HubSpot-Doing many things right
HubSpot (NYSE:HUBS), 11 months after a wrote my first article on the name, is almost certainly the real McCoy when it comes to its business model. Not particularly because the shares have seen major appreciation, although it has appreciated by a bit over 50% this last year. But it has seen its business grow as fast as any of its peers in the marketing automation space and has made some notable progress on its path toward profitability.
HubSpot has been able to achieve strong results in a very crowded niche. Just a few of its competitors include Oracle (NYSE:ORCL) which owns Eloqua, Pardot, Marketo, Adobe (NASDAQ:ADBE), Salesforce (NYSE:CRM), Infor, IBM (NYSE:IBM) which offers Silverpop, and Callidus (NASDAQ:CALD). And the space itself, while of decent size, is certainly not one of the giant opportunities of the software world. The latest surveys, a couple of which are linked here suggest the market size is about $6 billion-plus and that the CAGR is no more than 10%.
For the most part, it is easier writing about companies that are growing strongly in red hot spaces. When I write about Shopify (NYSE:SHOP), it is pretty straightforward in that they dominate a market segment that clearly is on a high growth trajectory and which is just in its infancy.
Marketing automation has been around for several years and many of the solutions seem to mimic each other. HUBS itself is more than a decade old at this point. While I doubt that saturation has arrived, the concept of marketing automation is used to refer to solutions that are in use at most large enterprises and a significant proportion of medium sized business in this country. There are, to be sure, factors that differentiate competitors and competition, especially in the SMB sector where the ultimate decision usually comes down to some specific piece of functionality as much as price. But I think it is fair to say that these days, it is far more difficult, as an analyst, to forecast that one or the other companies in the space will stand out and achieve hyper-growth for some years to come. The fact that HubSpot is doing just that deserves some more in-depth analysis and evaluation.
Another great quarter – but what’s to come?
HubSpot reported the results of its fiscal Q1 earlier this month. The results were considered an upside surprise and the shares appreciated 8% at the time. They have since retraced the entire move and are now below the price they were before the earnings were reported and guidance was raised.
The company’s results as will be outlined below were ahead of expectations pretty much across the board. The company had forecast $79 million in quarterly revenue and beat that expectation by 4%. The company showed a fair amount of operating leverage and essentially all of the revenue beat dropped to the bottom line. The company forecast revenues and EPS marginally ahead of the prior consensus for Q2. The company has beat expectations significantly over the past year and there is little reason to believe that guidance for this quarter will not be exceeded. The guidance for the year is probably more conservative than realistic. The company’s new full-year revenue guidance shows no upside beyond the Q1 beat and the modestly improved Q2 forecast. Revenue growth is supposed to fall from 40% in Q1 to 32% this quarter producing just a 3.5% sequential quarter revenue increase. Percentage growth year on year is supposed to fall further in both fiscal Q3 and Q4.
The company raised its earnings expectations, but again primarily as a function of the company’s Q1 beat and Q2 raise. It has basically not seen fit to increase expectations beyond mid-year despite what appears to be solid sales momentum and some visible expense discipline.
Subsequent to the earnings release, the company announced that it was selling $350 million of a convertible secu rity. The conversion price of the new offering was $94 and the interest rate is 0.25%. In commenting about financial numbers, I will ignore the convertible offering. The dilution is not relevant given the significant conversion premium and the interest rate is so low that interest payments will not move the company’s incomeunless of course, the company is able to make an acquisition, presumably the rationale for selling the debt.
In any event, the company reported 40% revenue growth in Q1, almost all of it within its subscription revenues. The company posted a 700-basis point improvement in the GAAP operating loss ratio which fell by 20% in dollars and reached 9.6% of revenue compared to 16.7% in the year earlier period.
Looking at some of the details: Subscription gross margins improved by 150 bps year on year. The company made some progress in terms of operating expense but surely has much further to go. Research and development spend increased by almost 3 7% year on year but the spend ratio for that expense fell by about 47 bps. General and administrative costs increased by 33% year on year and general and the administrative expense ratio fell by 45 bps. While research and development costs might be considered to be at relatively normal levels at 16% of revenues, the cost of general and administrative expense which is also 16% is far higher than might be expected for a subscription IT company.
The most significant opportunity however relates to sales and marketing expenses. As mentioned. marketing automation is a very crowded space occupied by all kinds of vendors, some of them much larger in size than HubSpot. The company spends a lot on sales and marketing because it needs to spend lots on sales and marketing just to get its message across to potential buyers in a very crowded environment with lots of countervailing and unprovable claims.
Last quarter, sales and marketing spend grew by 33% year on year, substa ntially less than revenue growth. As a result, the sales and marketing GAAP spend ratio declined from almost 60% to 57%.
