SPT - Sprout Social: This Is The Season For Growth And Flowering

Summary

• Sprout Social's recent quarterly report showed an acceleration in percentage growth of ARR.
• The company's partnership with Salesforce is in its nascent stage, and the benefits Sprout will achieve because Salesforce has sunsetted its product in this space are just starting to emerge.
• The company's largest competitor, Hootsuite, has run into financial issues and announced its 3rd round of layoffs and abandoned its free tier product offering.
• Sprout's analytics and its listening capability are particularly appealing to enterprises, and these modules took off last quarter.
• Unlike almost all other enterprise software vendors, Sprout is forecasting accelerating growth, particularly in ARR.

Sprout Social - Time to take a look at an old recommendation

In the investment world, 2020 seems to be centuries ago. Covid was raging, the Fed was supporting the economy, most of the world was shut down and Trump was still president. Baseball would have a short season and the Yankees… once again a bridesmaid. I recommended Sprout Social (SPT) shares back in April 2020 and haven't reviewed them on SA since that point. I owned the shares for a time and truth be told, I sold them far too soon-long before the spike that brought the shares to a high of $144 in the fall of 2021 . Like so many other high growth IT companies, SPT stock price chart looks like the sides of a mountain, and the valuation has returned to levels that make it possible to revisit the company as a reasonable investment possibility.

For readers unfamiliar with the company, it offers users what is best described as a social media management solution. And these days, social media management is coming into its own as a solution category with a current market size greater than $15 billion, and a CAGR of nearly 25% . Sprout is probably the only significant enterprise software company headquartered in Chicago… there used to be more. This has been a software company that hasn't had to reduce guidance-Indeed adjusted for the impacts of a recent deal with Salesforce ( CRM ), it is actually forecasting rising growth rates.

A couple of months ago, Salesforce dropped its competitive product in this space, Social Studio, and announced an agreement in which Sprout has become its preferred provider for social media management solutions. The fact that Salesforce dropped its competing product is likely to make this partnership more significant than many other such arrangements; it seems likely to add several hundred basis points to the company's growth even in its first year as Salesforce is a powerful sales engine with much greater scope than Sprout and the Sprout offering is quite complementary to the value proposition offered by Salesforce. Later in the article, the specifics of the agreement, and how it seems to be impacting growth will be detailed.

At this point, Sprout shares are certainly not the cheapest of enterprise software shares; the shares have an EV/S around 9.5X. That is close to average for the company's growth cohort which I estimate will be in the mid-30% range. The company has generated cash for some quarters now; that said it isn't yet profitable, and the current consensus for non-GAAP earnings over the coming year is just above break-even.

All of that aside, I think the basic reasons to buy/own Sprout Social is that the social media management space continue to grow at high rates, that Sprout Social is the leading vendor in the space, and that the company has been able to achieve a certain amount of operating leverage. I think the both the recent price increase and the partnership with Salesforce are likely to provide enough of a tailwind to overcome the macro headwinds that have plagued so many other IT vendors.

Last Friday, i.e. (2/24), was probably not the most auspicious day on which to start writing on an article about a high growth IT vendor. Presumably, all high growth IT equities, and that includes that includes Sprout, will be down reacting to the higher than anticipated inflation rate represented in the personal consumption index as well as the strong growth in personal consumption expenditures. This is NOT an article that attempts to deal with the subject of economic macros, how they will trend, how the Fed will react to their trending, and how that will read into share prices. It can seem perplexing to see consumer spending rise by an outsize amount, while two of the largest retailers, Walmart ( WMT ) and Home Depot ( HD ) are reporting exactly opposite trends, but many of the latest macros seem to be running opposite to what companies are actually reporting in their operating results.

In the case of Sprout Social, there are no such ambiguities and cause for cognitive dissonance. The latest quarter was a beat in an expanding market, and guidance suggests that the current year will continue to see growth above 30%, strong relative performance in an IT space that has seen contracting estimates for 2023 growth due to macro conditions. This is one of the very few IT companies to have spoken about accelerating growth-particularly as reflected by new ARR.

Sprout Social shares are up a bit more than 8% since the start of the year. The shares reacted positively to the earnings release of 2/21, although they have fallen since in line with the rest of the market. The shares are down by around 58% from the peak they reached back in the fall of 2021; fairly typical for high growth IT shares.

