HubSpot: Nice Trade For A Steep Worth (NYSE:HUBS) – In the hunt for Alpha

Thesis

I recommend a hold rating for HubSpot (NYSE:HUBS) based on two key factors: slowing growth in revenues and cash flow, and the stock’s lofty valuation.

Company Overview

HubSpot is a software company headquartered in Cambridge, Massachusetts. Founded in the early 2000s, the company has emerged as a prominent player in the realm of marketing and sales solutions. HubSpot’s approach combines marketing automation, CRM solutions, content management, and more.

HubSpot’s target customers are primarily SMBs and growing enterprises across numerous industries. Furthermore, HubSpot’s software solutions cater to the needs of various employees within an organization, including marketers, sales reps, customer service agents, executives, etc.

Financials

HubSpot exhibits impressive financial performance, with TTM revenue reaching $1.837 billion. The company has consistently achieved substantial revenue growth, maintaining a blistering pace over time. HubSpot’s revenues have historically grown at a 30%+ YoY rate, but growth rates have seen signs of decline to the mid-20% level as of late. Although this is still incredibly impressive, the results of recent quarters suggest that HubSpot may not be able to keep up the rapid growth that it has experienced in the past.

While it may appear unjust to downplay a company that continues to grow at a rate in excess of 20% YoY, it is important to note that HubSpot currently holds only a small portion of their estimated $45 billion TAM. With HubSpot’s TTM revenue representing roughly 4% market penetration, it’s unlikely that their top-line growth would be hindered by the typical pressures experienced when companies outgrow their market share. The modest 4% penetration indicates that other factors may be influencing the company’s recent slowdown in growth.

One potential factor that may be contributing to the deceleration in growth could be HubSpot’s ongoing expansion into multiple product lines, which, in a sense, creates more competition for the company. The image below depicts the expansions that the company has made over the years since its founding in 2006.

For those that are unfamiliar, HubSpot initially began with a focus on inbound marketing software as their core product line. However, over time, they have expanded their offerings beyond marketing to include sales, customer service, CRM solutions, etc. This expansion has allowed HubSpot to provide a more comprehensive platform for businesses and increased their TAM, but it has also introduced greater competition around their offerings. No longer can they simply be the best platform for inbound marketing, but they need to outperform every possible competing company across their product lines in order to make the most compelling case for potential customers.

I believe that this dynamic has potentially played a role in HubSpot’s slowing revenue growth. And if the company continues to place an emphasis on expanding into new product lines, this trend may perpetuate.

On another note, HubSpot has maintained a consistent gross margin of around 80% over the past couple of years. Notably, the company has experienced significant margin expansion in recent quarters. During the most recent quarter, gross margins reached an all-time high of 83%.

As HubSpot continues to grow its revenues, it is likely that the company will continue to see further expansion in margins in the future. The strong correlation between revenue growth and margin expansion suggests a positive outlook for HubSpot’s profitability.

HubSpot is clearly in a growth mindset, and as such, is yet to produce positive earnings. The company posted a net income loss of $141.7 million over the four most recent quarters. However, HubSpot has been cash flow positive ever since 2017. Cash from operations has been relatively steady, but in a similar fashion to revenue, growth has begun slowing down.

During the most recent quarter, HubSpot experienced a 1.4% decline in cash from operations compared to the same quarter in the previous year. This trend was also observed in Q4 of 2022, with a year-over-year decrease of over 5% in cash from operations. These figures shed light on a concerning narrative that suggests HubSpot’s future may face greater challenges.

HubSpot demonstrates robust financials overall, but there are indications of a potential slowdown in the future. Investors should keep a close eye on HubSpot’s revenue and cash flow trends over the next couple of quarters, as they will paint a clearer picture for the company’s long-term prospects.

Valuation

From a relative standpoint, HubSpot’s valuation is quite high. Seeking Alpha’s quant system measures the company’s valuation as a D-, which seems appropriate. HubSpot trades at a premium compared to its peers in virtually every possible valuation multiple. Not only that, but it generally trades several times over the sector medians.

