GTLB - What I Want To See Before Buying GitLab Stock

2023-07-21 14:07:36 ET

Summary

• GitLab, a growth company, faces high operational costs and no clear indication if these costs are slowing down.
• Their stock-based compensation is quite high as a percent of revenues and funding growth in this manner would not be sustainable in the long run in my view.
• Valuation accounts for AI-related growth and I am a skeptical until this is actually realized.
• Competitors ranked above GitLab are also introducing AI in their products, and it's unclear how much market share the company can grab.

Growth Stock investing process

GitLab ( GTLB ) has had a fantastic growth run these past few years but if I am being a buyer or an investor in a growth name, I try to check for these factors before taking a bite. These allow me to pick the best names in the category and set myself up for better returns in the long run.

1) How are operational costs affecting growth?

2) How is the growth being funded?

3) Is valuation overly optimistic?

4) How well is the company positioned against the competition?

When answering these questions, I realized that GitLab still has a long way to go before I can get comfortable as an investor. Therefore, I am rating this company as a hold for now.

Margins

Gross margins are quite high coming in at close to 88% but the company has been operating at a loss mainly due to high operational costs. SG&A to revenue is more than 100% which means that the company is spending more than what it is making without even accounting for R&D. But the direction of these expenses also matter. Overall, this ratio has been dropping as the revenues have picked up which is a good sign.

The above chart shows a big improvement in operating margins overall but what happened in the last two years is discouraging. Growth from 2021 to 2022 was ideal. While the revenues increased by more than 60%, SG&A remained flat. However, this was short-lived.

Comparing 2022 and 2023, revenues increased by the same amount but SG&A also exploded (Each incremental dollar of sales resulted in a corresponding increase in SG&A expenses). The first quarter of fiscal 2024, showed some encouraging signs with costs rising slower than revenues but I am willing to wait and see if this trend keeps up for the whole year (So far there is no clear trend, and SG&A expenses have whipsawed).

Funding the growth

There are multiple ways to fund a company's growth and most early-stage growth companies do not have the luxury of funding their growth through their earnings or cash flows. In GitLab's case, the balance sheet is pristine with the company being completely debt-free. Most of their growth was funded through stock-based compensation and it would be quite helpful to see how much it is when compared to revenues.

For the fiscal year 2023, SBC was at $122M which amounted to 29% of the company's revenues. This did not improve too much in the latest quarter either (27%). This is quite high and it's quite hard to keep up this level of compensation without seriously diluting the shareholders. Either way, shareholders will have to expect to see either dilution or an increase of debt on the balance sheet for the company to continue to grow. I am willing to wait and see how this stabilizes before being an investor in this company.

Valuation

The company is not profitable and it is richly valued when looking at the Price-to-Sales ratio which is currently at 17x. It is hard to justify this type of valuation unless you think the company has the potential to continue growing at the same rate it has so far (>65% growth).

But for fiscal 2024, the company is expecting close to 27% growth which puts the forward PS at 15x. Still richly valued. The current sector median is close to 3x and this type of high valuation of the stock relative to the sector was probably justified when the company was growing at more than 65%, but as we saw this growth has dropped off a cliff.

As a retail investor, it is hard to justify buying at these levels. Aside from the stock price clearly being in what I'd call bubble territory, the only way to justify the price in my opinion is if a bigger competitor comes along and buys it at an even higher level. This could happen. After all, that's what we saw happen with GitHub where Microsoft (MSFT) likely thought it was a strategic move to buy GitHub.

The deal was valued at $7.5B and reportedly had between $200-$300 million in annual recurring revenue. This implies a multiple of approximately 30 times ARR at GitHub's midpoint. This comparison should only serve as a proxy as it does not consider non-recurring revenues. If one were to consider non-recurring revenues this could come down although not by much.

AI Boost to Valuation

In early May 2023, the stock price saw all-time lows, clearly, the market started realizing the high growth level which it was accounting for was not sustainable. Then the AI-fueled boom started moving the stock upwards and in its latest earnings call, the company explained how it would incorporate AI in its products. I, for now, firmly belong in the skeptical camp as it's unclear how much it will drive overall sales. The company could go the route of charging additional dollars for the AI add-ons but I am willing to wait and see how this idea matures and could have an effect on valuation before being an investor in this company.

Competition

Aside from facing competition from the more popular GitHub, the company has multiple competitors in the space it operates. The good news is that the company has tried to differentiate and provide features in areas where other companies lack. The bad news is that many of its competitors are owned by bigger companies (Microsoft, Atlassian) with deep pockets and I am unsure of the moat provided by their differentiation strategy. Also, both Microsoft and Atlassian have large install bases and more salespeople to push their existing products and bundle their software development platforms as an add-on.

The current market share of GitLab is at 12% ranking third, behind GitHub and Git, with BitBucket close on its heels. Knowing the industry well, I don't expect GitLab to uproot or replace incumbents (especially GitHub) so it would be hard to see this market share change much in the next few years. I am willing to wait and see how well they are able to manage their competition before being an investor in this company.

What would prove me wrong and convert me into a buyer?

In my thesis, I am mainly waiting for several factors to become clear before I decide on being an investor in the company:

1) The company holding down its operating costs and a clear trend emerges in this regard which means that the growth is a lot more sustainable.

2) Revenue grows at a much faster pace than its SBC which could happen if we see AI indeed becoming a big driver of growth. The company could be on a trajectory to beat its own guidance by a wide margin which means that the big growth the market was accustomed to these last few years could be back on the table.

3) The stock price drops to a level that justifies its valuation against its growth.

4) The company gains significant market share through a superior differentiation strategy and is able to gain an edge over its competitors.

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