Smartsheet Stock: It’s Smart To Buy Now (NYSE:SMAR)

Evaluating Its Guidance – Is It Really Forecasting Taking A Step Back In Terms Of Profitability

It’s been years since I have written an article for Seeking Alpha on Smartsheet Inc. (NYSE:SMAR). Just for the record, the shares are actually up since I last recommended them, although the percentage appreciation of 27% after 2+ years is hardly anything of which to boast. I did take a position in the shares and that time – it hasn’t been the most profitable of commitments, although it hasn’t imploded either. So, what’s new and different that has led me to write about the Smartsheet at this point.

Basically, the company just reported an exceptionally strong quarter. Its guidance, based on its historic track record for such things, suggests great business visibility, beyond the specific numbers. In the meantime, the shares have compressed about 35% from their all-time high set last September. While 35% share price depreciation is really not more than about average for high-growth IT names over the last several months, the combination of stronger than expected growth for many quarters coupled with share price compression has created what I believe to be a compelling investment narrative.

While at one point, Smartsheet had been a high-valued software name, its valuation has come down to earth, while its growth prospects have brightened. My current estimate, in the wake of the recent results, and the conference call has an EV/S estimate of about 8.5X. That is now somewhat less than average for a growth cohort in the high 30% range The valuation of SMAR in terms of its net present value is tied significantly to how much credence to put into the company’s latest free cash flow estimate. It would take quite a bit for the company to burn cash even at the rather modest rate being forecast. I have forecast a positive free cash flow metric this year, rising steadily thereafter. That yields a net present value more than 50% greater than the current share price. Overall, I believe that Smartsheet has, become a strong competitor in a hot space with expectations that are anything but stretched.

At this point, I think investors are well aware that there are no tech companies that can escape risk-on/risk-off sentiment for much more than a few hours if that. After retreating and advancing since its earnings were released, SMAR shares succumbed to risk-off sentiment, and perhaps as well, analog trading with Asana (ASAN) shares on 3/25. It closed with a loss of 5.3% on the day although a gain of almost 4%% on the week. Since then, the shares have continued to back and fill.

This is not the place to discuss the correlation between inflation, interest rates and the valuation of high growth IT names. Sometimes investors act as though that correlation has been baked into valuations, and on other days, sentiment reverses. As mentioned, I think SMAR presents a compelling investment story based on its strong competitive position in a particularly hot space.

The space is going to grow rapidly for years, I believe. SMAR is making suitable investments such that it will wind up with one of the leading market shares in a space which is supposed to grow to more than $50 billion. But the shares are not going to be valued for that opportunity until current investors focus on interest rates and inflation relaxes for an extended period. It has, perhaps, become customary at this point to suggest, that as compared to prior periods, handicapping how SMAR’s growth will progress is difficult.

I don’t profess to know if demand for Smartsheet’s offerings, or any software offerings other than cyber-security solutions, might be impacted by the Russian aggression and devastation of Ukraine and the attendant geopolitical/economic dislocations. There is probably more uncertainty with regards to how the various steps that have been taken to wall off Russia from the western economy might ultimately impact software demand than at any time since the start of the pandemic and its impact on the economy two years ago.

While Smartsheet is in no way an analog of UiPath (PATH) other than they both sell software, everyone who follows the software space is probably aware of PATH’s rather disastrous guidance. As it happens, a significant focus of the accelerated opex investment being planned by Smartsheet is focused on what the company describes as increasing global awareness, or really hiring more sales capacity in the major international regions. So, I suppose from the perspective of Smartsheet management, the geopolitical environment doesn’t seem likely to constrain their growth rate noticeably.

During its most recent conference call, the company provided guidance for opex that concerned some investors and analysts and at least one author on SA. But this is a movie I have seen many times, and it most often has a decent ending. In the short term, after the shares wavered in after-hours trading, they took part in the overall market rally, and are up about 27% since the middle of the month.

Looked at since the start of March, SMAR’s 6% share price appreciation is just about average for a software stock, while the share price decline so far this year of almost 29% is a bit steeper than average. For example, the WCLD ETF is unchanged so far in March while it is down by 21% so far this year. I will discuss relative valuation as opposed to relative price action later in this article.

