Can Sprout Social Grow Into A Winning Stock?

In less than 2 decades, social media has evolved from virtually nothing into one of the most important marketing, engagement, PR, customer support, and brand-building channels available for companies to utilize.

Firms ignore social media at their own peril. Look at these facts:

• Over 4.7 billion people worldwide use social media, over 75% of the global population.
• Over 60% of those users check social media at least once a month, and 40% look at it daily.
• Social media has excellent ad metrics, with an ROI exceeding 30% and click-through rates (CTR) of over 2%.
• Social media ad impressions are growing at > 20% annually.

Outside of marketing, social is becoming more and more important in PR and brand management, in both positive and negative ways. GoPro is an example of a company that has made excellent use of social media to highlight how their cameras can capture the adventurous and creative spirit of their customers. On the flip side, brands like Bud Light have been hurt through negative social media backlash that can snowball into serious financial damage. Firms must be very careful navigating such powerful channels.

In today's Green Screen stock review, we look at a company that is aiming to make managing the many social media channels out there simpler and more effective . The company is Sprout Social (SPT). Does it make the cut as a "Green Dot" stock? Let's have a look!

What Sprout Social Does

Sprout Social is a cloud-based, software-as-a-service (SaaS) offering to businesses looking to centralize and streamline their use of various social media platforms. The service offers dozens of integrations to all popular social media platforms, including Facebook, Instagram, Twitter, LinkedIn, Pinterest, YouTube, Reddit, TripAdvisor, Glassdoor, and many others. Using Sprout Social, customers can centralize publishing (write once, publish to many), view reporting across sources (dashboards for engagement, interaction, following, etc.), generate business intelligence from both their own and competitor data, manage customer service and support channels, run marketing campaigns, coordinate public relations efforts, and various other functions.

Sprout has 30,000 customers in over 100 countries worldwide. Traditionally, it has aimed to service businesses of all sizes, from small one-person operations to multi-national global corporations. Their client list has some heavy hitters, including KraftHeinz, Johnson & Johnson, DoorDash, Subaru, and even the recently crowned NBA champion Denver Nuggets!

It is clear how clients get value out of Sprout (the company touts up to a 200% ROI). Any individual who has tried to manage multiple social media channels knows how out-of-hand it can quickly become. Simple things like cross-publishing posts is extremely helpful, but the more advanced features like reputation tracking, automation, finding mentions outside of owned channels, forming insights about your firm from millions of posts, etc. is something that would just be virtually impossible without a platform like this. For companies that are serious about social - and consumer-focused brands HAVE to be - managing a presence without something like Sprout puts them at a serious disadvantage.

The Revenue Model

Sprout Social is a SaaS platform with monthly subscription pricing. It currently has 4 tiers, running anywhere from $250/seat up to "contact us" pricing for Enterprise licenses. Firms pay month after month for ongoing access to the platform, so this is a fully recurring revenue model. That's one of our requirements to be a "green dot" stock.

Let's talk about growth. It's good! Sprout's 3-year compound annual revenue growth rate is 35% - very nice. Forecasts are for continued 25%+ growth over the next 5 years. Management has stated it believes the company has a $44 billion serviceable addressable market (SAM) that is growing at 20% annually. I cast a sideways glance at that figure, but clearly the SAM is large given the importance of social media to modern business. Even if we assume 1/3rd of that - $15 billion - Sprout's $330 million revenue run rate represents only 2% penetration in a rapidly growing market.

There is a good opportunity to expand with existing clients. As mentioned, the key function of social media right now is advertising, but there is a lot of opportunity in other areas. As customers expand their usage of the platform, Sprout can earn more license seats, growing within existing clients. Overall, the firm's net revenue retention is 110%, but among larger enterprise firms it is closer to 120%.

In all, it is clear that Sprout has a very attractive growth opportunity that should allow it to grow at 20%+ rates for many years to come.

Is There A Moat?

I believe Sprout is trying to develop a switching costs moat by focusing on its highest paying clients (the enterprise businesses). This is a smart strategy. Large companies are not only less likely to change vendors, but more likely to add seats as usage expands across departments. I mentioned the higher net retention above - that is both due to fewer cancellations and more seat expansions.

That said, I don't feel Sprout's switching costs will ever be as onerous as something like, say, a CRM or HR software system. This is clearly a "best-in-class" platform, with more features and better rated across numerous points (ease of use, administration, support, etc.) than its competitors. But there ARE competitors, including Hootsuite, Khoros, Sprinklr, AgoraPulse, Eclincher, and even offerings of big firms like Adobe. The company will need to compete for new business, and invest to keep its existing clients.

Sprout's switching cost moat could be characterized as "narrow".

Management and Financials

This company has a solid leadership team. Justyn Howard co-founded the firm in 2010, and today still sits as CEO and chairman. He has won multiple Glassdoor "Highest Rated CEO" awards, including taking the top spot in 2017.

Joining him in the C-suite is chief technical officer Aaron Rankin, another co-founder. Together, these two men control just under 50% of voting power in the firm through their ownership of "super voting" class B shares. Economically, each of them own shares totaling 7% of the company (roughly $130 million dollars apiece). That's enough to ensure their interests align with ours, as common shareholders.

The leadership team has done a good job building Sprout into what it is today. We've mentioned the firm's outstanding growth rates. This has been accomplished largely organically, with very little goodwill on the balance sheet, and no debt. Cash flows are modestly positive, with plenty of room for increasing margin (management targets 1-3% increase in FCF margin annually). Even so, cash flow return on invested capital is excellent at over 20%.

Management has also clearly done a great job building an attractive company culture. Sprout has won multiple Glassdoor "best places to work" awards, and has an amazing 4.8 rating with a 98% CEO approval rating.

To top it off, Howard is 43 years old and Rankin is just 40, meaning both of them are in position to lead Sprout for many years to come.

Risks

In the context of our other portfolio picks, Sprout Social ranks as a "higher" risk stock.

The biggest risk to investors is Sprout's execution. At its current valuation, the company not only needs to continue its 25%+ sales growth ramp, but it also needs to continue improving its profitability. Management's targets are for 1-3% annual improvements in operating margins and free cash flows. To justify its current price, Sprout needs to reach a 20% free cash margin - its trailing 12 month figure is 4.3%. That indicates that acceptable profitability is a long ways off. We need to discount that when determining a fair value number.

Another key risk is that Sprout relies on the various social networks' APIs. We've seen several social firms, most recently Twitter and Reddit, make substantial accessibility and/or pricing changes for clients using these. While Sprout is well positioned to absorb API pricing changes (better than smaller competitors), it would still be disruptive to business and potentially crimp margins.

Finally, there is a fair bit of competition in this space. If the addressable market really is $44 billion, there are going to be firms looking to it for growth. Sprout has a nice lead at present, but barriers to entry are not insurmountable.

Conclusion

I wanted to do an in-depth look at Sprout because it is a very interesting company with a lot of the characteristics we are looking for in a "green dot" stock. It has recurring revenues, a large growth opportunity, a modest moat in switching costs (particularly for the enterprise segment they are chasing), great founder-based leadership, and a strong and improving financial profile. There are some clear risks to be aware of, but Sprout leans more into the slightly speculative, "growth" side of the Green Screens.

It makes the cut as a new "green dot" stock, and will be added to the Watch List today! However, we're going to need a better valuation than what we are getting right now. Given management's muted profitability targets, and just modest cash flow generation at present, I only see Sprout worth about $33 right now. We're going to have to see continued improving margins and/or a lower stock price before buying.