For example, HubSpot’s EV/Revenue multiple is almost 15x, which is notably higher than the sector median of ~3x. Forward looking EV/Revenue multiples don’t fare much better, as HubSpot remains relatively high at ~13x. For comparison, Salesforce (NYSE:CRM) has a trailing multiple of 7x and a forward multiple of 6x. It’s important to consider that while HubSpot may have greater growth potential in the future, Salesforce, unlike HubSpot, is profitable, and this profitability should be factored into its valuation multiple. This comparison with Salesforce is merely one example that highlights the potential overvaluation of HubSpot.

The question arises: Does HubSpot’s past performance and future prospects justify its currently high valuation? While there is merit to some extent, it may not fully justify the current valuation level. The graph below shows HubSpot’s EV/Revenue over time.

If you disregard 2021, a period when markets were largely oozing with over-optimism, it becomes clear that HubSpot is currently trading at the higher end of its historical multiples. And with growth prospects for the company not as bright as they have been in the past with slowing growth rates in revenues and cash from operations, a ~10x EV/Revenue valuation seems much more reasonable than its current 14.5x multiple. Such a multiple would still be largely in line with how the market has historically valued HubSpot.

Despite the presence of many positive aspects, such as its strong financials, HubSpot’s valuation appears relatively steep.

Catalysts

While I maintain a bearish sentiment towards HubSpot’s stock price, primarily due to its lofty valuation, I recommend a hold rating because catalysts that could potentially lower the valuation are relatively unclear.

The most likely catalyst will be future earnings reports, as they will paint a better picture for HubSpot’s future. However, it may require several quarters worth of slowing revenue and cash flow growth in order for the price to normalize. A catalyst of this nature would likely materialize over a period of time, rather than occurring abruptly.

Investors should also keep a close eye on HubSpot’s retention metrics. Management noted in the most recent earnings call that net revenue retention fell three points to 104% and that they anticipate short-term pressures to continue for retention. Although levels are expected to stay above the 100%, this trend is still something that should be followed closely by investors. Increasing churn, coupled with slower growth, could cause the stock price to experience a pullback.

Risks

Consistent with my recommended hold rating, I anticipate that HubSpot’s performance will closely align with the overall market in the short to medium term. While I believe HubSpot is an exceptionally strong company, the current valuation is likely to impede the stock’s progress in the near to medium term. The risk with such a rating is that the stock will meaningfully outperform or underperform the market, both of which are possible.

The case for outperformance is that HubSpot is an incredibly well-built company and has a long history of outperforming the market. The graph below depicts growth in HubSpot stock as compared to the NASDAQ over the last decade.

As evident from the data, HubSpot has historically delivered outstanding performance, surpassing the NASDAQ by a margin of over 1500%. Based on this track record, one could argue for the likelihood of continued outperformance. While this scenario remains plausible, it is crucial to acknowledge the potential impact of HubSpot’s current valuation in the medium to short term, as mentioned earlier. The elevated valuation may act as a temporary obstacle, potentially suppressing the stock’s ability to outperform the overall market.

On the flip side, the case for underperformance hinges on factors such as revenue growth slowing greater than initially anticipated, a significant increase in churn, etc. However, I would argue that a large share of these potential factors have already been priced-in.

In the meantime, barring any unexpected circumstances, it seems likely that HubSpot will perform in line with the market, hence a hold rating.

Conclusion

The upcoming earnings report on August 4th holds significant importance for HubSpot’s outlook. As the company undergoes a transition into a new phase of its lifecycle, marked by a slowdown in growth, this particular earnings report will serve as a key determinant of its future trajectory.

Notable things to watch for from the earnings report are revenue growth rates, trends around cash flows, and updates on retention metrics. These key factors will likely have a tangible impact on the share price for HubSpot.