martin-dm/E+ via Getty Images
martin-dm/E+ via Getty Images
A couple Seeking Alpha readers were upset with me after my last article on Smartsheet (NYSE:SMAR ), taking particular exception to my concluding statement which offered that “I personally suspect SMAR will never become profitable.” In so many words, I proposed (in no specific order):
1. Tactical not strategic. Most SMAR customers are likely using their software as a tactical, departmental solution, with only a small number using the platform as a strategic, enterprise-class solution.
2. Weak moat. The company’s competitive moat might not be all that wide.
3. Expenses are too high relative to average annualized contract value (“ACV”) . High sales & marketing and R&D expenses, particularly stock-based compensation expenses, are likely to keep SMAR in the red given its relatively low ACV of ~$7K when I wrote the report.
My position is a bit of a paradox because I also happen to think SMAR has a strong product offering in the collaborative work management space, alongside those of Asana (ASAN) and monday.com (MNDY). I didn't mean to insinuate in any way in that prior article that the company itself is somehow “bad”. In fact, today’s Q2 FY ‘23 results were quite good, even if guidance left investors wanting:
Billings of $205.6M in Q2 FY ‘23 representing growth of 44% versus the analogous period in the prior year. Billings growth rebounded to a certain extent in the quarter versus “only” 36% growth YoY realized in Q1 FY ‘23.
Total revenue of $186.7M in the quarter representing growth of 42% versus the prior period and beating the consensus estimate of $180.6M. Subscription revenue comprised ~93% of sales in the quarter, with services accounting for the remainder. Notably, services revenue of $13.2M was up 24% YoY. As I argued in the last article, services growth may serve as a proxy for increasing strategic use of SMAR software by the customer base
Positive free cash flow of $7.2M. FCF was driven by an increase in cash flow from operations and a decrease in CAPEX spending, and represented the first positive FCF quarter in 4 quarters. FCF in the prior period Q2 FY ‘22 was ($3.5M).
Tracking for break-even FCF by the end of Q4 FY ‘23. Management noted that they are “...carefully managing our resources to drive improved margins and…remain on track to achieve break-even free cash flow by [the] end of this fiscal year.”
GAAP net loss per share of ($0.48). GAAP net loss beat the consensus estimate of ($0.56) by $0.08.
Net retention rate of 131%. SMAR continues to demonstrate strong success expanding its install base.
Good growth in key annualized contract value (“ACV”) buckets. Management noted “[the] number of all customers with annualized contract values…of $100,000 or more grew to 1,220, an increase of 63% year over year[, the] number of all customers with ACV of $50,000 or more grew to 2,738, an increase of 48% year over year[, and the] number of all customers with ACV of $5,000 or more grew to 16,682, an increase of 24% year over year.”
Average ACV per domain-based customer increased 28% YoY to $7,557. Average ACV increased ~8% versus Q4 FY ‘22 when I wrote my last article on SMAR.
Strong annual recurring revenue (“ARR”) expansion. “62 customers expanded their [SMAR] investment by over $100,000 and 201 expanded by over $50,000. [The company] also added three more customers to the $1 million ARR tier and now [has] 36 customers over this ARR threshold. [SMAR] ended Q2 with ARR surpassing $736 million and now [has] over 11.1 million Smartsheet users.”
Acquisition of Outfit to expand feature set of SMAR’s digital asset management platform Brandfolder. SMAR’s push into digital asset management, with the prior acquisition of Brandfolder and now the acquisition of Outfit, serves as an important differentiator with CEO Mark Mader noting during today’s earnings call that “...[the company’s] portfolio of [digital asset management] capabilities lets customers connect to a range of workloads unmatched in the collaborative work management space.”
To reiterate, management posted (another) strong set of results in Q2 FY ‘23; but forward guidance, and its context, was not as rosy.
Citing macroeconomic headwinds that surfaced during the quarter, and unanticipated sales organization challenges, management explained they are “...electing to lower [their] full year billings and revenue guidance with the assumption that the current macro environment persists.”
Figure 1: SMAR Q3 and FY ‘23 Guidance (SMAR Q2 FY '23 Earnings Presentation)
Figure 1: SMAR Q3 and FY ‘23 Guidance (SMAR Q2 FY '23 Earnings Presentation)
Previous FY ‘23 guidance from Q1 FY ‘23 earnings results called for net sales in the range of $756M - $761M, and billings in the range of $910M - $925M. While management could be offering investors a more conservative forecast with an “underpromise and overdeliver” mindset, there were a few comments made during the earnings call that, along with revised guidance, suggest a bumpy road may lay ahead.
As already mentioned, SMAR lowered guidance due to their view of sustained macroeconomic headwinds. Additionally, they cite sales organization challenges as the second major drag on their forward forecast. Both are worth exploring in a bit more detail and I want to drill into each, leveraging comments made during the earnings call. Quotes without specific links are taken from the earnings call transcript.
