Smartsheet (SMAR) Q4 2020 Earnings Results Review

On March 17, Smartsheet (SMAR) released earnings results for Q4 FY 2020. Overall, Q4 results exceeded expectations and this year’s projections are encouraging, considering the macro environment. The market responded favorably, pushing the stock price up by 2.9% the following day, in spite of a broad sell-off due to COVID-19 concerns. Analyst commentary was positive. Let’s take a deeper look at the results.

Headline Financial Results (EPS is Non-GAAP)

• Q4 Revenue was $78.5M vs. $77.7M expected, representing growth of 50.6% year/year. Beat of about $0.8M or 1%. Prior quarter revenue growth was 53%.
• Q4 EPS was ($0.13) vs. ($0.16) expected, representing a beat of $0.03.
• Q4 operating margin was -22%, compared to -16% in Q4 2019.
• Q4 free cash flow margin was -4.6%, compared to 2.0% in Q4 2019.
• FY 2020 Revenue was $270.9M, representing annual growth of 52%. FY 2019 Revenue growth was 60%.
• FY 2020 EPS was ($0.49), compared to ($0.36) in FY 2019.
• FY 2020 operating margin was -23%, compared to -22% in FY 2019.
• FY 2020 free cash flow margin was -9.9%, compared to -8.4% in FY 2019.

• Q1 FY 2021 Revenue guidance of $82-83M vs. $81.8M consensus, representing about a 1% raise and 47% annual growth at the midpoint.
• Q1 FY 2021 EPS guidance of ($0.21)-($0.19) vs ($0.15) consensus. Reduction of $0.05 at the midpoint.
• Expected Q1 operating margin between -29% and -32%. Magnitude is due to seasonal Q1 spend for bonuses, hiring and certain renewals.
• Expected Q1 FCF margin is -37% to -33%.
• FY 2021 Revenue guidance of $373-378M vs. $375.6M consensus, representing annual growth of 39% at the midpoint. Note that original FY 2020 revenue guidance called for 43% annual growth and actual growth was 52%. This would imply expected growth for FY 2021 in the mid to high 40’s, factoring in some conservatism. However, COVID-19 does present risk to upside.
• FY 2021 EPS guidance of ($0.62)-($0.55) vs. ($0.53) consensus. Reduction of $0.05 at the midpoint.
• FY 2021 operating margin is expected between -18% to -20%.
• FY 2021 FCF margin is expected between 0% to -3%.

Other Notes

• DBNER ticked up to 135% in Q4, versus 134% in Q3 and 134% a year ago. This was aided by a reduction in churn, which is now below 8%.
• Average Contract Value (ACV) per domain-based customer increased to $3,643, representing growth of 48% year over year.

• Q4 Calculated billings increased 58% year/year, representing a nice bump over Q3 annual growth of 52%.

• Non-GAAP gross margin for Q4 2020 was 82%, which has been inline for the past 4 quarters. Subscription gross margin was 88% and has similarly been pegged there. Gross margin approaching 90% on the subscription service is best of breed for a SaaS company. The difference to overall gross margin is explained by the low (20-30%) gross margin on services revenue, which is less than 10% of overall revenue.
• Ended the quarter with approximately 84,000 domain-based customers, versus 78,959 in 2019, or 6.4% annual growth. This seems a little low, but could also increase as Smartsheet has invested in brand/product marketing starting in 2H2019.
• The number of customers with annualized contract values (“ACV”) of $5,000 or more grew to 9,079, an increase of 47% year over year.
• The number of customers with ACV of $50,000 or more grew to 961, an increase of 116% year over year.
• The number of customers with ACV of $100,000 or more grew to 350, an increase of 138% year over year, which represented a new high.