There are, currently, three significant public companies in this space; Asana, monday.com (MNDY) and Smartsheet. All of them reported strong results for their last quarter. All of them forecast strong revenue growth in 2022. And all of them indicated that their opex would increase at a greater rate than their “guided” revenue forecast in order to capture some of the increasing opportunities that all saw in the space.

In addition to these 3 companies, some analysts might include Atlassian (TEAM) – particularly its Jira Workflow, Trello and Confluence offerings on the list of alternatives. Atlassian also reported a strong quarter and raised its revenue growth estimate. It, too, also has made a decision to ramp the growth in its operating expenses in order to exploit the market opportunity.

There will be, no doubt, some who might find this universal increase in both sales and research and development expense by all of the companies in the space to be off-putting, or perhaps an indication of the costs of maintaining a position in the business. My own view is that what is being seen reflects the economics of the space and its opportunities. The fact is that the growth rate of the space has continued to improve for a variety of reasons.

The unit economics for all of these companies, and particularly Smartsheet are strong. Subscription gross margins for Smartsheet climbed by 200 basis points last year, and have now reached almost 86%. The DBE ratio climbed markedly last year and reached 134%. That is an increase of 1100 basis points since the start of the year, and 300 basis points, just since last quarter. If gross margins are rising, and the DBE ratio is rising as well, the economics of increasing opex is exceptionally compelling – for Smartsheet and its competitors although it has not been particularly popular with investors.

Workflow management, as exemplified by these three companies, is essentially a new space. One market research review, linked above, has pegged the current market for workflow management software at around $9 billion in yearly revenues and forecasts that it will achieve a CAGR of 31% for the next 6 years, reaching a market opportunity of more than $55 billion in 2028. That is one of the highest growth rates and largest market sizes that is projected by 3rd party research.

With that kind of expected growth, it is little wonder that the three companies as well as Atlassian are willing to forego current profits in the interest of securing the maximum number of new customers who then seemingly expand their usage of the tool ad infinitum. Any other business strategy that doesn’t look to grow opex at elevated rates would not be optimal for shareholders, difficult as that can seem in a market that is looking for the most instant gratification possible.

Smartsheet’s record on guidance suggests more than typical conservatism, or perhaps murky visibility when it comes to the dimensions of the opportunity in the space. All of its quarters over the past year have been significant upsides compared to prior guidance. The company started off 2021 with a revenue forecast of $500-$505 million and wound up the year with revenues of $551 million. Its beat in terms of billings was even more significant; its initial forecast for billings had been $580-$585 million and it wound up the year with billings of $663 million – a beat of about 14%.

I do not particularly like to use billings as a proxy for sales activity, but given the specific mix of contracts that Smartsheet has maintained for several years, billings growth is a good indicator of the strength of the go-to-market motion. With that kind of track record, coupled with the growth in the company’s deferred revenue balance, as well as the strength of the market in which the company operates, my expectation is that Smartsheet is likely to achieve a noticeable beat compared to the revenue growth forecast of 37%, or $755 million.

The company has forecast that its DBE ratio, which just reached 134% will remain above 130% in the current year. Just mathematically, given the current rate of new customer acquisition, it would be difficult for the company to grow less than 40% in terms of revenue with a DBE ratio in the low 130% range as forecast. In fact, in Q4, the company closed a quarterly record of 286 deals of great than $50k in value, up 107% year on year, and it closed 98 deals in excess of $100k, an increase of 127% year on year.

As mentioned, unit economics for this company are strong and improving. The company forecast that its operating expenses for the year would increase by more than $220 million, or about 45% from the levels of 2021. In 2021, non-GAAP opex rose by around $145 million and that was a snap-back year after the constrained expenses during the height of the pandemic. I am not sure if this company will actually be able to prudently hire such that its opex rises by the forecast amount. But I am even more convicted that this company, and indeed no reasonable company, is going to spend $220 million additional on opex, in order to achieve a revenue increase of $200 million. I have a very hard time envisioning a board accepting that kind of relationship between revenue growth and opex increase short of being told that the extra investment would result in some dramatic revenue growth acceleration in 2023.

