Investment Thesis

Though collaborative work management is a crowded space, Smartsheet (SMAR) is holding up because of its unique value proposition and solid financials.

Introduction

Smartsheet, the Bellevue, Washington-based software company, IPO’d on April 27, 2018, at $15 per share. Shares closed that day at $19.55.

Fast-forward eight months and though the Nasdaq briefly dipped into bear territory, Smartsheet’s shares sit at $24.86, 27% higher than the first trading day’s close.

The Sub-Industry

Smartsheet’s software allows knowledge workers, all 865 million according to the company’s prospectus, to work smarter, not harder. My words, surprisingly, not its marketing material (it was probably copyrighted to be fair).

Essentially, Smartsheet’s product can be likened to a low-code ServiceNow (NOW) option, a way to manage projects, maintain calendars, and keep a steady flow of information.

The company sums it up best as it explains how it solves the problem of dealing with “unstructured work”:

Unstructured or dynamic work is work that has historically been managed using a combination of email, spreadsheets, whiteboards, phone calls, and in-person meetings to communicate with team members and complete projects and processes. It is frequently changing, often ad-hoc, and highly reactive to new information. Rigid applications, such as ticketing, enterprise resource planning, or ERP, or customer relationship management, or CRM, systems are poorly suited to manage unstructured work.”

Also in the prospectus, Smartsheet highlights some huge total addressable market numbers. According to IDC, by 2021, the market for project management software will grow to $31 billion. While TAM may be debated, it is clear the market is big enough to fit a couple players. It is unlikely to be a winner-take-all dynamic.

Source: Analyst Day 2018

Naturally, big markets attract competition as everyone wants to take a little piece of the big pie. Just take a look at this chart that is similar to the Gartner Magic Quadrant assessment.

Source: Smartsheet Blog

That’s a lot of companies vying for the same customers. However, Smartsheet is not so much going after developers as it is going after business users as evidenced in this chart.

Source: Analyst Day

Though crowded, the company does have a unique value proposition.

Unique Value Prop

To give an analogy, Smartsheet’s business is more of a buffet than a served entrée. The company’s products offer nearly anything you would need to get “unstructured work” done. It boasts documentation of over 2,000 use cases, anything from administration to sales.

By offering so many capabilities, the company stands out above the typical way of doing work, toggling between Excel and email all day.

Source: Analyst Day

As the CEO remarked on the last conference call,

So, it’s an opt in to enable some of these capabilities. It’s an opt in to take advantage of some of these enterprise capabilities that we’re releasing. If you were to, in a way, pollute the user experience by adding value to everybody who comes into the business, I think that’s absolutely the wrong strategy and that’s not what we’re deploying.

This is an important point because it is the lifeblood of the company’s go-to-market motion. Let’s break it down.

Step 1: Start with a huge sales funnel through a free trial (4.5 million non-paying users).

Step 2: Get a percentage of those free users to pay (over 90,000 total customers).

Step 3: Upsell the paid users with further capabilities.

Step 4: Rinse and repeat.

Here’re some more granular results for how this strategy has worked.

Source: Q3 2019 Earnings Call Presentation

As you can see, the number of customers with an average contract value of greater than $50,000 has grown the fastest, with 148% year-over-year growth.

Of note is that the customer factions are broken in two: domain and ISP. Domain customers sign up with a unique email domain like @cisco, for example. ISP customers have generic emails like @gmail. In aggregate, though there are about 13,000 ISP customers, these only account for about 3% of sales because they are usually personal accounts or small teams trying out the software within a bigger organization.

The big things that stand out are the impressive dollar retention rate coupled with the big increase in customers surpassing the $50,000+ range. This suggests that a lot of customers are expanding into that range rather than huge initial deal sizes.

But I would like to dive into the financials a little bit more as the numbers rarely lie.

Solid Financials

Revenue growth has been rock-solid over the past couple years.

Source: Q3 2019 Earnings Call Presentation

So sales rocketed 59% to nearly $47 million in the latest quarter. At the same time, billings accelerated to a whopping 69%, up from 57% last year. All the while, subscription gross margins tipped the scales at 89%. Not a bad trifecta.

Moving down the income statement, in the latest quarter, the company’s non-GAAP net loss narrowed from -32% of revenues to -22%. Furthermore, while free cash flow numbers can sometimes be distorted based on collections and seasonality, free cash flow margins improved from -18% of sales to -4%. And this was achieved in the same quarter that the company’s annual conference, ENGAGE, was held.

The company also has a solid balance sheet, fresh off its IPO, of $212 million in cash with no debt. But it’s important to look at the negatives as well.

Risks and Valuation

Again, the company competes in a crowded space. Giants like ServiceNow and Atlassian (TEAM) have a huge presence. Not to mention a bunch of smaller yet wildly popular players like Asana and BaseCamp.

As the market grows so will Smartsheet’s opportunity, but fierce competition has a way of dwindling profits in the long run.

Another risk is paying too much for a fast-growing cloud-based software company. However, in the latest sell-off, Smartsheet’s valuation has become more tolerable.

Its trailing revenues come out to $159 million. Applying a slowdown in sales growth to 45% for next year, we can get $230 million in forward sales.

Jumping to the market cap, the latest number was $2.57 billion. Backing out the $212 million in cash, the enterprise value is $2.35 billion.

So the forward EV/sales ratio comes out to about 10.7.

This, of course, isn’t wildly cheap, but for near 60% growth, it’s not too bad.

Here are some comparisons with software companies whose growth is similar (note, these are trailing multiples).

Chart

AYX EV to Revenues (TTM) data by YCharts

To End

Smartsheet is down 36% from its highs. The rocky 2018 finish for tech stocks left a lot of companies limping into the new year. Smartsheet could be a darkhorse in 2019 if the company continues posting huge growth and operating leverage.

I think readers would do well to keep this one at the top of their list.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in SMAR over 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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2019-01-02