The company reported a very modest non-GAAP operating margin of 1.6% due to the dollar increase in stock based comp expense. As a ratio, however, stock based comp expense was essentially consistent with the prior year level at 11% of total revenues.
The company showed far greater cash flow generation than it has had in the recent past. About two-thirds of the improvement was based on balance sheet items. The balance was a product of a smaller GAAP loss coupled with greater stock-based comp.
The investment merits – and demerits – for a company like this
Hubs shares, while hardly outliers in terms of valuation, are certainly not in the value category either. The company will need to beat consensus estimates in order to see rising share price targets and rising share values. At the moment, that seems likely given the guidance that the company has provided and its acceptance by analysts in forming the consensus.
The company has 36.2 million shares currently outstanding and a current share price of $66.70. That produces a current market cap of $2.4 billion. Its current balance sheet shows a net cash balance of about $160 million thus yielding an enterprise value of $2.25 billion. With current year sales forecast at $358 million, the EV/S metric comes to 6.2X.
The business issues for this company are pretty straightforward. For how long can the company sustain a differentiated and strong revenue growth rate and how rapidly can the company’s business model evolve? The company despite headlines to the contrary really did little in terms of guidance to suggest answers to those questions as part of its Q1 release and that is perhaps why the shares have retraced their initial advance. Company guidance, mirrored in the published First Call consensus forecast, modestly raised expectations in terms of revenues and earnings for this current quarter, but left expectations for the balance of the year consistent with prior consensus expectations.
The sequential growth the company is forecasting is quite minimal and the growth in earnings from Q1 to Q2 and beyond is actually negative.
The first question during the course of the conference call related to the sustainability of growth in the context of a marketing automation market that has been expanding far more slowly than Hubspot’s revenues. The answer was not terribly explicit.
One of the growth concerns for this company involves the success it might have selling a standalone CRM solution. The tool itself is free. Revenue generation comes based on the user purchases of users typically sign up to use HubSpot’s SalesPro which costs $50/month and users also tend to purchase additional products on their HubSpot Growth Stack marketing platform. There have been early signs of success, but nothing that is terribly quantifiable at the moment. One reason why I believe that the growth compression expectations embodied in the consensus are unlikely has to do with the CRM opportunity and the opportunity the company has with some of its other product initiatives, particularly what it calls One HubSpot, which is a platform approach to the company’s product portfolio. Again, there is nothing to which I can point in the numbers that have been released or discussion on the conference call – it is more about emanations and penumbras so to speak. One HubSpot is a relatively recent initiative and has yet to be tested in terms of its wide-scale deployment but early results seem to be encouraging.
One number of significance for a company such as this focused on the SMB space is churn. The company defines churn based on revenue retention rather than customer retention and that metric climbed to above 100%. The company is moving toward re-defining the churn metric although given the pr oduct line extension, it is likely to be a distinction without a difference.
The company focused on sales productivity during the call and how it could evolve its sales effort to better mimic what it describes as the “light touch” model that is used by companies such as Shopify. This lighter touch paradigm is the strategy the company has for reducing the huge burden it carries in terms of sales and marketing spend. Part of the lighter touch strategy includes the use of a freemium model coupled with an emphasis on both cross-selling and on focus on what the company calls its marketing starter kit.
I don’t want to suggest that I have anything close to second sight. But I think that the combination of product launches, selling strategy and just a good time in which to be selling marketing automation solutions to the SMB space has been under-estimated in forward guidance and the consensus forecast. And if, indeed, the sales strategy works, then it is almost inevita ble to believe that the company will drop a substantial portion of its incremental revenues to the bottom line as was the case in Q1. Most of these are expectations at the margin. Add a few million to revenue expectations this quarter and build on that foundation. Expect a significant proportion of the sales overage to drop to the bottom line as was the case in Q1. These are not very outlandish expectations. But it is those kinds of high odds expectations that I think will propel the shares significantly.
Why is this happening?
I think if you invest in shares at this point, you are basically investing in the company’s concept of in-bound marketing compared to the traditional outbound paradigm. I wrote about the features of that paradigm when I first published an article on this site back a year ago. It hasn’t changed although the addition of a CRM solution enhances both the business model of the company and the attraction it has for customers, overall. I have l inked to a description of what is involved in creating an inbound marketing solution. Vying for attention is hard. This is a strategy that apparently works and which is not the same as that offered by all of the other companies in the space.
