months ago.

Somewhat surprisingly, the investor day did feature commentary about the current state of the business. The presentation indicated that ARR at the end of Q3 had exceeded $350 million. That is growth of $23 million sequentially, and compares to sequential growth of $17 million in Q2. The company also indicated that the results of its latest acquisition, Tagger, is exceeding projections. Overall, the commentary with regards to ARR indicated that its upside was a product of robust enterprise activity and above planned performance for the company's Tagger acquisition.

The company’s guidance for the fiscal quarter that has just ended was fairly undemanding-indeed prudent guidance has been a factor in the company’s share price performance issues. I have no particular insight as to the specifics that will be reported for this latest quarter, although Q2 trends, when carefully looked at, presented a fairly clear picture of a successful pivot to the enterprise market. Exactly how the strong ARR performance will map to reported revenues is not totally clear; obviously ARR growth through the quarter is not the same as reported revenues. I write these articles, and invest on a long-term basis. But I do listen to lots of presentations made to the analyst community. Based on that standard, this was as positive and upbeat as any I have heard recently, with the possible exception of Nutanix. So, I would be a bit surprised if the reported results and guidance weren’t a somewhat more satisfactory to traders than the last two-but do not buy the stock based specifically on expectations for the quarter and the potential for a short squeeze. Sprout has never been considered a meme stock, and I doubt it will become one in the foreseeable future.

I do believe, at this point, that some of the confusion and so-called “messiness” around eliminating Sprout’s many smaller customers from its revenue and ARR forecast will not be a factor leading to confusion and to a constrained share price when the company releases the results for Q3 in early November.

At this point, the valuation of Sprout shares has compressed noticeably with my projected EV/S ratio of 6.3X based on the closing price as of 10/4/23. The company has recently turned the corner in terms of reported profits and free cash flow; what I found encouraging and surprising is that the company is now projecting a free cash flow margin of 20%-22% by 2028. The company’s free cash flow margin last quarter was 7.6%, and it was 9% for the first half of 2023.

The market most recently has been roiled by higher interest rates. Notionally higher interest rates impact the valuation of high growth shares. Obviously that was the case, and more than the case, throughout 2022 and it was the case during the month of September, 2023. This is not an article forecasting bond prices and the yield of long bonds does not always correlate perfectly with the Fed policy rate. Indeed, there are more than a few articles about the current state of yield inversion. There are of course many reasons why long term rates are rising and many of them do not have to do with inflation expectations. The budget deficit along with the rundown of the Fed balance sheet (QT) is putting lots of supply of bonds into the market.

That said, to a certain extent higher yields on long dated bonds suggest less angst about the state of the economy. On the one hand the valuation of Sprout shares will be constrained by the 'higher for longer" mantra. On the other hand, a better business environment will certainly benefit Sprout’s current operational performance. But the pattern of higher long term yields is likely going to impact the appreciation potential of the shares in the short term. That said, Sprout has a current enterprise value of $2.6 billion; if the company does achieve annualized free cash flow of $200 million as it is projecting for 2028, in almost any set of conceivable circumstances, the shares will appreciate significantly.

Sprout's Business-Why it should be able to sustain strong growth for years into the future

Sprout Social is one of the leading companies in the social media management space. It held its IPO in 2019 and started life as a high growth business making significant losses . The company's business has essentially trebled since the time of the IPO with a fair number of twists and turns between then and now.

Basically, the company has a platform that helps users to plan, schedule and publish social media marketing/influencer marketing messages. Most marketing experts and corporate managers agree that social is fast becoming the primary channel for connecting with their customers. But only 5% of potential users have adopted any kind of social management platform.

The company has a few well-known reference accounts including IBM Watson Health ( IBM ), GE Power ( GE ), Kraft/Heinz ( KHC ) , Campbell’s ( CPB ) and Six Flags ( SIX ). Klaviyo ( KVYO ), a recent recommendation is also a customer. Premium products include what is called Listening which allows a brand to capture data by creating and refining topic queries and then sifting through billions of data point to figure out specific trends which are used to guide future social media strategies. The company also offers a premium analytics product which can provide users with 150 pre-built reports and tools for users to create custom reports for their specific requirements. Sprout offers another solution based on Employee Advocacy . This gives employees and partners a channel to share content across their own social networks. Premium products are one of the principle growth drivers for the company with ARR for premium solutions having grown to $91 million, or about 28% of total ARR and with a CAGR of 47% the past couple of years. .

