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A Powerful Growth Stock Worth Considering

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We write a lot about income investments, however we also like to invest in powerful growth stocks, as well, because they add important diversification to an investment portfolio, and because they can help keep your nest egg growing. This article focuses on one of the fastest growing companies in the US in terms of this year and next year’s sales growth, at scale. We provide an overview of the company’s attractive qualities, as well as a review of the common pitfalls to watch out for when investing for powerful long-term growth and capital appreciation.

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Smartsheet has been a publicly traded stock for just over one year, and it continues to grow like wildfire. We actually decided to review this company after running a screen for the fastest growing companies traded on either the NYSE or Nasdaq based on this year’s and next year’s expected sales growth (we also required market capitalization to be at least $2 billion).

Fastest Growing Companies:

Here are the results of that screen (Smartsheet ranks #28 on the list in terms of next year’s sales growth, and its business strategy caught our eye after we skipped over many risky biotech and China companies that rank higher).

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About Smartsheet:

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Smartsheet is a leading cloud-based platform for work execution, enabling teams and organizations to plan, capture, manage, automate, and report on work at scale, resulting in more efficient processes and better business outcomes.

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Today over 95,000 customers, including more than 77,000 domain-based customers and over 70% of the companies in the Fortune 500, rely on Smartsheet to implement, manage, and automate processes across a broad array of departments and use cases.

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And as you can see in this next chart, sales have been growing very rapidly.

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Attractive Subscription Model:

And one of the things we really like about the revenue is that it is mostly subscription based, which means lots of repeat revenue. So not only is Smartsheets bringing in new customers, they are retaining customers. Plus they discuss their “land and expand” strategy which is a common and attractive strategy among subscription businesses whereby not only do they retain/renew existing subscriptions, but they also expand to additional services with existing customers thereby growing revenues further. Subscription based services can be an extremely attractive business model.

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Large Total Addressable Market:

Another attractive quality about Smartsheets is the large (and rapidly growing) total addressable market. According to a recent Markets and Markets report, “ The enterprise collaboration market is expected to grow from USD 34.57 Billion in 2018 to USD 59.86 Billion by 2023, at a CAGR of 11.6% from 2018 to 2023.”

And important to note, Smartsheet was recently named the leader in the enterprise CWM (collaborative work management) market due to its product features and future strategy (per a Wave Report). SMAR was ranked highest in 9 categories including customer satisfaction, integrations, enterprise adoption rate, and workflow. 

When trying to address the large total addressable market during the most recent quarterly earnings call, Smartsheet management made clear the market is very large and that the company is still in the early innings of powerful long-term growth opportunities, by saying:

“We're trying to get smarter about what solutions we introduce to people so that they achieve that growth. But it's very difficult to sometimes comprehend. How do you compare a $2,500 contribution report from Fortune 500 Dollar Company to a multimillion dollar contribution? It is not one big stair step. It's a series of steps. And we're trying to figure out how to compress that and to have people drive value more quickly.”

Overall, Smartsheet’s collaborative work management industry is large, growing rapidly, and presents a great opportunity considering Smartsheet’s leadership position in the industry.

…Yes. And maybe just to add on to that. I think last quarter I talked about the average ACV for the Fortune 500 being close to $50,000. We're now north of that. So it's still a relatively small number in the context of the opportunity and so we think there is a lot more to go.”

Not Yet Profitable:

One of the things that immediately turns many investors off to Smartsheets (and young growth stocks, in general) is that the company is not yet profitable. That’s right, earnings are negative (and expected to remain negative).

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However, this is completely normal for new growth companies. As a growth company matures throughout its lifecycle, it typically spends very heavily in its early years whereby it focuses on growth; this results in negative earnings as it still hasn’t reached significant economies of scale benefits, nor does it mind spending very heavily on sales, marketing and growth in its early years because it will reap the rewards (healthy earnings) many years into the future. Here is what management had to say about spending during the most recent quarterly earnings call:

“Research and development was $14.7 million or 28% of total revenue, flat with the prior and year ago quarter. Finally, sales and marketing expense was $28 million or 54% of revenue versus 60% of revenue in the prior and year ago quarter. The reduction in sales and marketing as a percentage of revenue was driven primarily by headcount scale and the absence of our ENGAGE conference, which occurred in the third quarter.”

This is a tough pill to swallow for many investors, but it is typical of growth stocks, and in the case of Smartsheet, the business appears very healthy and on track.

Valuation Metrics:

For young growth companies with negative earnings, a few of the valuation metrics to watch include sales growth, gross margins, and price-to-sales ratios. As we saw earlier, sales have been growing rapidly. Also, the company just recently raised its full year guidance for this upcoming year.

Also important are gross margins. According to the earnings call, gross margin is very high, and attractive in our opinion:

“In the fourth quarter, overall gross margin was 82%, flat with the prior and year ago quarter. Subscription gross margin was 88%, 1 percentage point lower than the prior and year ago quarter, driven by higher personnel costs and partially offset by lower credit card processing and hosting costs. Professional services margin was 30%, as we maintained high utilization rates and delivered higher margin services packages.

With respect to overall gross margin, we do expect it to trend down towards our long-term target margin of 78% to 80% this year as we begin migrating our services from our co-location facilities to the public cloud, which should provide us more flexibility to scale as we grow.”

This next table (and chart) provide a variety of valuation metrics, but price-to-sales in one we really like to focus on for young aggressive growth companies like Smartsheet.

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From a price-to-forward-sales standpoint, anything over 10 better be backed up by some serious long-term growth potential, and in the case of Smartsheet, we think it is. Also very importantly, the near-term price volatility of young growth stocks like Smartsheet can be very significant, so we pay closer attention to our entry point (i.e. we like to buy these types of shares after a price pullback). However, remember that this is not a value stock, it’s a growth stock, therefore you’re going to have to pay up (a bit of a premium) for the anticipated future growth. 

Conclusion:

Smartsheet is growing rapidly, but the rapid growth comes with pitfalls such as a volatile share price (don’t panic and sell when the price sells off, you need an iron-clad stomach), the earnings are negative (don’t be turned off, this is normal for a powerful young growth stock), the valuation is very high (there is a premium for the growth), and the company only has a short one-year history as a publicly traded stock (don’t be turned off, this can be an indication of long-term opportunity). Further, Smartsheet is addressing frustrating pain points for enterprise workers by making their project management work easier (don’t underestimate the value of making workers more productive), and the total addressable market is large and growing (Smartsheet is a leader in the growing and critically important “collaborative work management” industry). We’re not opposed to the idea of long-term investors nibbling at Smartsheet now (i.e. initiating a small position), however we’re simply keeping it high on our watchlist, and we may initiate a new position on any significant price weakness, especially considering the enormous and powerful long-term growth potential of Smartsheet.

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