The approach is quite a bit different than using cold calls, regardless of how well the target market has been refined by targeting tools. All of this material is obviously a bit of hype and I do not want to pretend that I have road tested it at this point. I most likely will, but I am happier to look at testimonials, the buying behavior of the installed base and the company’s growth record as validation points that suggest that this is a strategy that has seen success. Without trying to be a commercial for what this company does, its solution is clearly more relevant and less interruptive than typical marketing strategies, even those based on digital engagement
Most recently, the company has begun to offer a free CRM tool. Most of these freemium adventures have their glitches but it is an interesting way to distinguish HUBS from its competitors. The free product is quite basic but it serves the needs of the HUBS base adequately and significantly enhances “stickiness” and adds to overall average revenue per user. It is part of the process in building product differentiation to protect the company’s inbound marketing franchise.
While the overall marketing automation space isn’t huge as these things are measured, it represents a huge opportunity for a company that is doing less than $400 million of annual revenues. The CRM space, as linked here, is quite a bit larger than what is called marketing automation and produces a very substantial TAM for this company. I don’t think that looked at holistically, this company has any lack of available market space in which to grow and it appears to have a successful strategy for pursuing the opportunity.
Like many companies t hat are experiencing rapid growth, valuing HubSpot is not a science and I think the use of price targets in this case cannot be readily defended. I think that this company has built a considerable moat and offers a differentiated solution in its space. I think that the company ought to be able to continue to achieve growth at above the rates in its category for several years. As mentioned, I think that the reversion to the mean that has been forecast is at a pace far greater than is likely to happen. The company is still on the upside of the curve for several of its most recent product initiatives. The environment for selling marketing automation software remains very positive. The company has a very reasonable set of sales strategies that should improve the efficiency of its ability to generate new name accounts.
The consensus is looking for 32% growth this year and 25% next year. It is based on a particularly peculiar rate of sequential quarterly revenue growth that seems unlikely. I am inclined to think that the set-up provides a strong opportunity for the company to beat all of the next three quarters that it has forecast and to achieve full year growth of 35% and to achieve growth in 2018 that reaches above 30% again. It seems likely to me that the recent convertible offering will be used to fund some acquisitions further boosting growth. I would be surprised if the company did not reach at least $500 million in revenues by the end of 2018 as a run rate which means that its EV/S at this time for that period is really just a bit over 4X, a reasonable metric for a company with a definable and defensible competitive moat.
Investors do not buy this company based on current earnings estimates but on the path to profitability that the company has laid out. Management has spoken to the point that its product gross margins have most likely reached an asymptote and based on the experience of many other companies in the space that seem s likely. Improving services margins also seems likely and this is not going to have a major impact on profitability.
The big numbers are going to come from reducing the costs of sales and marketing and general and administrative cost meaningfully. At scale, and by that I mean above a $500 million revenue run rate with management planning for top line growth of between 20%-25%, there ought to be at least 2000 basis points of available margin enhancement at a reasonable level of execution. That would take pre-tax profits to $100 million-plus and presumably would yield more than $70 million in net earnings. I think expecting that the company can generate $2.00/share in GAAP income by 2019 is indeed what the valuation of this company is based on.
I think the transition the company is making to a part freemium sales model is one in which the company is essentially replacing direct sales and marketing spend with what are arguably product demos. It has the potential for the company to disrupt the CRM space in the SMB world and to generate customer acquisition for paid products above rates than HUBS has sustained in the past.
The company will probably continue to spend 16%-19% of its revenues on research and development. It gets meaningful leverage by investing in products and with its lighter touch sales model it makes even more sense to accelerate product development.
While the company generated a noticeable level of cash flow in Q1, that is unlikely to be representative for the year as a whole. Much of the cash generation related to seasonal balance sheet impacts that are very unlikely to be repeated going forward. The company will be consistently able to over-achieve cash flow because of its business model. It bills its core product one year in advance and assuming the number of users rise and the annual revenue per paying user also increases, deferred revenue will increase consistently. I assume that over the next two years-plus the company will reach free cash generation of more than $150 million/year. That is another element in suggesting that despite what looks to be an extended valuation HUBS shares have significant upside.
At the moment, HUBS shares are reasonably well loved by analysts. The average rating published on First Call is 1.8, which is between buy and strong buy. There are only four hold ratings out of 21 published estimates – the balance are buys and strong buys.
As mentioned earlier, the Q2 set-up seems quite reasonable for investors with sequential revenues forecast to increase just 3.5% in a seasonally strong quarter and with earnings forecast to be less than Q1. That simply doesn’t appear to be a reasonably likely scenario based on previous seasonality and I think the quarter will ultimately be another quarter of beat and raise.
There are many entrants vying for attention in the marketing automation space. I think HUBS has one of the better chance s of becoming a substantial presence due to its differentiated solution that seems to have been widely accepted by a significant cohort of users. The shares have done well over the last year and I believe it can continue to show positive alpha going forward.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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