2023-06-21 14:54:10 ET
Summary
- I am downgrading NABL to a hold as the stock has risen 25% since December and is now trading at 43x NTM PE.
- However, the outlook for FY23 remains positive, with increased guidance and sustained growth momentum, supported by diversified MSP partners and the secular tailwind of digitization.
- The stock's valuation at 43x NTM PE suggests limited upside potential and possible multiple compression.
Recommendation
N-able ( NABL ) stock is now up around 25% since my coverage at $11 from last December, and I believe the upside from here will be limited given that NABL is now trading at 43x NTM earnings. As such, I am adjusting my recommendation from buy to hold.
Investment thesis
NABL solution is designed to fit the needs of managed services providers (MSPs) to remotely monitor and manage client environments, provide security and backup, and manage client relationships. The MSP business models address the fact that small businesses may not have the resources to employ full IT departments that have the capacity to manage these IT-related issues that need to be addressed with varying degrees of severity. MSPs service this environment by offering technology and service sophistication scaled across a greater breadth of resources. Compounding the opportunity for NABL, in my view, is a shortfall of talent across the Security industry. As networks become more complex, the number of threats continues to increase, and the risk of disruption increases, demand for technology to automate and scale infrastructure and security management is also increasing.
Over the past 6 months, NABL did not fail to meet expectations, as the company generated strong revenue and profit growth as demand in the MSP industry remained robust. I believe the outlook for FY23 is further de-risked with management calling for an increase in FY23 guidance. Even though NDRR was still low at 103% for the quarter, I don't think it's a big deal because of the current FX environment's volatility (FX was a 500bps headwind). When adjusted for FX, NABL's growth remains very strong and healthy, with recognized revenue increasing by 10% year over year. In particular, I anticipate sustained growth momentum as NABL's large MSP partners continued to expand at a healthy rate (MSPs with >$50k in ARR grew by 12% and now makeup slightly more than half of total ARR). The more large MSP partners NABL can capture, the faster and more stable the growth will be. For the former, these large MSPs are enough capital to target a wider basket of customers at once, which also improves margin at the same time as lesser MSP account managers are needed. For the latter, the more diversified base of customers across multiple verticals will improve the stability of NABL earnings and growth profile.
Demand environment remains strong
Looking ahead, I believe the business will continue to do well, supported by management's strong execution profile and healthy demand commentary. Surprisingly to me, given that this is a common theme in the Software industry, NABL noted that its customers did not experience all of the increased macro pressure in 1Q23. Despite the difficult macro environment, strong demand trends persisted this quarter. My impression is that NABL's business strategy has helped the company avoid the headwinds (poor macro leading to poor demand, etc.) that other businesses in the software vertical have faced. Because of its diversified MSP, end user installed base, and most importantly, the strong secular tailwind of digitization, NABL's underlying customers are much more resilient and stable. This final point is crucial because it serves as a mitigant in a market where many companies are looking for ways to reduce overhead. One of the simplest ways to optimize cost structure is to digitize legacy processes that are taking up too much manpower, like utilizing manhours to manage an Excel spreadsheet for database purposes. As a result, I still believe that NABL is positioned favorably to gain from the market's emphasis on lowering prices.
Valuation
Public equity (stock) investors, unlike private equity investors, are at the mercy of daily valuation mark-to-market. This principle applies to NABL, especially in this instance. I am bullish on the company's fundamentals and growth prospects, but at 43 times forward earnings, I believe the stock has already embedded the bull case. Despite NABL's short operating history, we can use its historical trading range prior to 2023 as a guide because the growth profile and current expected growth profile are similar. NABL used to trade in the 27x to 38x range, but it is now trading at 43x. When I wrote about the stock at 30x, there was no threat of multiple compression; however, the stock now faces a possible compression from 43x NTM PE to 33x NTM PE. If it compresses over a year, this is a 25% headwind to shareholder returns. I'd also like to point out that the S&P 600 SmallCap Index has a PE ratio of only 16x, whereas NABL is trading at roughly 3x this level after previously trading in the 2 to 2.5x range.
Risks
NABL is not able to control how fast MSPs acquire customers
NABL expands due to two main factors: the number of MSPs on board and the number of SMEs aboard each MSP. NABL can control the first through its customized sales approach, but it has no control over the latter. This makes forecasting future growth difficult because it is heavily dependent on the quality of MSPs on board and how quickly they grow.
SMEs have high churn rates
Dealing with SMEs is difficult due to their high churn rates. A recession or any other event that has a significant negative impact on SMEs would reduce the number of MSPs in the market, which would have a direct impact on NABL's growth and business.
Summary
NABL has performed well over the past six months, generating strong revenue and profit growth in the robust MSP industry, and hence, has reached my target price. The outlook for FY23 appears positive, with increased guidance from management and sustained growth momentum expected. NABL's diversified MSP partners and the secular tailwind of digitization contribute to the company's resilience in the face of macroeconomic pressures. However, the stock's valuation at 43 times NTM earnings suggests limited upside potential, with the possibility of multiple compression. Comparisons to historical trading ranges and the broader market highlight the current premium valuation. Risks include the dependency on MSPs' customer acquisition and SMEs' high churn rates. Considering these factors, I am adjusting my recommendation on NABL from buy to hold, as the stock's potential appears to be already priced in at current levels.
For further details see:
N-able: Downgrading To Hold As Valuation Becomes Too Pricey