The company has made two acquisitions thus far in 2023. Repustate was a small company with revenues of about $5 million when acquired. It provides AI powered technology that analyzes text, sentiment and enterprise search data. It also acquired Tagger Media which is a marketing platform for influencer based campaigns and intelligence. Neither of these is an earth shaking acquisition from a financial perspective. But they are in line with the company’s strategy of building a comprehensive social media platform that offers enterprises maximum functionality and a 'single source of truth.'

I confess that influencer marketing is one of those capabilities that simply lies in a paradigm that is beyond my personal cultural ambit. But regardless of how I react to influencer market, this is a category that has become significant amongst marketing professionals. Sprout indicated that influencer marketing capabilities were already in more than half of its enterprise RFPs. A strange new world-at least for this writer.

The integration of Tagger with the rest of Sprout’s capabilities is apparently creating a significant tailwind and competitive moat, although the exact revenue contribution of the acquisition itself probably isn’t all that great. From what I can tell, the Tagger acquisition in particular, is likely to be more significant than is perhaps understood by other analysts. 2023 has been marked by investor attention to all thing generative AI, and there are, to be sure, good reasons for that. But in the social media marketing space, the focus of the year has been on influencer marketing. It seems to have taken off and become a central feature of many campaigns. It seems likely that there is significant cross-sell opportunity for Tagger within the current Sprout base, and Tagger already has some enterprise customers such as Estee Lauder ( EL ), Bose and Omnicom ( OMC ) that are obviously targets of opportunity for Sprout. In the first hour after the merger was announced, the Sprout CEO, Justyn Howard , received 40 inquiries from its customers looking to have a presentation of the integration strategy with Tagger. Since then, Tagger’s revenue contribution has apparently exceeded initial expectations. This bodes well for Sprout’s CAGR performance both in the short term and going forward the next few years. .

Overall, the social media management market size is projected to grow from $17.5 billion to $52 billion over the next 5 years, a CAGR of 24%. Obviously, given the current size of Sprout, this suggests a multi-year growth runway of considerable proportions. It is difficult to tell at this point just how much the use of generative AI will add to this estimate.

The potential for AI in the social media management space is quite evident and substantial. Much of Sprout’s current R&D spent is focused on developing applications that use generative AI. Currently, the company is using AI for language detection, suggested responses, sentiment and content detection and filtering. Overall, generative AI can probably automate almost everything being done by Sprout’s software currently. Over time, and with the use of properly trained models, AI can create social content, optimize scheduling and targeting, manage approvals and workflows and of course deliver analysis and reports to stakeholders.

During the last conference call, the CEO made the claim that Sprout had the most skilled product teams which will allow the company to outpace anything being done in the space. I can’t validate such an assertion-there is no objective way to do so now. And I wouldn’t want to suggest that Sprout should be classified as an “AI stock,” although given its recent trading trajectory there doesn’t seem any danger of that in the near term. I do believe, however, that in evaluating the probable CAGR for the company, and market share trends, the company’s current focus on infusing AI throughout its stack is likely to prove a significant positive, as yet not reflected in estimates or valuation.

While the pivot from smaller customers to the enterprise has disguised the actual success of the company’s selling motion, and the positive impact of the partnership with Salesforce, the company is self-evidently continuing to gain share in its space. I expect that its current product set, augmented by AI capabilities will continue to support market share gains.

Competition in the Social Media Management space

There are very few corners of the enterprise software world that are without competition, and social media management is not an exception. Here is the Gartner listing of significant competitors , many of which are private and probably little known by most. Probably the best known competitor in the space is Hootsuite which is private. I have linked here to a product comparison by Ascent , an industry service that provides competitive evaluations. Their verdict is that Sprout provides better functionality in terms of features, support, analytics and Sprout’s listening capability. It’s a better choice for the enterprise, which of course where Sprout is focusing its selling motion.

Hootsuite ran into financial difficulties last year and wound up laying off 40% of its staff throughout the year. It also made some pricing changes. Laying off such a large proportion of any company's staff in the IT space obviously will have significant impact, and apparently Hootsuite is no longer growing. Hootsuite has introduced some generative AI capability, and there is no indication that the company will not continue as a competitor, although almost certainly larger enterprises will gravitate to a profitable company such as Sprout when evaluating which social media marketing platform to choose.

