Finally, SaaS At A Reasonable Valuation: Smartsheet

There’s no denying one of the favored industries to go hunting for "green dot stocks" is the enterprise software-as-a-service (SaaS) space.

And why not? The Green Screens are littered with stocks from this sector. Software doesn’t require a lot of hard capital in the form of factories, equipment, or real estate. The SaaS model is subscription by definition, setting up naturally recurring revenue models. The migration to cloud-hosted, subscription-based software offerings instead of the traditional on-premises model has been a multi-decade transition that is still taking place. Best of all, the industry is enormous and continues to grow - over $300 billion globally this year, and expected to reach over $1.2 TRILLION by 2032.

Put it all together and it’s not hard to see why these are some of the most attractive investment opportunities in the market, with good growth, recurring revenues, strong cash returns on invested capital, and in many cases, retain the economic moat of high switching costs characteristic of enterprise software historically.

The trick has been finding SaaS firms trading at stock valuations reasonable enough to provide an acceptable return over a long-term holding period.

Well, today I want to share a SaaS entry in the Green Screens that has all of the things we like about this space, along with a reasonable valuation that puts it very close to "buy" territory. Some may even consider buying today!

The stock is Smartsheet (SMAR). Let’s have a closer look!

How Smartsheet Makes Money

For a long time, collaborating at the workplace was a matter of creating Word documents, Excel spreadsheets, and Powerpoint presentations, sharing them mainly through email or cloud repositories like Sharepoint.

While this was a big step up from paper documents, fax machines, and telephone calls, it still has a lot of gaps. Updates from multiple users were difficult to coordinate, multiple versions of documents often led to confusion, important people were left out of conversations, and it was near impossible to get an accurate high-level view of the status of large projects - just to name a few issues!

Smartsheet’s software offerings are designed to help teams and organizations manage work and collaborate between internal and external teams, partners, and customers. It is known as a Collaborative Work Management, or CWM, suite of tools.

Smartsheet offers a lot of different tools, but some of the most important include: scheduling, budgeting, resource management, digital content management (videos, images, text), application builders, workflow automation tools, etc. Many of these have integrations into systems of record from other vendors, such as DocuSign, Dropbox, Salesforce, and AWS, allowing integration of data from multiple sources into easy-to-use business intelligence dashboards.

The revenue model is simple enough to understand. Smartsheet usually gets a foot in the door through its "freemium" model, with one small team or department trying it out for free, then gaining subscriptions as the firm adopts it for ever larger groups within the enterprise (you can see the company’s pricing sheet here).

The product is widely used and well regarded. Close to 85% of the Fortune 500 have active Smartsheet usage of some size. The suite has been named a "Leader" multiple times by Gartner Magic Quadrant and IDC for Collaborative Work Management.

Revenue Growth and Recurrence

Over 94% of revenues come from subscription payments, so we are looking at a near fully recurring revenue model. The rest of sales come from professional services, for such things as onboarding large deployments, helping to set up workflows within the tools, training, etc.

Growth has also been a strength, and should continue to be going forward. 3-year compound annual revenue growth rate is 35%, an excellent figure. This is slowing recently into the 15-20% range. Still, there should be plenty of growth left. The CWM software market is estimated to be worth $30 billion annually within the next few years. Smartsheet just recently passed $1 billion in subscription sales, meaning it has only captured 3% of the market. There’s PLENTY of growth left for sustained double-digit percentage revenue growth for the next 5-10 years.

The Moat

Enterprise software in general benefits from high switching costs, but the volume of those costs really varies between different types of software and how large the organization using them is.

The highest switching costs come when two factors are in play. One, when the customers are primarily very large, multi-departmental organizations with a lot of people using the software across different teams and disciplines. And two, when the data managed by the software is of long-term value and generated manually, instead of by automated systems. Put these together and you get very hard-to-dislodge systems that can create years or even decades of switching costs to migrate away from.

I believe Smartsheet falls into this "sweet spot". Customers with over $100k of annual recurring revenue has been by far its fastest growing cohort, and over 50% of revenue is generated by 2,000 seat customers or bigger. Its use cases are wide and varied, from creating sales pipelines to product launch tracking to planning out a new software system. It can be utilized by thousands of employees, from individual contributors up to CEOs. And it has numerous integrations into outside software suites, as we mentioned earlier.

This "stickiness" is clear in the numbers. Smartsheet has averaged a net revenue retention over 120% for the last 3 years, meaning not only don’t customers leave (96% gross retention), but they increase their usage of the platform, consistently, year-over-year, by about 20%.

CWM is an attractive space and there is no shortage of capable competition. Some examples include products from Atlassian, Asana, Monday.com, and Microsoft Project, just to name a few. Smartsheet will always have to compete for new business against these firms, but once established within a large corporation, expansion is a much less competitive proposition.

Management and Finances

Mark Mader is the CEO. While not technically a founder, he might as well have been - he has been CEO since 2006, less than a year after the firm was founded by Brent Frei (who still sits on the board). Smartsheet’s history of successful growth has been under his leadership. At 52 years old, he is about average age for a CEO and should have many more years leading the company, if he wants it.

Insider ownership isn’t particularly impressive, but neither is it non-existent. Mader and Frei both maintain about a 1.5% economic in the firm, worth $80 million each at the time of this writing. That’s a reasonable fortune that aligns their interests with those of us as general investors.

Financially, Smartsheet had been somewhat of a disappointment up until recently. This was a firm that clearly embraced the "grow at all costs" mantra, with a negative free cash flow balance throughout most of its history. That turned in fiscal ’22, with the first meaningful free cash generation, then accelerated rapidly in ’23, with an impressive $144 million of free cash flow, or 15% of revenues. With guidance for $200 million in ’24, it looks like the firm has permanently pivoted into the more mature, self-financing stance that we like to see.

The balance sheet is excellent. Smartsheet has no debt and has been very selective and modest with acquisitions. That allowed it to generate an impressive 36% cash ROI last year. I expect those strong ROIs to continue going forward.

Risks

Given the "stickiness" of its solutions, the large nature of its clients, and the debt-free nature of the balance sheet, I would place Smartsheet into the "medium-low" risk category.

On the business side, the risks are pretty typical for the sector. Economic slowdowns will lead to customers pulling back on expansion spend and just making do with what they already have (hurting sales growth). Competition is strong and pricing wars are not out of the question as the market matures. Falling behind on features could cause competitive disadvantages.

There is some risk on the valuation side, as well. My fair value estimate assumes Smartsheet can and will eventually generate more industry average cash flow margins, in the low-to-mid 20% vicinity. While there has been a lot of improvement recently, the firm has a history of weak cash generation and we don’t want to see it slip back into that. In my opinion, that weakness versus its more cash profitable competitors has been a big reason the stock hasn’t commanded a valuation multiple like competitors Atlassian or Monday.com.

Conclusion

You all know I’m a sucker for enterprise SaaS, particularly the "big enterprise, sprawling data" model. Well, that’s where Smartsheet fits in, so really it is kind of a no-brainer for "green dot" stock status. This is one that has not escaped my radar in the past, but it (like Asana) was never much of a cash profitable firm, which limited its attractiveness. That seems to be changing, and it looks like a good time to get in.

Using a modest 14% annual growth rate, assuming about 3% annual dilution, targeting an industry-average cash flow margin of 24%, and a slightly higher-than-normal 11% required rate of return, my fair value for Smartsheet is $46/share. At a current $37 and change, the stock looks attractive right now, but not quite at the 25% margin of safety threshold for buying. We will stick it in the Watch List today and look for a better price, hopefully in the near future.