Smartsheets: Some Way Points In Its Evolution - Smartsheet Inc. (NYSE:SMAR)

Smartsheets (SMAR) has been one of the shooting stars in the IPO firmament. The company, which went public in April 2018, started trading at $18.50, and shares now selling for $51 as of Tuesday evening. That has created an enterprise value for this company of just short of $5 billion. $5 billion might seem like an extended valuation for a company such as this that sells a desktop spreadsheet application. . And indeed, notionally, Smartsheet shares, with an EV/S of just a bit more than 17X based on my estimate of 12 month forward revenues of $285 million, obviously have a stretched valuation, and one that is a bit greater than average for the 40% 3-year growth cohort. That being said, however, the shares have doubled so far this year, and trade close to their all-time high. Not terribly surprisingly, the shares have become well-owned by hedge funds chasing growth.

Several subscribers of my Ticker Target investment service have asked me to take a deep dive into the outlook for this name. In some ways, SMAR shares have been seen by some as an analog company of Alteryx (AYX) and perhaps Anaplan (PLAN) and just about anything connected to AYX and PLAN is something worth considering these days. As a practical matter, the connection in terms of functional equivalence is weak but on the other hand, in these days of algorithmic trading, even weak analogs are often considered grounds for a trade.

For readers unfamiliar with Smartsheet, it is essentially an adjunct, and not really a replacement for Excel. In evaluating this company, that is a very important distinction. I do not think this company would have the kind of future I believe it does if it was simply another spread-sheet. There are plenty of those, and it is hard to distinguish one from the other. The Smartsheet application, like many these days, is resident in the cloud and 90% of its revenues is subscription. Growth last quarter was 55% year on year and 8% sequentially. Those results were a beat of about 3% on revenue and management raised full year guidance for revenue by 3%. At the current guidance, full year growth would be 49%. Presumably most holders and analysts think that expectation will be exceeded-the shares jumped 10% when the earnings were released and have continued to appreciate and reached a new high on Wednesday.

The company and some of itslarger shareholders sold almost 15 million shares last month. The share sale affords the company a substantial level of liquidity with cash on the balance sheet now almost $600 million. The shares initially reacted to the sales with a pull-back, but they have recovered lost ground at this point. Presumably, the cash balance will be used to fund some tuck-in acquisitions that broaden the footprint and accelerate growth by offering adjacent solutions.

The Smartsheet product offers features significantly beyond Excel in terms of collaboration, dashboards, forms and integrations. But at the end of the day, this is a spreadsheet with features that facilitate collaboration and workflows. It is not a simplified version of Alteryx (AYX) or of Anaplan (PLAN) and it never will be. That leads to 2 consequences-Smartsheet’s has an addressable market in the tens of millions of users (the company says hundreds of millions but I will be conservative), and it will always have a fair amount of competition.

What should investors do with the shares? The shares are well loved by analysts and have an almost universal buy rating at this point. The real longer-term growth rate is hard to know because the category in which this company operates is one they are creating. The company has forecast that its revenues will grow by 49% this year, and almost inevitably the actual results will exceed that target. I have personally used Smartsheets-and I have found it worth the money in terms of collaboration and project management. The individual plan is $14/month, billed annually and the more typical enterprise plan costs $300/user/year. There are many other tiers of offering.

I haven’t chosen to own these shares partially because I already have significant positions in Alteryx and in Anaplan. Trying to differentiate amongst companies whose products are in the same broadly defined space, and which are enjoying hyper-growth is a tricky undertaking. This company, along with Anaplan and Alteryx, continues to expand its offering and in particular this company is pivoting strongly to solutions that are more complex and more differentiated. I will detail some of the statistics below, but the results of this most recent quarter were exceptionally promising when it comes to evaluating the uptake of the company’s newer, more complex offerings.

Needless to say, part of any investment conclusion rests on addressing that subject. At one level, just about everyone who is an investor has most probably built a model using Excel. At this point, Excel has been around for 3 decades and I imagine it is taught in middle school. That is not the secret sauce of Smartsheets. Excel does have a modest collaboration capability. The core of Smartsheets is collaboration. But there are certainly other solutions, starting with Google sheets that have a reasonable solution for many users in that regard.

It can be difficult to describe Smartsheet’s secret sauce in words. But what it does is to make it much easier for teams to create work processes. It is easy for most users to learn and very easy to share work and to set up what are called “accountabilities” within work teams. (I did not make up that word-it apparently is used by marketeers and seems to have acceptance.) The accountability feature is one of those capabilities that sounds mundane, but in practice is extraordinarily useful for any team manager. I can’t validate all of the productivity claims that Smartsheet makes for its app. Obviously, with 80,000 organizations with more than 5 million users having bought the tool, the claims do resonate and are credible. I know from personal experience that the collaboration feature of this company, while similar to other offerings, is about the easiest to learn and use-or else I couldn’t use it.

The company is currently involved in a pivot to add additional solutions to its basic platform as part of a strategy to grow the average size of its user. Part of that strategy has involved a massive program tohire development personnel and that is painfully visible in the financials. But the company’s strategy is about raising its competitive moat, and there is some evidence that it is being successful with a wide variety of products that surround the core platform.