The only recognizable vendor on this list is Adobe ( ADBE ). The Adobe solution has mainly been put together through acquisitions. From a functional standpoint, it appears as though Sprout has significant advantages. That said, however, Adobe is going to be a significant competitive factor simply because it is Adobe. Here is a comparison between Sprout and Adobe.

Overall, I believe that Sprout has many competitive advantages. Its partnership with Salesforce is significant both now and over the next several years. The acquisition of Tagger provides it with functionality that its competitors don’t have. Its listening function seems to resonate with users to an unexpected extent. And, according to user surveys, it has superior and more extensive analytics than competitors. Further, while AI is just in its earliest stages in terms of transforming the social media marketing space, Sprout is focusing on the technology, and I expect that the focus will provide additional deliverables in the near future.

I don’t want to pretend to be some social media marketing guru. I am not. I have yet to respond to any kind of social media marketing myself, and I doubt that I ever will. But the issue isn’t what this writer does, but how does Sprout compare to other offerings in this space. From what I have read, Sprout is currently the category leader, and I think its competitive advantages have deepened and extended over the past year and are likely to do so going forward. The author of the linked article said it all when she wrote that while she had more experience with Hootsuite, she recommended Sprout to her clients whenever she had the chance. That is a pretty strong endorsement from a third party evaluator, and compared to most such evaluations I have read is significantly more specific and dispositive.

Sprout’s Q2-Perhaps messier than wished but underneath the headlines very impressive growth trends.

Investors and analysts were singularly unimpressed with Sprout’s quarterly report. While analysts didn’t change their ratings, they didn’t raise estimates and that presents an obstacle for the performance of a high growth software company. The company’s headline numbers were as follows: Revenues were $79.3 million, up by 29%; the company had projected revenues of $78.6 million. Non-GAAP EPS was $0.07 based on non-GAAP operating income of $1.9 million. The company had projected a non-GAAP operating loss of $1.7 million.

Previously the company had projected total revenues for the full year of $332 million, with total ARR growth of 33%. The company had projected non-GAAP full year operating income of about $2.2 million, and non-GAAP EPS of $0.07-$0.08. The company is now projecting total revenue of $328.7 million, and non-GAAP EPS of $0.07. The company’s projection is based on eliminating all estimates for its smaller customers, i.e. those with ARR of less than $2k/year. This customer cohort has most recently been 4% of revenues or about $3.2 million/quarter. The company bought Tagger, and Tagger is expected to add about $3 million in revenues in the last half of the year. So, after adjusting for the results of Q2, and the changes in the model construction, the full year revenue projection was unchanged and the ARR growth metric has been forecast a bit higher. Tagger is expected to have a non-GAAP loss of $$3-$3.5 million for the balance of 2023. On an organic Sprout basis, the company’s new target implies a modest increase in operating margins for the back half of the year.

The company has projected a non-GAAP EPS loss for Q3 of about $0.05. That was significantly below the prior published consensus of positive EPS of $0.01. There were some specific expenses embedded in that projection including the company’s global sales event, and the onetime expenses connected with the Tagger acquisition. In addition, the company was able to hire sales personnel in Q2, and most of those expenses will show up in the Q3 P&L. Overall, these onetime events were forecast to cost 3.2% of revenues in Q3, or a bit greater than the operating margin loss now being projected. Seemingly ignored was the fact that Sprout essentially maintained its full year earnings forecast, implying significant improvements in cost ratios for this current quarter. The company has reported consistent earnings beats for several quarters at this point; I would be surprised if that will not prove to have been the case when the company reports Q3 results which will likely be in the 1 ^st week of November.

The company does not explicitly project ARR growth quarter by quarter. ARR growth in Q2 was 27% compared to ARR growth of 30% in Q1. ARR growth of core customers, i.e. those with revenues of more than $2k/year, was 33% last quarter, compared to 35% in Q1. The company has projected that ARR growth in Q2 will have been the slowest percentage growth of the year and that for the full year ARR growth will match revenue growth-in other words ARR growth will accelerate from the 27% reported in Q2 to something greater than 32% in the next couple of quarters.. That said, record new business ACV, drove total ACV growth to a record of 29% year on year, with up-market success above plan . Bookings growth, as derived from the RPO metric, showed even more significant increase with RPO growth of 62% last quarter . That extremely strong growth in RPO was driven by a 48% growth in Sprout customers with an ARR of greater than $50k and a 130% growth in customers with an ARR of greater than $250k. Similar trends were seen in those customers Sprout defines as enterprise. Some of the strong growth in ARR growth was a function of accelerating growth in the attach rates of premium modules. RPO growth was 10% sequentially, a significant result for a Q2. From the standpoint of actual sales performance, Q2 was a significant upside, masked by the rapid decline in non-core revenues, at rates greater than previously forecasts. It was this dichotomy that led the company to pull all non-core revenue metrics from its forecast to establish a baseline that relates to its current strategy.