I think that based on the historical record, just how difficult it can be to hire high-caliber professionals at this point, and the momentum in the space, a more likely financial performance scenario for Smartsheet would be for revenue growth in the 40% range, or about 3% above guidance, with opex growth in the high 30% range. This would yield a non-GAAP operating margin of -3%, and free cash flow margin for the year in the mid-single-digit range.

What Is Workflow Management; Why Is Its Growth So Strong

Sometimes there are categories in the IT world that can surprise investors. A couple of years ago, workflow management was really not a category. Atlassian had developed some collaboration applications but these basically were designed as communications channels, mainly used by software engineers as part of improving communications within project workgroups, more than the establishment of a true workflow management system. Smartsheet itself started providing a collaboration tool for spreadsheets – that is what I used it for.

Workflow management is often confused with project management. Project management tools are far less evolved and look like refined spreadsheets. Project management tools are designed to do just that, but they are not intended, nor do they serve to optimize workflows.

These days workflow management software is a set of software tools that channels the flow of a project’s work. It looks at dependencies, i.e. what has to happen along the way for a project to reach fruition. The tools are supposed to add a layer of structure and visibility. They help ensure that what is delivered, is what had been specified and that the quality of a project is maintained. Users are able to schedule tasks, collaborate with other team members, manage workloads, create and share documentation and evaluate progress.

I think anyone who has worked in a large organization and has done work that involved teams and projects has seen the results of trying to do this using excel spreadsheets and Gantt charts. Manual processes are inherently cumbersome and do not provide real-time visibility, which in turn means there can be no real-time remediation. Workforces are becoming more and more distributed, and that is so regardless of returns to on-site working. That in turn means that it can be difficult to keep everyone on the same page. Many knowledge workers have to multi-task.

Organizations have strong incentives to optimize workflows. Optimizing workflows is one of the better ways of improving productivity of knowledge workers. Automating manual processes alone saves a great deal of time. But knowing who is responsible for what, and what the schedule is for individuals to complete tasks, helps to fix individual responsibility and makes it much easier for workgroup members to know where to go for required task inputs. If organizations can’t optimize workflows and keep workgroups on the same page, they risk employee disenchantment, that in turn can lead to both missed schedules and employee turnover.

One reason I think that the workflow management space has been on fire lately has to do with the “great resignation.” Turnover is a fact of life these days, and nowhere more so than individuals that can be classified as knowledge workers of various kinds. Workflow management helps team leaders understand what turnover can mean to a project schedule, and can help team leaders in reassigning tasks. And to a certain extent, workflow management tools, at least according to colleagues who have used them, create a better work experience and seem to reduce the frustrations that can be part of working in teams or workgroups.

Finally, from what I can tell, it has become more or less de rigueur for enterprises to have adopted management paradigms based on the use of workflow management software. I don’t think I am hyping or overstating the case to suggest that enterprises have become collectively convinced that they must embrace workflow management software to remain relevant as progressive businesses. When it comes to the adoption of enterprise software, style and trendiness are at least as important as any other justification there might be to acquire solutions. Workflow management is now in the sweet spot in terms of its broad acceptance by many organizations.

Smartsheet’s Competitive Position

As mentioned earlier, the market for workflow management solutions is populated by more than a few competitors. I am not trying to suggest that Smartsheet is the best workflow management solution although it gets high marks from 3rd party analysts. The basic reason why Smartsheet wins is that its tool is a natural evolution for companies who have been heavily reliant on both Excel and Google (GOOG) sheets which are still the leading project management tools in use within many large enterprises. It is very easy for most users to migrate from Excel and Google Sheets to Smartsheet, and since it is a no-code solution, its time to benefit is very short and most knowledge workers are able to start using the service without any formal training.

Just for completeness, I have linked to one of the many 3rd party reviews of workflow management tools. One of the more interesting evaluations actually came from a blogger for monday.com to which I have linked as well. monday.com is a major competitor of Smartsheet, so I think it is of some significance that it has provided such a positive review of the Smartsheet solution. It is not unusual for companies to have multiple workflow management solutions and because of the spreadsheet orientation of Smartsheet, it can readily be used to advantage by enterprises that have chosen either Asana or monday.com.