The investment case for Sprout is fairly straightforward. It is the leading competitor in a high growth space, and has been steadily gaining share. Its newly forged partnership with Salesforce is already having an additional positive impact on its growth, and will likely do so on into the future. It has pivoted its business model and continues to address larger users with higher long term expansion opportunities. It is starting to generate some level of free cash flow and should be able to increase its free cash flow margins steadily. It is very close to achieving a Rule of 40 metric, and should achieve continued growth of that metric. The company is founder led. It has a significant short interest - 11.5% at the end of January, and its most recent earnings report reflected that it was seeing less impact from current macro headwinds than most other enterprise software companies.

I don't expect that the shares will be able to generate significant positive returns in an environment still characterized by a highly charged risk-off paradigm. But I do think it will be one of a group of IT equities that will provide above average returns when the market, itself, pivots to valuating growth and earnings as opposed to a focus on fears of inflation and Fed policies.

I also need to point out for readers that Sprout does use stock based compensation. Not all that much as it happens, but in the last year, stock based comp was about 18.6% revenues. As I have mentioned in previous articles, the real cost of stock based comp. is dilution, and nothing else. Dilution for Sprout in the last year was 1.6%. I actually allowed for 3.5% dilution in the valuation data that I present in this article.

Sprout: Has it really broken out from the pack in the Social Management Space

As part of the script during the company's last conference call, the CEO of Sprout, Justyn Howard, provided a rather unique perspective on Sprout's outlook and competitive positioning. I think most analysts and observers expect that company managements will use their conference call presentations as part of theme in terms of their unique technology and differentiation.

The combination of our thesis on the market and the strength of our team have prepared us for the breakout opportunity we see today and have afforded us the ability to continue our investment in our product, innovation and people in any environment. We believe Sprout is now uniquely positioned to pull away in 2023.

Entering the year, we believe our full pricing, product, go-to-market and customer strategies are aligned to the most productive parts of our market where we're already winning and we are best positioned to provide outsized value to our customers within our platform.

Commentary at that kind of pitch is a bit of an outlier. Personally, I am not a fan of excessive hype, but that is what was said, and I do think it worth noting. Over the course of a quarter, I listen to and review lots of conference calls. I expect commercials and hype: CEOs have a visceral need to promote their companies. This kind of commentary is beyond what I have heard most often when listening to many other conference call scripts in the last month or so. Most recently CEOs have focused on macro headwinds, and how companies are coping with problems not on how their companies are "pulling away."

I think there is little doubt that in terms of projections and the results of the last couple of quarters, Sprout is doing better than competitors. The questions are: why might that be, and how sustainable are the company's advantages. I will address some of the specifics of that below, but basically the company's success in the market, outside of the obvious attribute of effective sales execution and a major new partnership with an industry leader, rests on a platform strategy, better analytics capabilities, and a very noticeable upmarket pivot. All of these factors, coupled with problems at a major competitor are leading to outsize market share gains, more than offsetting macro headwinds. Right strategy, right time, and right people sum it up.

Before discussing the specifics, it probably is worthwhile to review just what social media management actually is and why it continues to thrive in this environment. Social media management allow organizations to monitor online conversations that speak to brand awareness and sentiment. The tools allow brands to schedule content at appropriate times to optimize the reach of a campaign. The tools allow users to post to all the major social channels at the same time. The tools allow brands to upload multimedia content and allow for what is called geo-targeting. Social media posts need to be tagged, and a critical factor for marketers is access to robust analytics dashboards.

Most third party consultants and industry analysts have long since concluded that campaigns on social media that aren't using management tools are not going to succeed. There are simply too many dead ends, missed notifications, multiple channels for professional marketers not to use available tools. Scheduling posts is a necessity that is well documented and yet just 1 in 3 marketers are actually taking advantage of the technology. In larger organizations, especially in this era of IT budget constraints, the use of social media management tools is one of the few ways that ROI can be "proven" within an enterprise. And the ability to download pictures easily almost invariably leads to more shared pages than almost anything else.