As mentioned, while to me the Sprout message was pretty straightforward, and was backed up by some positive sales performance metrics, apparently other some analysts were seemingly unimpressed by the positive messaging and attainment and the conference call was marked by some indication of analytical concern. Of course I don’t see every note by analysts, and no one wound up changing their published rating, but the net results was a 23% drop in Sprout’s share price from which the shares have yet to recover materially.

Overall, I thought Sprout’s Q2 results ought to have engendered some positive reaction, although the headline number for Q3 EPS and the headline revenue forecast for the balance of the year were below prior estimates. But my view is that if even a bit of effort is expended in understanding context and the actual growth of those business areas in which Sprout is focusing, Q2 results were convincingly strong, and with the share price disappointingly weak, the setup going forward seems positive to me.

Sprout’s business model-Very visible progress that should accelerate once the Tagger merger expense is absorbed

Self-evidently, the substantial beat that Sprout achieved in terms in EPS last quarter had most to do with improving operating margins given the slim beat in revenues.

Non-GAAP gross margins were 77.7% last quarter, compared to 76% in the year earlier quarter, and to 78.1% in the prior sequential quarter. The research and development spend ratio was 18.5% last quarter and that compares to 20.2% in the year earlier quarter. Sequentially, research and development spend was essentially flat growing less than 0.2%. Non-GAAP sales and marketing expense was 40.4% of revenues last quarter compared to 39.5% in the year earlier period. Non-GAAP sales and marketing expense grew by 7% sequentially, while reported revenues grew by 5%. The CFO projected a similar pattern in terms of sales and marketing expense growth in Q3, partially due to the expense of a company wide sales event.

Non-GAAP general and administrative expense was 17.3% of revenues last quarter, compared to 18.6% of revenues in the year earlier quarter. General and administrative expense rose by about 10% sequentially. Overall, non-GAAP operating expense was 75.2% of revenue compared to 78.5% of revenue in the year earlier period. The sequential increase in non-GAAP operating expense was 5%, more or less in line with sequential revenue growth. In the time I have been following this company the CFO almost invariably over-estimates the growth in non-GAAP operating expenses; that is why there have been consistent upside surprises in non-GAAP EPS.

Overall, the company has forecast that its non-GAAP operating margins will improve by about 2000 bps over the next 4 years. The company is forecasting that its G&A expense ratio will reach about 8%, that research and development expense will be about 16% and that sales and marketing expense will be about 34%. The company is forecasting non-GAAP gross margins of 80%-81%. None of these ratios seems particularly outlandish or aggressive. That kind of improvement is certainly not currently embodied in the current EPS forecast for 2024, which currently forecasts that non-GAAP EPS will be $0.20. The company didn’t choose to make an EPS forecast as part of its recent investor presentation. Based on the revenue and margin projections the company made, coupled with estimates for dilution, 2028 EPS would be in the range of $3.50+. It did project free cash flow of $200 million, or a free cash flow margin of 20%, and EPS of $3.50)/share is consistent with that kind of forecast.

Sprout uses stock based comp. Last quarter stock based comp was 20% of revenues compared to 20.6% of revenues in the year earlier period. I prefer to look at dilution as the actual cost of stock based comp. Dilution over the last year was 1.8%. In the last quarter, dilution was 0.5%. The company is forecasting that weighted average shares will not change for the balance of the year; in the interest of conservatism, my projection of EPS of $3.50+ is based on dilution over the next 5 years of 16%.

Last quarter free cash flow was particularly strong. Free cash flow rose by 5X from the previous year and the free cash flow margin for the quarter was 8%.The free cash flow margin for the first half of the year was actually 10%. The biggest part of that increase was the doubling of the increase in deferred revenues. Deferred revenues are rising as the company sells much larger deals to enterprise customers. The small customers that used to be Sprout’s mainstay almost never signed multi-year agreements with a deferred revenue component. Some enterprise customers are signing such agreements, and that is what is driving both deferred revenue growth and the growth in RPO balances.