Smartsheet probably does not have every specific feature that’s available from either Asana or from monday.com, and in a specific sales situation, these features can be important. At this point, Smartsheet ranks #1 in the market in terms of the number of total users, and is probably a bit larger as well in terms of the current revenue run rate. The last reported user count for Smartsheet was 10 million and a study by Okta (OKTA) found that Smartsheet is the most popular work management platform used by enterprises in conjunction with Microsoft (MSFT) 365.

I imagine that monday.com will wind up winning the percentage growth stakes sweepstakes, but not by all that much. There is plenty of business opportunity for all of these 3 companies as well as Atlassian to grow substantially. Despite the numerous competitors in the space, and competition amongst the leading brands, there is no evidence I have seen or read about in terms of severe price discounting.

The Smartsheet offering has evolved considerably since I first used it some time ago. I suspect many readers, if they have used Smartsheet, are familiar with its Excel-like format that does away with complicated formulas. Using Smartsheet is a no-code solution, and that means that even those of us like this writer who can be technologically challenged, can use the tool without a steep learning curve. Given just how many Excel users there are, Smartsheet operates in a target-rich environment which has been much of the reason for the company’s success.

The company does offer what is described as workflow automation and visualization based on GANTT charts, calendars and cards. It offers a feature called Critical Path which, as the name implies, is designed to highlight the tasks which impact the completion of a product. Because the tool was built as an improvement of Excel, summary reports can readily be delivered in that format to all parts of an organization. It does not have all of the tools that one can acquire when using either Asana or monday.com. It does not have the equivalent of Asana’s Work Graph. Here is a side-by-side comparison between Asana and Smartsheet.

Smartsheet has various pricing tiers. Smartsheet Advance has all of the features available from Smartsheet, and it is available at Silver, Gold and Platinum levels. Advance was introduced as an offering in Q2 of FY-2022. The company introduced its Pro Plan last fall, and that apparently has been a factor in the company’s above plan growth. As mentioned, since the Pro Plan offering was introduced, new business volume has been at record levels measured in a variety of ways. Overall, I think most users probably wind up paying a bit more for SMAR than they might pay for monday.com or Asana, as many users are attracted to the Excel-like layout of the tool.

I imagine that most readers are well aware that security has become even more of an issue that is an important consideration In choosing a particular solution. It is difficult, of course, to determine whose security features are better or more effective. Smartsheet offers a number of standard security features such as encryption keys, data loss prevention, granular sharing and egress controls.

The acceptance of Advance has exceeded initial expectations that Smartsheet had provided. It’s actually been a significant driver of deals to new Smartsheet customers. While there are many competitive drivers for Smartsheet, it has successfully moved up the value chain, and its average ACV per domain name has grown by 37% over the past year. That kind of growth is another factor that leads me to believe that current revenue guidance will prove to be quite conservative.

Depending on definitions, the most widely accepted estimates of market growth in the collaborative work management space, one of the many titles used to describe the Smartsheet offering, calls for multi-year growth in the low 30% range. Based on the comments I have read from 3rd party analysts and the recent track record the company has compiled, I expect SMAR to continue to grow faster than the overall market for the foreseeable future.

Smartsheet’s Business Model

Does Smartsheet have an existentially unprofitable business model? One author on SA basically made that assertion recently in the wake of the company’s most recent guidance. I have been doing this a long time – I suppose there are those who might suggest I have been doing this for too long. Before I did this, I worked in the corporate world at various IT firms. Managers at IT firms don’t have some view that their companies are playthings or that they are not required to make plans and budgets that achieve a certain level of ROI.

I have mentioned it earlier, but it bears repeating: any IT company that has gross margins of 86%, a 134% DBE rate, some evidence of market share gains, and a huge available market would be foolish not to increase its opex. There are signs that some of the company’s product initiatives such as Advance are already positively impacting the company’s business model. And the strong growth in ACV per domain is another proof point that a measured increase in sales and marketing and research and development expense is only logical.

The CEO talked about an addressable market of 1 billion knowledge workers. Obviously, no one thinks that Smartsheet or the other companies addressing this opportunity are going to capture anything like that number of potential users in the foreseeable future. But the size of the addressable market compared to the current installed base of Smartsheet and its rivals strongly suggest why all of the market participants are attempting to spend enough to capture at least part of the opportunity.