Perhaps surprisingly, despite the utility of managing the huge investments being made by most enterprises in social media marketing, the current penetration of tools in this space is said to be less than 1% as depicted in Sprout's latest investor presentation based on a calculation of "Served Addressable Market" something that is equivalent to the more typical TAM used by other IT vendors. Part of the reason that Sprout has not seen the growth slowdown that has plagued so many other high-growth IT vendors despite the macro headwinds is that penetration is so low. In this era in which customers are focused on optimizing their IT investments in just about everything, anything that will improve the efficiency of resource allocation gets a priority and that is part of what is apparently driving this market.

Why is Sprout growing faster than its market these days and is that a sustainable trend?

When readers consider the nature of Social Media Management tools they may be tempted to ask how can one company have a better set of solutions than other companies in the space. After all, sending messages at the same time, or tagging them, or geo-locating is hardly some kind of advanced software technology, and uploading pictures is something most of us have done ourselves from time to time. Sprout does offer a social listening module which offers users the ability to understand the conversations about brands and their competitors in the social space. It is a way brands have of dominating the conversation, and it is not a capability that is offered by all of Sprout's competitors.

Sprout says that it is the platform solution, and third party analysts seem to agree that this is one thing that differentiates the offering. This link from Investopedia is pretty forthright in declaring that Sprout has the best overall platform . This link from Forbes Advisor says Sprout has the best analytics. A company in the space, Buffer, suggests that Sprout's reports, in other words its analytics are also peerless according to this link. Some of the reviewers opined that Sprout's UI was more "elegant" than those of other competitors. I am not too sure how to evaluate "elegant" with regards to a UI for social management, but it is apparently a significant factor in evaluating products for analysts.

The advantage that Sprout has in analytics showed up significantly in Q4 results. Overall, 40% more customers purchased analytics from Sprout than in any previous quarter, and the company booked 80% more analytics ACV than in any previous quarter. Presumably there was a fair amount of drag associated with this performance by a single product.

There is not always a direct correlation between analyst reviews and a company's sales success. In this case I believe that having an advantage in analytics is one specific factor, and will continue to have a significant positive Influence on Sprout's ability to gain share. Analytics are of greatest utility to larger, enterprise customers, and larger enterprise customers are the focus of Sprout's go-to-market strategy at this point.

Historically, the most used social media management tool platform has been an offering from a private Canadian company called Hootsuite. Hootsuite is said to have 18 million users, but of course many of them have not been paying users. Hootsuite has had a freemium model with a free tier for some time now. The company has recently run into financial difficulties and has had 3 rounds of layoffs. It has now ended its free tier offering, apparently because of financial exigencies. One of the principle factors in the relative success of Sprout have likely been the difficulties at Hootsuite, and I imagine Sprout will be able to gain some significant market share as some Hootsuite users who will now have to pay will be looking for a more stable vendor. While Hootsuite has eliminated free tier, users can get a 30 day free trial, similar to what is on offer by Sprout. That said, Hootsuite still has very low=end pricing tiers.

Sprout recently instituted a price increase which will have a noticeable impact on margins and growth over the coming year as existing customers pay new prices. It will turn out to be far easier for the company to manage any fallout from its price increase which has been a subject of investor concern when the largest company in the space has dropped its free pricing tier. The CFO was rather coy about the specific impact of the pricing change on guidance, and would perhaps be more forthcoming given the additional round of layoffs and the end of Hootsuite's freemium tier. The price Increase had been a major investor concern for several months; given the early results, it is having the more than the planned impact, with total ARR rising at an accelerating pace in this last quarter. Overall, Q4 saw new business ARR more than doubled year on year with far fewer logos.

Last quarter, Sprout's price increase impacted the lowest ACV tier with churn rising modestly from historical levels; the average ACV of users who cancelled was less than $1100. On the other hand, over the entire user base, the dollar-based retention rate shifted materially higher. Indeed, the net impact of the pricing change seems to have accelerated Sprout's pivot to selling to much larger, enterprise class users. It appears that these users actually looked at the pricing change as an opportunity to add listening and analytic functionality to their plans

Late last year, Salesforce announced that it was abandoning its own product in this space, Social Studio. It had previously started a partnership arrangement with Sprout and the two companies began product integration activities, which included adding Sprout to the Salesforce service cloud, to Tableau and to Slack. This activity is ongoing and now reaching fruition. On December 6, 2021 Salesforce and Sprout, announced a significant partnership/integration that included tight product integrations across many Salesforce offerings. Sprout is now being sold by Salesforce, and Sprout's platform is the default integration for Salesforce customers. Last quarter the impact of the Salesforce partnership/integration started to accelerate with 175 new logos for from the collaboration, up from 75 the previous quarter. There are literally thousands of potential conversions that are likely to happen as well as substantial new business opportunities based on Sprout's inclusion in the Salesforce offering.