1. Macroeconomic headwinds are creating a perfect storm of sales environment challenges. Management explained that they started to “see” certain macroeconomic-related impacts to their business starting in July, “...including longer sales cycles, …deal compression, and additional approval layers.” These effects were reflected in lower sales pipeline close rates. This is, obviously, exactly what investors don’t want to hear. However, SMAR is not the only enterprise software vendor to acknowledge a changing market with, for example, Datadog (DDOG) management offering investors a more cautious second-half outlook as well, not too long ago. If customers are creating more “hurdles'' for SMAR to jump over when chasing deals, and deal sizes may be getting smaller (in some cases), this naturally implies the company must compensate somehow. Management has already lowered their forecast. But, the company is also going to have to do a better job growing the sales pipeline since management noted close rates are decreasing; and they are also going to have to do a better job with sales execution. On both points, this could logically mean increased sales and marketing spend, thus cutting into margins and putting, for example, management’s goal of breakeven FCF at the end of the fiscal year at risk. Further, as management expects a prolonged non-ideal selling environment, they might have to “carry” this hypothetical increased spend for several quarters. With sales and marketing expenditure already running high, as mentioned in the introduction, this creates a challenging operating condition that SMAR has to navigate carefully, balancing growth with financial discipline.
2. Sales execution issues may hint at deeper problems. Management also attributes their lowered guidance to issues ramping new sales reps, offering that “...[their] previous guidance assumed a ramp time for sales reps [that SMAR] hired at the beginning of the year to be consistent with what [the company] experienced in the past. However, this ramp time has been slower than [management] anticipated.” This comment stuck out to me given my own experience selling enterprise software. Why should SMAR have this particular problem, at this particular point in the company’s growth? Well, the increased ramp time could be easily explained as being due to the increasing breadth of SMAR’s solution portfolio: in other words, new sales reps have a lot to learn. However, Mr. Mader responded to a question along this line of reasoning suggesting that “...the support mechanisms [SMAR has] around [sales] enablement and the [related] tooling [is] dramatically improved from the early days'', implying that the right training tools and processes are in place to help sales reps, in spite of an increasingly complex portfolio. So, again, why is ramp time taking longer? Is there a problem with the quality of the sales reps that are being hired? As I have already stressed, SMAR carries a high sales and marketing expense; in fact, analyst Keith Bachman from Bank of Montreal stated during the earnings call that “..your sales and marketing is certainly high relative to most software companies.” If SMAR is (essentially) paying a premium for their sales talent, but that talent is not producing, could there be other, more serious issues that the company is wrestling with? For example, could there be problems with sales management whereby those leaders are not hiring good candidates and/or are ineffective at leading/training those candidates? Obviously, I am speculating as to what the underlying causes might be. But, I am driving towards suggesting to you, the reader, that I don’t fully buy the “ramp time” story as an explanation for lowered guidance. In fact, in my own experience selling, the sales organization has a tendency to be used as the convenient “fall guy” as management masks more serious problems with the business. Again leveraging my own experiences, these are often problems with (1) the product or (2) management itself. I fully concede I could be way off base with this suggestion. However, “having seen this movie before” during my own enterprise software sales career, I am led to question management’s narrative.
The combination of a prolonged downturn in the economy, the potential for even greater sales and marketing spend to compensate for lousy selling conditions, and the possibility of deeper organizational and/or product problems equals a tough road forward. To be fair, and to reiterate, I could be way off base with my suggestion that SMAR’s “ramp time” issue is a mask for another issue; and it is not a foregone conclusion that the economy is going to tank. But, I think parsing the earnings call comments in the context of SMAR’s selling environment and sales execution issues must lead a reasonable investor to be – at least somewhat – pessimistic about the company’s likely performance closing out FY ‘23 and heading into FY ‘24.
SMAR was trading above $50 when I wrote my last article on the firm and made a call to sell. The stock has since fallen ~(40%). Shares closed today just shy of $31, and are close to the 52-week low of ~$27/share. By some metrics, SMAR might now seem like a relative bargain.
Figure 2: SMAR and Selected Competitor Statistics (Yves Sukhu)
Figure 2: SMAR and Selected Competitor Statistics (Yves Sukhu)
Total cash data from Yahoo Finance except SMAR data sourced from Q2 FY '23 earnings release.
Shares outstanding data from Yahoo Finance, except ASAN data from Macrotrends.
P/B data from Yahoo Finance except SMAR data calculated from Q2 FY '23 earnings release.
Further, analysts are quite bullish on the company, albeit with many lowering their price targets recently.
Figure 3: SMAR Analyst Ratings (Marketbeat)
Figure 3: SMAR Analyst Ratings (Marketbeat)
Even with the pullback in shares, and in spite of the broader position of the analyst community, I reiterate a sell call on the company. As noted earlier, when I suggested that SMAR may never reach profitability in my last article, my core argument was rather simple: expenses, particularly sales & marketing, were too high relative to the company’s average ACV. This idea found support during today’s earnings call with Keith Bachman affirming that “...[SMAR’s] average ACV is still pretty small relative to [the] client base” and asking management “...how do you solve that sales and marketing riddle and really reach…operating profitability?” With the sales environment and sales execution challenges outlined in the previous section, I’m not sure there is a clear-cut answer to Mr. Bachman’s question, although SMAR management offered that their pathway to profits centers on (1) expanding their footprint with their largest customers, who also drive the most profits; (2) expanding the breadth of their portfolio and leveraging their existing sales resources to push that additional functionality; and (3) natural economies of scale that will present themselves as the company continues to grow. It's not an unreasonable answer; however, given things as they are right now, I still don't see a clear path to profitability and stand behind my call to sell.
This article was written by
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.