Smartsheet (SMAR) Thesis

“Where are the opportunities? Both on the Long and Short side… there already are a number of companies that have lowered the bar enough and those are your better candidates to be buying. Don’t be looking to companies that have not lowered the bar” - Mike Wilson, Morgan Stanley. 10/12/22

Setup:

SMAR offers an attractive risk/reward that we believe will be realized via a catalyst path largely dependent on earnings beats vs. street expectations driving multiple rerating and narrowing the valuation gap with CWM peers (MNDY/ASAN). Our base case assumes +20% upside, downside case -10% and a upside case of +32% if the stock rerates in-line with the blended CWM peer multiple. Additionally, we believe the Company is a compelling take-private candidate for a strategic or private equity buyer helping further positively skew the risk/reward at current levels.

During the Q2’23 earnings call Management lowered guidance for both FY’23 revenue (36-37% YoY) and billings (32-33% YoY) from the previous Q1’23 guide for FY’23 revenue (37%-38%) and billings (38%-40%). The CFO called out the revised guidance as “prudently thoughtful” with the revised guidance accounting for continued weakness which started to appear at the beginning of Q3, additionally, the CFO broke out the -7% billings guide down as follows (3% Macro, 2% Sales Productivity, 1% Europe Weakness, and 1% FX). The stock rallied 10%+ the day after suggesting the market positively interpreted the new guidance as worst-case scenario/better than feared supporting our theory of current levels being a floor in valuation. Our estimates suggest that management is likely being overly conservative where we model positive upside to consensus estimates for both FY’23 Q3/Q4. We believe the stock will likely rally on the Q3 print to reflect better than anticipated results. Our estimates vs. consensus might not jump off the page but we believe outperformance will instill investor confidence that SMAR can continue to perform even in a recessionary environment. To segue into our short/pair thesis, the CWM market is highly correlated as all three public CWM players (SMAR, MNDY, ASAN) have some presence in the majority of each other’s accounts - suggesting that customer weakness will eventually spillover to SMAR’s CWM peers. We believe Monday and Asana may likely guide down on the Q3 call to reflect current CWM market conditions, in addition, we believe their revised guidance could potentially be more severe than what SMAR reported as both MNDY and ASAN have greater non-US exposure (approximately 40-50%) and much greater exposure to SMB.

Smartsheet’s multiple trades at a steep discount (on our estimates) to blended CWM peer multiples (MNDY/ASAN) suggesting the street is pricing Smartsheet as the clear loser in the category. Due to Smartsheet’s substantial lead in the enterprise, similar consensus revenue growth/profitability outlook to CWM peers, and the likelihood of outperforming street estimates, we believe the discount is unjustified and has largely stemmed from excitement driven by retail flows that plowed into new IPOs.

Company Overview:

Smartsheet is a pioneer and leader in the largely greenfield Collaboration Work Management (CWM) market - simply put many refer to Smartsheet as Microsoft Excel meets Microsoft Project on steroids. CWM is a very busy market with a handful of public competitors including Monday.com, Asana, Trello (Atlassian), Workfront (Adobe), and formerly public Wrike (Citrix). In addition, there are a number of well-funded VC start-ups including ClickUp, Notion, and Airtable. So why isn’t SMAR a fantastic short based on intense competitive pressures creating a race to the bottom? Truthfully, we aren’t sure it isn’t and that is why we believe implementing a pair trade Long SMAR and Short either/both (MNDY/ASAN) makes the most sense. Where we have strong conviction is in SMAR being the player that wins the enterprise category. The enterprise category will likely determine the winner of the CWM market as it is the category with the largest TAM and CAC efficiency.

Why Smartsheet Wins CWM Market

So why is SMAR going to win the Enterprise? Smartsheet has invested heavily into developing both their technology and GTM capabilities to be enterprise-ready over the last number of years providing them a substantial head start vs. peers (MNDY/ASAN) that have taken a broader approach to bottoms-up adoption across segments. Smartsheet’s ARR is comprised of primarily enterprise customers (50% of ARR) vs. Mid-Market (25% of ARR) and SMB (25% of ARR). Quantifiable evidence of SMAR’s lead over MNDY/ASAN can be found when comparing Gross Retention, Dollar-Based Net Retention, and >$50K ARR Customer Count.

Qualitatively SMAR’s technology investment in enterprise-grade admin control and security standout vs. peers which we believe is best highlighted by their government certifications including FedRAMP designation (FedRAMP Moderate Level) and Department of Defense (Impact Level 4 Authorization) underlying their strong security and governance capabilities both of which are unique to Smartsheet. MNDY/ASAN lack such level of certification putting them at a large competitive disadvantage.

The recent rollout of Smartsheet’s subscription packaging plans called Advanced points to management’s ability to bring innovative marketing solutions to the enterprise that lessen sales friction by easing the ability to increase seat licenses and adoption of add-on features/capabilities.

KPI disclosures also underline SMAR’s lead position in the enterprise as they are the only CWM peer that discloses the count of their largest customers by ARR including >$100K ARR Customers (1,220) and $1M ARR Customers (36), where peers only disclose >$50K Customers. Additionally, SMAR has 2.4x more >$50K customers than peers MNDY/ASAN.

SMAR’s gross retention rates have been in the low to mid-90s the last 12 quarters vs. peers that we believe are in the 80s. Overall company Dollar-based Net Retention Rate (DBNRR) for SMAR is in the low-mid 130s vs. peers in the low-mid 120s highlighting the fact that SMAR has superior unit economics. SMAR achieved a 13x LTV / CAC vs. 5x-7x when they first went public due to improved DBNRR and Gross Retention from focusing on the enterprise. We believe CWM peer LTV / CAC ratios are likely closer to 5-7x due to more SMB exposure.