• Q4 ending cash and short-term investment balance was $566M.
• On the analyst call, the CEO talked about speaking recently at a private forum with CIOs from 50 of the world’s largest companies, where they discussed important trends in IT. Smartsheet was invited to help share perspective on why no-code development and workflow automation are important to their workforces.
• Leadership confirmed that Smartsheet is still seeing few competitive deals as they add new customers.
• Highlighted growth in the new Accelerators (also referred to as Capabilities) offerings. These are point-based solutions focused on a particular customer use case. The biggest growth areas are content collaboration, marketing workflows and resource management (10,000 ft acquisition). Also, the new conversations and commenting feature launched late last year is very popular. Q4 was the best quarter to date for Accelerator sales, which now make up 15% of billings, versus 11% in Q3.
• Head of Product mentioned that they are considering new packaging and pricing models, which would bundle the majority of the Accelerators into a platform-based licensing structure. This would enable organizations to leverage the entire suite, and result in incremental revenue for Smartsheet.

Analyst Reactions

Analysts were generally positive in their reaction to earnings. Most re-iterated their buy rating, but lowered price targets, due to the macro environment and uncertainty of the COVID-19 situation.

In addition to the ratings captured above, there were two others:

• Oppenheimer: Maintained outperform rating. Cut price target from $53 to $48.
• Wedbush: Maintained neutral rating. Cut price target from $42 to $40.

So, in all, we have 6 buy ratings and 2 neutral ratings following the earnings report. Neutral ratings were both in place before earnings and reflect concerns over valuation of SaaS stocks in general.

Of the analyst commentary, I think that BMO Capital Markets summarized the analyst position well.

BMO Capital Markets lowers their SMAR tgt to $48 from $57. Firm notes that while SMAR did not blow out the quarter, they think the results/guidance were enough to restore the confidence in the durability of the business model. They believe that the combination of productivity improvements, including across different locations (e.g. work from home), relatively low purchase price, selling motion that is largely driven by tele-sales, and tremendous up-sale capabilities to the existing installed base, make SMAR a compelling investment. They are not making meaningful changes to estimates, but lower target price given higher risk profile for all stocks.

Briefing.com, March 18, 2020

COVID-19 Response

Like many software companies, Smartsheet is gaining visibility by offering solutions customized for response to the COVID-19 situation. There were a few items on the call worth highlighting:

• After creating a Coronvirus preparedness dashboard internally for Smartsheet employees, the company is sharing these as re-usable templates for all their customers. These provide a communications hub and resource center for employees, along with targeted forms and reports that help assess risks within an organization.
• Made their Smartsheet Gov environment available for any U.S. government agency responding to the COVID-19 pandemic. Smartsheet Gov is a secure, enterprise-grade platform made specifically for government agencies, built on AWS GovCloud and is FedRAMP authorized. Government agencies can use Smartsheet to plan, coordinate, track, and communicate their COVID-19 response free of charge.  This should provide a mechanism to introduce government agencies to Smartsheet tools, and leadership mentioned seeing some uptake already.
• Highlighted a rapid customer roll-out for a global healthcare provider to help them significantly expand their global testing capacity for COVID-19. Within 48 hours of receiving the request, Smartsheet was able to help them fully customize a Smartsheet solution they had developed internally. This solution enables the company to share the volume of tests conducted and current supply levels of their testing systems with federal agency partners.
• CEO and CFO emphasized on the earnings call that to-date, they haven’t seen a material impact on their sales pipeline due to COVID-19. Also, confirmed that hospitality, airlines and retail industries represent 3.8% of their total ARR.
• Similarly, they are continuing to hire new employees, including sales reps, as they allocate capital for the growth opportunity.