Last quarter, the company’s research and development expense ratio was 23% non-GAAP. That compares to a non-GAAP research and development expense ratio of around the same level in the year-earlier quarter. The sequential increase in non-GAAP research and development spending was about 15% while the sequential increase in quarterly revenues was around 9%. I very much doubt that the company will be able to maintain this kind of ramp in research and development spending. That said, the company is enjoying accelerated growth in both revenues and billings, and part of that is obviously a function of new products which extend the company’s footprint and offer more attractive packaging and consumption options for users.

Last quarter the company’s non-GAAP sales and marketing expense ratio came to about 55% compared to 50% in Q4-FY 2021. The company has apparently been getting a significant return on the higher sales and marketing spend given just how strong the growth in calculating billings was. On a sequential basis, sales and marketing expense rose by 17% while calculated billings rose by 38%. There is some seasonality, no doubt, in both of those numbers, but it does suggest that the rising level of sales and marketing expense is leading to an even more impressive increase in calculated billings.

Overall, the rapid rise in billings was responsible for the 51% increase in the company’s deferred revenue balance year over year. Looked at another way, The company started last year with a deferred revenue balance that was 40% of the revenues that the company achieved last year. It is starting the current fiscal year with a deferred revenue balance equal to 44% of its revenue forecast. Its visibility, therefore, has improved noticeably and I believe that the current sales momentum, coupled with the elevated deferred revenue ratio will translate into sales that are higher than the company projected.

The company spent about 14% of its revenues non-GAAP on general and administrative expense last quarter, compared to a similar percentage in the prior fiscal year. The company has begun to open a significant number of new geographical regions and launched Smartsheet Regions in the EU to enable customer to establish plans with their content hosted in Germany. This investment will enable the company to better comply with European GDPR regulations. I certainly anticipate that the company will be able to achieve significant leverage on that investment, perhaps this year, but certainly in the next 2-3 years.

Smartsheet’s Valuation – Wrapping Up The Investment Thesis

In the wake of Smartsheet’s latest quarterly report, its valuation has become significantly more attractive. It is still not a bargain name, on a relative basis, but it no longer has the stratospheric valuation that it held for most of the time since it became a public company. Based on my estimates, SMAR shares have an EV/S of about 8.5X. That is about 15% below average for its growth cohort. I have projected that SMAR will be able to generate free cash flow this year, mainly because I anticipate that its current projection of 40% billings growth is likely to be noticeably exceeded. The company is projecting a free cash burn of about $10 million; I expect free cash generation of $35 million which would require billings to be about 5% greater than the company forecast, consistent with historical trends.

I estimate that SMAR’s NPV is about 50% greater than its current share price. Of course, that is quite dependent on the level of free cash flow I am projecting in the next few years, which, as mentioned, is above the company’s forecast.

I think SMAR should be compared to the valuation metrics for Asana and monday.com which are growing faster, but are really addressing the same market. monday.com’s EV/S is about 12.5X and it should achieve free cash flow breakeven this year. My 3-year CAGR expectation for monday.com is a bit greater than 50%. Asana, after its swoon last Friday, has seen its valuation compress to an EV/S ratio of 12X. It is still some distance from free cash flow generation; I expect its 3-year CAGR to be comparable to that of monday.com.

I have chosen not to include Atlassian in this comparison because its footprint is so much larger, along with its current revenue, and of course its profitability is far greater than any of the three workflow management specialists. I think anyone investing in the high-growth IT space is going to want to include a workflow management investment in their portfolio, and perhaps will choose to include two as I have.

The latest quarter that Smartsheet reported was one of its strongest in several years, particularly in looking at billings, and the growth in the deferred revenue balance. The company is addressing an immense market with a product set that has evolved and deepened. It has been able to consistently improve its gross margins as a function of scale coupled with a mix of higher-priced SKUs such as Advance offering.

The company has ramped its spending on research and development and sales and marketing. It has made sense to do so given the level of gross margins and the acceleration of billings growth. I think investor concerns about continuing this strategy, despite the bias of the market in recent months, are not well-founded.

I think SMAR shares offer significant positive alpha this year and into the future as investors rerate the company to account for higher growth assumptions.