I think the company understands the challenge of creating a real IP moat and it is moving far beyond spread sheets and collaboration in an effort to fill in gaps. At this point, I think the project has achieved a fair amount of success.

I am often struck by the number of articles to be seen on the SA site that relate to what is considered to be the over-valuation of a particular company. Smartsheets has been no exception in that regard. For the most part, I think that in looking at higher-growth businesses, and rating them on historical data simply ignores the obvious point that their valuation is discounting a far different future than history can foretell.

In the case of Smartsheets particularly, the company’s strategy is based on pivoting its go to market efforts to larger users who will acquire more seats and additional ancillary products. The statistics of the recently reported quarter depict some of that strategy in terms of the relevant metrics. I have detailed some of the more salient proof points of the strategy below. In the most recent quarter, the company spent 62% of its revenues on sales and marketing; that was up by 59% on a GAAP basis from the prior year, and up by 21% sequentially.

Does that kind of investment make sense? It does, if the company can start to raise its profile amongst larger, enterprise users who can reach an ACV of $1 million. Of course that hasn't happened yet. If it had, the complainers on this site would have something else to critique. But the point is-commenting about what hasn't happened yet for a company with a plan to change some of its spots really doesn't make much sense.

Basically, the goal of this company is to reach out to users who will choose to deploy thousands of seats. It is a strategy that clearly has some risk and one dependent on the continued growth of teams and collaboration as a paradigm for modern work methodologies. Certainly the size of the opportunity would suggest that this company is taking the appropriate chances with the appropriate product and go to market strategies. Readers may suggest that they want more substantiation before buying shares. But the fact is that once there is more substantiation, the shares will support an even higher valuation.

Many observers are going to say they want to buy shares in this name-but at a lower price. Perhaps the lower price will happen-these are volatile shares, and volatile times. My strategy would be to scale into a position like this over several months. But I do think Smartsheets is a company whose shares are worth owning, particularly for investors who do not already have positions in Alteryx and Anaplan.

Most of the users of Smartsheets have chosen to acquire the technology because they are looking for an upgrade to Excel that offers functionality beyond number crunching. These days, teams have become a standard of work in most enterprises. That is essentially why Slack (WORK) has been able to grow so rapidly. It is typical for many work groups to look to acquire a spread sheet application that is focused on some form of project management. Management talks about a TAM of close to 1 billion individuals-essentially because that number is similar to the overall user base for Excel. Smartsheets is not really a replacement for Excel but an adjunct. While I think looking at an addressable market of 1 billion users is a bit absurd, the market is more than large enough to support high percentage growth for Smartsheets for the foreseeable future.

I don’t propose to try to evaluate Smartsheets vis-à-vis Excel. There are plenty of reviews that one can access on the web. For those specifically interested, I have linked to a couple here andhere. Users find that Smartsheets is a tool with substantial advantages in terms of project management and collaboration. Excel is a tool for number crunching and financial analysis. Microsoft has a product called Planner which is essentially project management light. Anyone who is serious about adopting a project management paradigm, will not wind up using Microsoft Planner because it is not designed as a management tool for managing complex projects that have multiple team members.

On the other hand, Microsoft does have an offering called Project Professional which is designed…well for the most sophisticated of project management use cases. The Smartsheet solution is one that can be used by civilians as opposed to project management professionals, but which provides those civilians the sophistication they actually need to accomplish the kinds of tasks that are common in the workplace these days.

It appears that most of the people in enterprises that use Excel will, over time, need to have some kind of project management software as well as number crunching software. I have linked here to a discussion of Excel’s longevity and the opportunity that exists to displace that product. At this point, Smartsheet has 5.1 million paid users, up about 300k sequentially. No one today really knows precisely what the market will be for project management software seats, but it seems clear enough that as more people in enterprises work in teams and work on projects, the ubiquity of the market for Smartsheets will continue to expand. As a Smartsheet user, I find its capabilities, beyond those offered by Excel, to be well worth the cost-particularly in trying to work with remotely located individuals.

Smartsheets, however, does have a very focused strategy to grow revenues per named user, and that involves additional products as much as seats. The company has had a dollar based net retention rate the last two quarters of 134%, but perhaps more significant is that the ACV per domain based customer grew by 48% year over year. Currently the ACV per users is still very small and the opportunity to build on that base is enormous.

At this point, it appears that the different Accelerators, which are pre-built solutions that are tailored for a variety of use cases, is enjoying the greatest level of success of all of the company’s non-core offerings. The company started last quarter with 5 Accelerators and has launched 3 additional offerings in the last several months including a rather unique offering for GDPR which was co-developed with a consulting partner. It was said on the most recent call by the CFO that the growth of Accelerators has actually tempered the growth of professional services, although the numbers are still small. Subscription revenue growth last quarter was 57%, while services revenue showed just a 38% year over year increase.

Management believes that the accelerators are a key to unlocking the potential in larger enterprises, and that seems to be a logical concomitant of the offering. In other words, the company can lead with the Accelerator solution, and thereby can introduce the core technology to a potential user. So, I wouldn’t necessarily just focus on the rate of revenue increase for non-core products-because non-core products are part of a consistent sales strategy to target larger users.