Competition:

SMAR CEO stated they see very little head-to-head competition in the CWM market “There's not a lot of head-to-head. As I said, when we have those – like those rare but notable RFPs, we're talking single-digits in a quarter, right. So, it's difficult to say what the others are experiencing. Again, most of our deals are not contested. Most of our business is grounded in expansion where they're really committed to Smartsheet already.” - CEO Mark Mader Q2’23 Earnings Transcript. This GTM approach is consistent with what we’ve gleaned from transcripts of former sales executives that highlighted SMAR’s GTM focus is not competing directly against CWM competitors but more so expanding their footprint in departments and also cross-department using champions with the ultimate the goal of getting IT to standardize on Smartsheet thus crowning a winner of the account. It is very common for all three CWM peers SMAR, MNDY, and ASAN to be in the same account, however, there is usually one leader that is further penetrated and has the most potential for a wall-to-wall deployment.

Market Opportunity:

Smartsheet has a massive greenfield opportunity with over 1bn knowledge workers globally. Smartsheet in primarily replacing legacy tools such as spreadsheets, emails and presentations, while occasionally displacing competitive CWM products. Management estimates single-digit penetration within existing customer base supported by comments the CEO made about an estimated $1.4bn opportunity just within the largest 2.8k customer if they were to achieve $500K ARR in those accounts (there were 41 Customers >$500K+ customers at the time). IDC forecasts the TAM at approximately $60bn comprised of $51bn Collaborative Applications, $6bn Project and Portfolio Management, and $1bn Digital Asset Management.

Risks To Thesis:

Sales Productivity - Further deterioration in sales force productivity could prove our estimates to be overly optimistic. We doubt this is likely to occur as our productivity estimates fall below peak COVID-19 productivity figures. However, anything is possible in a recessionary environment, and we want to remain cognizant of such possibilities. In addition, management called out that some enterprise customers have chosen to forego buying Advanced plans in lieu of purchasing capabilities a la carte which could drive smaller lands and lower DBNRR, we believe this is largely accounted for in our productivity and DBNRR assumptions.

Unforeseen Executive Departure - Executive departures in CY’21 including the CFO and CPO led to investor speculation of internal issues leading to exits. We believe this was likely a major contributor to the stock underperforming peers during the FY’21 bull run. Former employee interview transcripts highlighted a cultural misalignment with the CPO stemming from commentary that his “large corporate approach” was not a fit for a high-growth start-up such as Smartsheet. In addition, there was speculation from formers that the CPO had interest in jumping into a CEO role which seems reasonable as he left for a CEO position. We have less visibility into the CFOs departure, however, she had previously guided to aggressive LT FCF targets that were not achieved, and we speculate this may have played a role in her departure but there is no concrete evidence to support such assertions.

Hedge/Pair Short Position Take-Out: Monday.com or Asana could potentially be taken-out for a large premium as they are down 80% from their FY’21 highs. We believe this is unlikely as SMAR is the CWM peer that would be most attractive of the three as a take-out candidate due to valuation and their enterprise customer base but also due to the high insider ownership and share structure of MNDY/ASAN making a take-private transaction difficult.

Financial Model

ARR Model:

SMAR management periodically discloses ARR, however, our ARR estimates use current period Subscription Revenue and account for intra-period timing (Cur Sub Rev x 0.3535 x 12). Utilizing DBNRR and Gross Retention (disclosed quarterly) to drive ARR from existing customers while utilizing a Quota-Carrying Rep (QCR) productivity model to drive new customer ARR.

On the Q2’23 Earnings Call management highlighted recent challenges primarily driven by macro headwinds causing elongated deal cycles and deal compression while guiding to a mid-high twenties DBNRR for Q3/Q4. In addition to macro headwinds SMAR is also lapping tough comps in 2H’23 from post-COVID acceleration experienced in 2H'22. We model continued weakness in DBNRR into 1H’24 with incremental improvement in 2H'24 to account for easier YoY DBNRR comps and improving macro outlook.

QCR Productivity Model:

Management called out prolonged ramping of new QCR hires which was likely driven by over hiring in 1H’23. We believe our model overprovisions for QCR productivity weakness as well as the challenging macroeconomic backdrop by assuming a sharp decline in productivity for 2H’23 and continued double-digit YoY productivity declines into FY’24. In addition, we assume that net new QCR adds essentially screech to a halt in Q3’23 which is consistent with managements QCR hiring practices during the pandemic. CFO also called out their frontloading of QCRs in 1H’23 with muted hiring in 2H’23.

Customer ARR Model (Downside Case)

To sanity check our ARR assumptions, especially, the QCR productivity which requires a number of assumptions, we built an additional ARR model utilizing ARR per Customer and Customer Count instead of QCR productivity. Our QCR Productivity Model is likely more accurate and appropriate as it accounts for rep ramp productivity issues, but the Customer ARR model is helpful to directionally confirm the accuracy of our QCR model assumptions. (See both models for slight differences in Ending ARR).

Revenue Model:

Subscription Revenue is driven by our ARR model; however, we find it useful to breakout the drivers of net new subscription revenue by product including new seat licenses and capabilities (add-on features) to further enforce our conviction of the underlying trends.

Billings Model:

Our Billings model accounts for a sharp decline in gross retention in 2H'23 with further weakness into 1H’24 to account for potential churn driven by a softening macro backdrop. Our gross retention troughing at 92% mirrors that of COVID-19 results which we believe adequately accounts for a shallow recession and then a slow recovery.