HubSpot, Inc. (HUBS) offers what it calls a “leading growth platform” which includes a free Customer Relationship Management (CRM) application as well as four other “hubs”, including marketing, sales service and now CMS.
HubSpot serves the small-to-medium-sized business market which is the worst market segment for customer churn and it is no surprise that the company has experienced some problems since the start of the pandemic. The company management has indicated that the net revenue retention rate dropped from more than 100% to the low 90s in 2020 Q1. Management is actually predicting that Q2 will actually be worse for churn as they work to keep customers by:
- reducing the price of the starter suite by 50%;
- offering (paid) features in the freemium subscriptions on a temporary basis; and
- working with customers to temporarily downgrade and/or restructure subscriptions.
These actions, while reducing the net retention rate, have actually stimulated new customer growth, albeit at the cost of lower revenue growth. Once the pandemic retreats and things get back to normal, these initiatives should translate into higher revenue.
In addition to the pandemic-specific actions that have been taken, HubSpot has also been busy with relaunching the enterprise tier for the marketing hub and introducing the CMS hub. The CMS capability should stimulate revenue generation from new online businesses. The relaunch of the marketing hub will help HubSpot set its sights higher, i.e., on the enterprise market.
Regardless of how HubSpot is performing in the current market conditions, Mr. Market is bullish on this stock which is breaking out to all-time highs.
(Source: Yahoo Finance/MS Paint)
I usually take note of breakouts as they often signify more bullish action to come. In the case of HubSpot, it seems that Mr. Market is optimistic regarding our economic recovery and the belief that HubSpot is in a good position to benefit.
In any case, HubSpot has strong growth potential, with 31% annual growth prior to the pandemic, positive free cash flow, and a strong balance sheet with $960 million in cash and cash equivalents. In short, HubSpot won’t have any problem weathering the pandemic and subsequent recession. The stock breakout is gravy, making my bullish rating an easy call.
The Rule Of 40
One industry metric that is often used for software companies is the Rule of 40. The rule provides a single metric for evaluating both high-growth companies that aren’t profitable and mature companies that have lower growth but are profitable. Revenue growth and profitability (expressed as a margin) must add up to at least 40% in order to fulfill the rule. Analysts use various figures for profitability. I use the free cash flow margin.
The rationale for the Rule of 40 is as follows. If a company grows by more than 40% annually, then you can tolerate some level of negative free cash flow. But if a company grows by less than 40%, then it should have a positive free cash flow to make up for the less-than-ideal growth. This rule accommodates both young, high-growth companies as well as mature, moderate-growth companies. The 40% threshold is somewhat arbitrary but typically divides the digital transformation stock universe in half, separating the best stocks from the so-so ones.
For a further description of the rule and calculation, please refer to a previous article I have written.
The two factors required for calculating the Rule of 40 are revenue growth and free cash flow margin. HubSpot’s annual revenue growth for the last year was 31%, while its free cash flow margin was 8%.
(Source: Portfolio123/MS Paint)
Therefore, the Rule of 40 calculation for HubSpot is as follows:
Revenue Growth + FCF margin = 31% + 8% = 39%
Well, who wants to split hairs! HubSpot’s performance suffered pretty dramatically in the last three weeks of 2020 Q1 and I am inclined to give the company a pass on the Rule of 40 in spite of only reaching 39%. HubSpot essentially fulfills the Rule of 40, suggesting that HubSpot has a healthy balance between growth and profitability.
The plot below illustrates how HubSpot stacks up against the other stocks on a relative basis based on forward sales multiple versus forward revenue growth. Note: please refer to a recent article for more information on the scatter plot relative valuation technique.
(Source: Portfolio123/private software)
According to the scatter plot, HubSpot is slightly undervalued relative to its peers. I have also highlighted Salesforce.com (CRM) on the scatter plot for reference purposes.
I expect that HubSpot’s business performance will be subdued for the rest of 2020 due to the small-to-medium business market niche. But Mr. Market is looking past 2020 in the stock valuation. The risk for this investment is the quite real possibility that there will be an extended recession with depression-like unemployment. In such a case, I would expect there will be a longer-term bear market that occurs, and HubSpot shares will suffer along with the rest of the market.
The current stock market action is somewhat reminiscent of the dot-com era, when technology stocks had unrealistically high valuations. While HubSpot’s valuation is reasonable, a new software bear market set off by the deflation of overvalued stocks would likely cause HubSpot to get swept away along with its software peers.
Once the economy recovers, there is no guarantee that the new customer growth resulting from the recent initiatives will stick.
Summary and Conclusions
HubSpot provides a platform including CRM along with marketing, sales, service, and CMS hubs. These tools target small- and medium-sized businesses, although the company is taking steps to improve its posture in the enterprise market by relaunching its marketing hub. Small- and medium-sized businesses have been hit hard during the pandemic and this has translated into significant customer churn for HubSpot.
The company has done well to keep its customers by restructuring payments for those customers in need and also to expand its customer base by slashing the price of the starter suite and offering features temporarily in the freemium subscription.
I anticipate that HubSpot will likely have a so-so year given the current economic conditions, but once the adverse economic conditions subside, HubSpot should be in a good position to resume a high level of revenue growth and improving positive free cash flow. I don’t believe that 2020 will be a catastrophic year, and the SaaS business model will likely keep the company’s revenue growth in pretty good shape.
The company has nearly $1 billion in cash and cash equivalents. This should be enough to carry a company with positive free cash flow through the pandemic and recession. HubSpot is fairly valued, a factor that is important in this super-heated software bull market that could deflate at any time. Therefore, I am giving HubSpot a bullish rating.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any 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.