Just how much will the Salesforce partnership wind up contributing to the growth of Sprout? It is mainly speculation at this point. Given the size of Salesforce, and the size of Sprout, the potential for the partnership to markedly accelerate growth of the latter is unquestionable. It is not just the inevitable migration of Salesforce Social Studio users to Sprout, but the force multiplier of an enterprise salesforce basically a couple of orders of magnitude greater than what Sprout has now, or might have on its own in the foreseeable future.

I am not a fan of triumphalism in any form, and the sins of hubris are all too common in the software business. This is a very difficult environment in which to sell enterprise software, and that is not going to change in the near future. That said, the question I posed here is whether or not Sprout's market share gains are sustainable and if so why. I think they are, and have enabled the company to avoid the all too common guide downs seen by many other enterprise software companies. The CFO, in response to a question summarized the point.

Michael Turits

I just -- this may have been asked before, I'm not sure, but maybe you could talk about some of these things in terms of forward-looking indicators that give you the most confidence a solid quarter, but obviously a tough environment and a very good guide. So level of confidence in that guide and what are the things that give you the most confidence there?

Joseph Del Preto

Yes. Michael, good question. So I think for us, there's a couple of things. One is if we look at -- first of all, Ryan talked about as we think about the momentum we're seeing with the price changes on existing customers, let's start there. We've seen very little pushback. The only areas that pushback are on the really low end of the market. And so overall, we feel really good about our strategy to roll out those price increases across 2023 because we just haven't seen a lot of churn from that.

Then you layer in what we saw on the new pricing on the website so far. I know it's early 60 days in what we talked about, we doubled our new business ACV doubled in December from -- on a year-over-year basis. We like the momentum that we're seeing in the mid-market enterprise. We talked about the attach -- the increase in the premium attach rates.

And so we're just seeing a lot of momentum in what we consider the healthiest part of our business. And then you layer in the success that we're seeing with the Salesforce relationship, and we still think -- like Ryan said, I think we're really early and that opportunity, not only with the Salesforce Studio customers, but the customers across all of the Salesforce kind of ecosystem with the service cloud integration.

So there's a couple of things there. Now obviously, we're early in the year, and we see a lot of momentum right now, but those are kind of the key things, Michael, that we're seeing that kind of give us confidence going into 2023.

There is simply a confluence of events that has, is, and will enable Sprout to escape some of the headwinds that are plaguing many other enterprise software companies. As mentioned, I thought the CEO's script and indeed most of the company presentation was an outlier compared to most of the other companies I try to track. But in considering the numerous tailwinds here, that simply aren't present in much of the rest of the enterprise software space in 2023, the reasons for optimism seem well anchored.

Looking at the last quarter and forward guidance: The Sprout business model is still evolving

Last quarter, while revenue growth was 31%, and was up by 7% sequentially, revenues were only consistent with the company's prior forecast. While the company's subscription revenue growth was 31% and above plan, with record growth of new ARR, the company had a shortfall in services revenue, basically as a result of free on-boarding of the 175 Social Studio conversions. This headwind is going to persist into the current year; on the other hand the tailwinds from the pricing change, the acceleration of conversions of current Social Studio customers, and the ramping of opportunities from the Salesforce partnership in terms of sales to new customers is going to overwhelm that headwind, and ARR growth is expected to accelerate to at least 33% this year. To say the least, it is unusual these days to find a software company talking about accelerating growth and to increase its forecast for ARR expansion in 2023. It is obviously one of the factors leading me to write this article at this point.

The company, because of its growth outlook, and because of the availability of talent due to so many layoffs by companies in the IT space is projecting a rather modest improvement in non-GAAP operating margin growth, especially in comparison to many other IT companies who have announced layoffs and other cost remediation steps. Like the forecast for any other IT companies, the outlook for margins is highly dependent on the actual trajectory of revenue growth. The company has beaten guidance most of the time , and based on the inputs that inform its forecast for ARR and license revenue growth that seems likely to be the case in 2023 as well.