My Take-aways

• Revenue growth is has been slowly decelerating. Some of this is expected as their overall base is growing. FY 2021 revenue guidance calls for 39% annualized growth, below the 52% achieved for FY 2020. However, they over-achieved in FY 2020 by about 9%, so FY 2021 growth would normally be in the high 40’s. Also, we can expect some conservatism in the annual guide from the COVID-19 situation. While management didn’t see impact in the current quarter, they are less clear about the rest of the year.
• Billings growth is encouraging. At 58% for Q4, billings growth was higher than revenue growth. This is a positive sign. Also, subscription contracts are shifting more to annual, versus short term. In Q4, 92% of subscription billings were for annual contracts.
• New customer growth rates seem a little low. Smartsheet started investing in brand awareness marketing starting in the second half of calendar 2019. We should see further improvement here.
• Smartsheet’s high DBNER (consistently above 130%) and low churn rates reflect very strong expansion within existing customers. The CEO commented about his meeting with CIO’s of the 50 large companies that probably 90% of them were already Smartsheet customers in some capacity. Anecdotally, a small team in an enterprise usually starts using Smartsheet for one use case, and then more teams and uses continue to be added through socialization.
• Similarly, the growth in ACV is strong and indicative of major expansion motion. The 138% annual growth in customers spending >$100k is amazing and further underscores the growth opportunity within large enterprises.
• I like that the target FCF margin for this year (FY 2021) is 0% on the high end of the range. This indicates continued efficiency in the operating model, as they continue to grow.
• Operating margin will improve by 400 basis points in FY 2021, increasing from -23% in FY 2020 to -19% at the midpoint for FY 2021. The company is still investing for growth, but demonstrating a trajectory towards profitability.

• Spending by category has been fairly consistent over the past 12 months. Particularly, we are not seeing a large surge in Sales and Marketing spend required to maintain high growth rates. S&M spending spiked up in Q3 due to Smartsheet’s annual customer conference, but dropped back down in Q4. The year/year increase is due to the new marketing campaign for broader brand awareness, which should help with new customer acquisition. Existing customers seem to happily expand their spend without much prodding, as reflected in DBNER and ACV growth rates. The CFO also confirmed that for FY 2021, they will be spending about the same on Sales and Marketing year/year, so as a percentage of revenue, S&M spend should come down.
• The growth in Accelerators is reassuring, as this represents a way to differentiate Smartsheet from generalized project management products offered by competitors.
• On a Rule of 40 basis for Q4, Smartsheet passes. 51% revenue growth – 5% FCF margin = 46. For FY 2021, revenue needs to be in the mid 40’s to maintain this level, assuming they hit the FCF margin target of -3% to 0%.

Items to Watch

• DBNER and ACV growth are important drivers of revenue expansion. These should not decelerate significantly in FY 2021, or overall revenue growth will be harder to maintain.
• Similarly, new customer domain growth is under 10% year/year. This may be reflective of saturation in the Fortune 500, implying that international expansion is the next big opportunity for Smartsheet. The brand awareness program started in late 2019 should also help with new customer acquisition.
• Competition doesn’t seem to be a factor currently, according to management. This may be because Smartsheet is evolving away from broad project management into vertical solutions (Accelerators). I think there is plenty of playing field in this market opportunity, so competition may not be an issue for a while. Also, at about a $400M revenue target for FY 2021, Smartsheet is still relatively small. With all that said, competitive offerings should be monitored, particularly for the emergence of point-based use cases.
• Profitability needs to continue to improve. I like the progress projected for FY 2021, but if they reverse course and maintain the same negative year/year operating and FCF margins, then this would be a red flag.

Investment Plan

I am maintaining my long term investment thesis. I am still recommending SMAR for investment with a 2024 price target of $140, representing about a 3.5x increase over today’s share price.

This is supported by Smartsheet’s significant expansion motion in its large customer base. Customers clearly value the product. Smartsheet is continuing to extend their offering, particularly with the new focus on vertical solutions (Accelerators). The leadership team is strong and execution is consistent each quarter. With enterprises looking for more ways to drive efficiency and collaboration in their distributed workforces, Smartsheet’s solutions will continue to drive value.

On the earnings call, the CFO confirmed she is maintaining their 3-5 year financial plan to hit $1B in revenue with 20% operating and FCF margins. SMAR currently has an EV of $4.4B and an EV/Revenue ratio of 16. With those profitability targets, $1B+ revenue in calendar 2024 and assuming revenue growth dropping to the low 30% range, I would expect an EV of $14 – 16B.