2023-11-30 10:57:56 ET
Summary
- I revised my rating to a buy as the business environment stabilizes and sales force productivity improves.
- Revenue growth in the third quarter indicates a rebound in research contract revenue, particularly in the Global Technology Sales and Global Business Sales segments.
- The company's sales team is reaching optimal productivity after a significant increase in headcount, leading to anticipated accelerated growth and potential margin expansion.
Summary
Following my coverage on Gartner Inc. (IT) in September this year, which I recommended a hold rating as I wanted to have a larger margin of safety before investing. My ideal point of entry is when valuation dips to 29x forward PE back then. Since then, the stock price (now at $430) has reached near my previous price target of $417. My mistake for being too conservative, seeking a larger margin of safety, resulted in my missing the rally. This post is to provide an update on my thoughts on the business and stock. I am revising my rating to buy for IT as I feel more comfortable buying the stock at 33x forward PE, in large part due to lesser business risk. The stabilizing business environment, coupled with growing sales force productivity, bodes well for both revenue growth and margin expansion.
Investment thesis
Early this month, IT reported its 3Q23 results on November 3rd, with revenue growing 5.8% to $1.4 billion, beating consensus estimates by 160 bps. The beat was supported by growth across all three segments. Research revenue grew 5.3% to $1.2 billion, with subscription revenues growing organically by 7.7% y/y, offset by a decline in non-subscription revenues of 8.7% y/y as there was less demand for lead generation, which is not surprising in the current environment. The total value of contracts grew +8.1% y/y constant currency with Contract Value reaching $4,659M at the end of 3Q. Consulting revenue increased 24.1% year over year, driven by labour-based and contract optimization work, while Conference revenue declined 25.7% year over year due to the timing of events.
One of the main reasons I'm raising my rating to a buy is because the quarter has shown that there is significantly less business risk. The overarching theme is that the weakness faced by IT previously is mostly over, and growth should recover and continue to accelerate from here. The first significant sign of growth stabilizing or recovering is the 8% year-over-year growth in research contract revenue in the quarter. This growth was driven by enterprise function leaders experiencing double-digit contract value growth in both Global Technology Sales [GTS] and Global Business Sales [GBS]. Within GTS, new business within the IT enterprise function grew mid-teens, with tech vendor showing signs of stabilization (up low-single-digits). Keep in mind that although GTS wallet retention fell to 102% from 107% last year, the retention rates of IT enterprise function leaders' wallets were still higher than historical GTS levels, suggesting a return to historical trends (stabilization) rather than persistent weakness. As for GBS, during the quarter, every GBS practise experienced double-digit or high single-digit growth.
I expect growth to accelerate from here as IT's growth driver-the sales team-should be reaching its optimal productivity after 9 months since the huge increase in headcount in 4Q22. Typically, IT has about 35 to 40% of their sales force comprised of new sales reps, but this figure has shifted up to 50+%. New sales representatives need time to learn the ropes, study the products they are selling, and craft the right pitch. With average tenure trends towards more normalized levels and the overall demand environment stabilizing or getting better, I expect growth to accelerate.
"As we've made our way through this year, obviously, all those people we hired in 2022 have gained experience and tenure. We did -- were very backend-loaded last year in terms of the hiring. And so, those people we hired in third and fourth quarter of last year are now approaching or have just crossed over their one-year anniversary." 3Q23 earnings results call
Importantly, management noted that the current sales headcount is sufficient and will likely be keeping headcount growth muted in the near term (sales headcount mostly flat for the 3rd consecutive quarter since 4Q22). This implication from this comment is huge, as it means that revenue growth will come at high incremental margins. If we look at IT's historical adjusted EBITDA incremental margin, ignoring the major fluctuations due to subprime and COVID, the 2-year incremental margin tends to trend in the high-teen percentage range. The reason for using 2 years is because a y/y comparison would be too volatile as new sales reps make up ~40% of sales headcount. Over the past 2 quarters, the incremental adj EBITDA margin was 9% and 11%, and I expect this figure to improve back to the high teens over the coming quarters as operating leverage kicks in. In fact, I believe the productivity of the newly high headcounts will be much higher given that they are mostly incentive-driven (quota-bearing headcount). As such, the incremental margin could be above 20%, driving further margin expansions. In fact, I believe management was already hinting at this when they reiterated the medium-term EBITDA margin target of low-20s with the opportunity for incremental margin expansion annually.
Valuation
Forward-looking thoughts
My revised price target is due to my revised growth expectations for FY24 and FY25, as I expect sales rep productivity to normalise and the business environment to continue stabilizing and recovering. My expectation is for revenue to grow by 10% in FY24 and 15% in FY25. Another important variance vs. my previous model is that I am expecting incremental margin to kick in at 20%, which should drive net income margin upwards to ~16% in FY25.
Price target
My target price for IT based on my model is $506.35, and I am revising my rating to a buy from hold. Recall previously that the main reason I was hesitant to give a buy rating was because of IT's valuation and because I wanted a larger margin of safety. Now that the business risk is much lesser, I am more comfortable buying the stock at its current valuation. Rather than focusing on buying the stock at the best price (which is hard to come by), I am revising my framework to invest when the price is "attractive enough," which is near the historical average. Historically, IT trades at an average of ~34x forward PE over the past decade. In my model, I expect IT to trade back to 34x.
Risks
My worry with IT is that the business environment could flip for the worse as rates stay higher and longer and the US unemployment rate remains low. There is little reason for the Fed to not continue increasing rates. As rates go higher, the pressure on businesses will continue to snowball, which will directly impact IT growth momentum. Another risk is that I might be wrong in the return in growth as 1 quarter of data is not exactly representative of a trend. If the next quarter data indicate that situation has worsened, my bullish view will be impaired.
Conclusion
In conclusion, I am revising my rating to a buy for IT. The company's 3Q23 results showcased a positive trend, with revenue growth across segments, indicating a more stabilized business environment. Notably, the quarter demonstrated lower business risk, evident in the growth rebound of research contract revenue, especially within GTS and GBS. With the sales team's productivity approaching optimal levels after an influx of new hires, I anticipate accelerated growth. Moreover, management's indication of stable sales headcount implies potential revenue growth at high incremental margins.
For further details see:
Gartner Q3: Rating Upgrade As Business Environment Stabilizes Along With Better Productivity