The company is seeing the kind of increase in the size of its users that is part of its strategy. The customer cohort with more than $100k of ACV grew by 139% in terms of users to 189 last quarter and yet that cohort is still just 19% of ACV. The company does not report how much of this kind of growth is driven by seat expansion vs. the growth of the company’s newer capabilities. Overall, the non-core offering reached 9% of revenue last quarter, up from 8% in the prior quarter, a growth rate of about 21% sequentially and close to 90% year on year.

On a GAAP basis, Smartsheets research and development expense grew 58% last quarter and by an astounding 26% on a sequential basis. Research and development is now 36% of revenues on a GAAP basis. Part of the increase has been driven by stock based comp recorded for the research and development category which grew by more than 3X-but stock based comp is a real expense element and can’t be ignored. I think the takeaway here, is that Smartsheets is trying to build a product suite, particularly including pre-built solutions such as its Accelerators and other workflow and automation tools, and it is dramatically accelerating the funding for those projects. Overall, I expect that the acceleration in research and development spend particularly, is likely to lead to the company showing significantly higher percentage growth than the 37% growth forecast by the First Call consensus for the company's fiscal 2021 year (ends 1/31/21).

Most recently, the company acquired a company called 10,000 ft. It is a team based management tool that is a bit more complex than a spread sheet but simpler to use than some of the other offerings in the market. It has some noteworthy users including Ogilvy, Mercedes and PWC. It is a small acquisition and will not have a material impact on revenue growth this year. In the wake of the company’s recent secondary, Smartsheets has substantial cash balances in the wake of its recent offering-around $600 million and I expect that some of that will be used to acquire additional tuck-ins such as 10,000 ft. Overall, I anticipate that these kinds of tuck-in acquisitions will boost growth in coming quarters by a few hundred basis points and will further accelerate the company’s growth of its non-core offerings.

Smartsheets has consistently exceeded its targets for both revenue and the size of its loss since it has been a public company. This last time around, despite huge increases in two major opex categories, the loss per share on a non-GAAP basis was $.12 compared to a projection of $.18. The company wound up increasing its revenue growth estimate, but also increasing its estimate of the quarterly loss. And in fact, so far as it goes, the published First Call consensus calls for little earnings leverage and declining growth.

Needless to say, no rational observer believes that anything like that scenario is going to play out. I cannot imagine any company which plans to ramp opex to the extent portrayed in the latest earnings release and conference call expecting to see any growth deceleration. And indeed, looking at the speed with which the company is introducing products and adding to its sales force suggest that expectations of growth to remain at or near 50% seem reasonable.

I have forecast a 3 year CAGR of 40% for Smartsheets but I am inclined to believe there is likely upside to that forecast. At a 3 year CAGR of 46-47%, the shares would be valued as average for that growth cohort. The company, on its last call, made no mention as to when it might achieve leverage at scale. About the most that was said in that regard was that general and administrative expense had dropped as a bit as a percentage, but it still grew by 60% year on year on a GAAP basis. Investors that are looking for some kind of immediately visible leverage at scale, should look at another investment. This company has a growth at all costs strategy-it is one that is more likely to work in the context of the current demand drivers in the IT space.

At the moment, I would be inclined to give this company a pass on expenses. It is engaged in a furious pursuit of new enterprise users, and investors can evaluate whether they want to pay the price for the execution of that strategy. Part of the price involves extremely rapid growth in opex, and no near-term path to profitability.

Needless to say, Smartsheets is a long way from reaching cash flow breakeven, and that is true despite the rapid growth in stock-based comp expense. Overall, the combination of the growth in stock based comp coupled with the growth in deferred revenues should take operating cashflow to breakeven during some quarters next year. Over time, this company should be able to achieve a strong level free cash flow margin.

Over the last year, the deferred revenue balance has grown 79%, and last quarter the growth in deferred revenues rose by 35% year on year despite the seasonal effects of a Q1. At this point, duration is not a factor with almost all of the company’s customers acquiring their licenses for 12 months. I imagine that over time, longer-term deferred revenues will start to grow as large enterprises will push the company to offer ELA’s that will reflect longer-term plans.

The company’s license gross margin has already reached 88%. I doubt that there is much in the way of upside beyond that level. Overall, I would expect Smartsheets to have a business model comparable to that of most other enterprise software vendors. It will continue to grow its opex investments at a prodigious rate so long as it continues to achieve growing success in its selling motion.

Should readers own these shares? As mentioned at the start, I do not, and have no immediate plans to build a position but that relates to my investments in Alteryx and Anaplan. I do not love recommending new names that have just made a new high. And yet…I see the opportunities for this business very clearly, and depending on the precise growth rate it will achieve, the shares are not huge outliers in terms of their valuation. Teams and collaboration and workflows sound like hype-but that is really how people are tending to work these days. The performance of Slack suggests just how much demand there is for software that helps workgroups to collaborate and to automate communications and workflows. That is basically what Smartsheets does and it is likely to maintain hypergrowth status for some years into the future.

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.

Source: Seekingalpha.com

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