Overall, Sprout certainly has plenty of opportunity to improve its cost ratios. Last quarter, the company's non-GAAP gross margin was about 79%, up 300 basis points from the year earlier level and up about 100 basis points sequentially. As Sprout scales, gross margins could continue to trend higher due to inherent efficiencies in the company's model and unified code base. The previously mentioned price increase should also be a factor in increasing gross margin percentages.

The company, as mentioned, has been taking advantage of available talent to hire at a substantial cadence. That drove sales and marketing expense to rise to 41% of revenues, non-GAAP, up from 39% in the year earlier period. The sequential growth in sales and marketing expense was 10%, and it probably will continue at that pace for much of 2023.

Research and development spending was 19% of revenue. That is relatively modest for a company of this scale. R&D expenses were essentially flat sequentially. I would be surprised to see the R&D expense ratio improve any further at this scale of the company.

The company's general and administrative expense ratio showed some leverage last quarter. G&A expenses were 18% of revenue, a 300 bps improvement year on year. G&A expenses rose about 5% sequentially, and I expect that the company will be able to achieve greater expense discipline in this category with more leverage likely in 2023.

The company, as mentioned, has projected a very modest goal of 3% operating margins for 2023. Even that modest goal was above the prior consensus. The company doesn't project free cash flow explicitly. Last quarter, free cashflow margin was less than 5%, although that was actually better than had been anticipated. There was nothing extraordinary in cashflow metrics last quarter although the company indicated it had signed $10 million of customer contracts in December which were included in the RPO balance, but were not invoiced to customers until January 2023. I have projected that the company's free cash flow margin will reach 8% this year as it pivots to selling to larger users who often sign multi-year commitments which results in momentum for deferred revenue growth and reaps benefits from its price increase.

Wrapping Up - Reviewing Sprout Social's valuation and reiterating the share purchase recommendation

Sprout Social is atypical amongst the software companies that I follow in that it is enjoying accelerated growth and has actually forecast an acceleration in the percentage growth of new ACV and ARR in the current year. It is forecasting an increase in non-GAAP operating margins, although the increase is relatively small. This is not a company announcing layoffs or specific cost mitigation strategies; it has some unique opportunities and it is investing to exploit those opportunities.

To recapitulate Sprout's opportunities rest on several specific pillars. The company has struck a partnership with Salesforce which is sunsetting its product in the space and it has significant integrations with CRM that will leverage the sales capability of that company to accelerate the growth of Sprout. Over time a large proportion of Social Studio customers are likely to migrate to the Sprout platform. The company's largest competitor, Hootsuite has run into financial problems and is laying off staff and has ended its free tier offering. Seemingly fortuitously, Sprout has instituted a price increase and that is accelerating a pivot to much higher valued customers. These customers are using Sprout's analytics and listening products at a rate significantly above prior levels. It is the combination of all of these factors, as well as the continued growth of the market for social media management tools that is enabling Sprout to escape the headwinds that are affecting growth percentages for so many other IT vendors.

Beyond these specific growth pillars, the fact is that social media management is still a nascent space with a substantial untapped opportunity. Social media is how enterprises advertise these days, and they spend billions doing so. Most users of the technology don't believe they get good value for money, although there are many reasons for that. Using available management tools is one way of doing more with less, a consistent mantra during this period of economic headwinds.

Sprout shares have had a fairly muted response to the results of its latest quarter. The shares did rally about 10% on the day after the earnings were released, but have since retraced most of that spike. At this writing, i.e. 3/1/23, the shares are up just 7% year to date.

Some of that probably has to do with perceptions that the shares aren't cheap. The EV/S is just under 9.5X, and the company is just now starting to generate meaningful free cash. Many investors in this environment are looking for deep value and Sprout shares are not that. The shares are unlikely to generate significant positive returns in a market with a risk-off bias that is concerned about every hint of the direction of inflation.

That said, I believe that a company whose leadership in its space has been significantly augmented by a new partnership, and the problems being faced by its erstwhile largest competitor deserve a premium valuation. This is a substantial, multi-year opportunity, and the results are going to stand out significantly in 2023. This is a company whose shares are geared for long term growth investors and which should generate meaningful alpha over the coming year and beyond.

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