Summing Up-The Case to buy Sprout Social shares

Sprout Social held its analyst event last week. Overall, the presentation was upbeat. In terms of specifics, the company indicated that its newest acquisition, Tagger, was running above plan, and it indicated that total ARR had increased by 7% sequentially, or more than $23 million, compared to a $17 million increase in Q2. The acceleration in ARR growth was said to be the result of stronger than anticipated enterprise bookings, along with above plan success for Tagger. The company is continuing to forecast a CAGR of 25% or more over the next several years, and it is projecting, as well, that its free cash flow margin will reach, or exceed 20%. It presented a quite specific view as to how the company could exceed the 25% CAGR for ARR; I expect it is more probable that the company will exceed its 25% CAGR projection than just meet it.

Sprout Social is the leader in the social media management space. Social media has probably become the primary tool that most companies use to connect with their customers. Customers use social media for communications of all kinds beyond sales and marketing messages: some users have social media strategies to ensure that their customers use their products successfully, others use it as a support channel and others use it to update product information. While most companies are sold on the need for a social media strategy, only about 5% of enterprises have deployed a social media management platform at this point. This kind of dichotomy suggests that the overall space will grow rapidly in coming years.

Sprout Social is in the midst of a significant transition in which the company essentially is eliminating its smallest customers by refocusing support, and is focusing its efforts and its technology on enabling larger users. Revenue from the enterprise grew 50% year on year and is now 43% of total ARR, and the company’s reported backlog (RPO balance) has grown more than 60% in recent quarters.

The company’s projections are for revenue from its smallest tier of customers to go to zero by the end of the year, while the rest of the business shows a continued growth acceleration. Excluding those smaller customers suggests that the company will be achieving growth in ARR and in revenue in the low to mid-30% range. That growth rate is likely to be sustained into 2024 as the company’s initiatives in AI, but also with its Tagger influencer marketing acquisition start to become significant revenue drivers.

Sprout’s principle competitor is Hootsuite, a company based in Vancouver, Hootsuite has run into financial difficulties and had to lay off about 40% of its staff in the last year. A 3 ^rd party evaluator has rated Sprout’s solutions as palpably better than that of Hootsuite for enterprise customers. Hootsuite is about half of the size of Sprout and its growth rate has been eviscerated.

Sprout has a significant partnership with Salesforce.com . Last quarter the company migrated 176 logos from the now defunct Salesforce platform to its own technology. An activist short seller had opined that the potential for the Salesforce partnership had been exaggerated; The 176 new logos was the strongest performance the company has achieved since the partnership was announced last fall and the company has projected steady additional increases over the balance of the year with a seasonal high in Q4.

The company has made steady progress in terms of improving its operational performance, and it was non-GAAP profitable last quarter, significantly exceeding its prior forecast.

While guidance, with its elimination of revenue contribution from the smallest tier of customers was confusing to some, overall, on an organic basis, the company is expecting growth to continue to accelerate. Profitability will be constrained in the next couple of quarters as the company absorbs the cost of its Tagger merger; excluding that item, margins are expected to continue to improve.

Should readers buy Sprout shares? I recommended them about 6 months ago at higher prices, and with a lower near term outlook. At this point, my estimate is that Sprout shares have an EV/S of about 6.3X based on the closing share price as of 10/4. That is noticeably below average for the company’s growth rate cohort. The company had a free cash flow margin of 10% for the first half of the year. The strong cashflow is, in part, a function of the company signing annual and multi-year commitments with enterprise customers so cash flow generation may exceed earlier projections.

As mentioned, in the wake of analyst day the shores rose more than 8% on elevated volume as the company suggested that ARR growth accelerated noticeably in Q3. That share price spike hasn’t lasted; investors are far more fearful of the “higher for longer” paradigm than they have been in evaluating Sprout’s actual operational performance and outlook.

Sprout shares, like all high growth IT equities are not going to perform consistently while investors remain in an extremely risk-off mode. The shares fell by over 5% on Tuesday, Oct. 3 ^rd .before retracing some of that loss the following day.

I think the combination of a leadership position in a strong space, a more complete set of product capabilities than its competitors, a successful pivot to the enterprise, robust set of AI capabilities that is improving the performance of Sprout’s platform and a noticeable improvement in profitability and free cash flow margin ought to lead to a valuation level reflecting these positive trends. In my view the shares are attractively valued and should produce positive alpha over the next 12 months.

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