EngageSmart: Stay Smart By Holding On To The Stock (NYSE:ESMT)

Thesis

I believe the stock performance is a clear indicator of my thesis for EngageSmart (NYSE:ESMT) working out – especially when the valuation was at 6x forward revenue. Based on my updated model, I think there is still upside to the stock given the updated figures and valuation.

Overall, my thesis for EngageSmart has not changed. Looking forward, management provided optimistic guidance that exceeded consensus estimates and expressed confidence in the progress being made in constructing the enterprise pipeline. I also found the message conveyed regarding SMB price increases to be positive – this reinforces my idea that ESMT has a sticky business model that enables it to raise prices. Also, ESMT’s strong unit economics in SMB and continuing momentum in expanding into the premium market for behavioral health and related industries should help with growth too. In terms of macro weakness, I think the defensive verticals and diversified mix of subscription and recurring payments that ESMT offers will help it weather through. Together, all these changes should result in significant operating leverage and valuation support.

In terms of valuation, while I do note that the stock has revalued up from 6x to 8x today, I point out that ESMT is still expected to grow at 20%+ over the near-term, and the market seems to recognize this momentum. While it might seem slightly expensive (valuation wise) given the current rates environment, I think the growth and profitability profile of ESMT should support the valuation in the near-term.

4Q22 results

With growth in both the SMB and Enterprise markets, ESMT’s 4Q22 revenue of $84 million exceeded consensus of $82 million by 2% in 4Q22. Adjusted gross margin came in at 80%, up from 79% in the previous quarter. As for expenses, operating expenses totaled $54 million, an increase of 9% from the previous quarter. Revenue that came in higher than expected allowed for a higher margin on adjusted EBITDA of $14 million. Finally, the number of customers in 4Q22 was about 24% higher than in 4Q21, thanks largely to the results of digital marketing campaigns, positive word of mouth, and an increase in the number of SMB clients.

My highlights

In addition to the impressive top-line numbers, I am keeping an eye on a couple of metrics that also suggest ESMT will continue its momentum. First, ARR per SMB customer increased 6% sequentially from Q322 to Q422 (2.5%). This growth is due to SimplePractice’s Plus offering gaining traction with group practices and the general public. The increased rate of growth is conclusive evidence that the ESMT product is finding favor with its intended audience. Additionally, InvoiceCloud signed two of the four largest deals for FY22 and established new partnerships in a variety of industries to strengthen the pipeline. These two large deals are likely going to have a bigger impact as ESMT moves towards FY24. That said, I think FY23 is poised to be a promising year for the segment thanks to the 20 bps price increase for integrated payments. Looking forward, what gives me hope is that management has signaled its intention to make incremental investments with the hope of adding value to group practices, and also plans to implement revenue cycle management to free up staff time previously spent on billing and insurance claims.

Guidance

Management updated guidance for FY23 and the 1Q of FY23. Management anticipates $380-384 million in revenue and $66.5-$69.0 million in adjusted EBITDA for FY23. The management also provided FY23 guidance for other important metrics.

1. The number of customers acquired remained consistent with the year 2022.
2. Gross profit margin is expected to increase
3. Adjusted EBITDA to be converted to FCF at a 50% rate
4. Despite an anticipated increase in churn, net revenue retention to remain above 100%.
5. Growth of 30% was projected for SMB segment, while growth of 20% was expected for enterprises, although the growth rate for enterprises was expected to be more moderate.

ESMT projected a range of $86.0 million to $87.0 million in revenues and $13.5 million to $14.0 million in adjusted EBITDA for 1Q23. Due to the timing of 4Q22 transactions, management expects a slight sequential decline in 1Q23 revenues from a seasonality perspective. It is also forecasted that 1Q23 will be the quarter with the highest volume of new customers and practitioner appointments. Importantly, higher transaction revenue is anticipated for 2Q23 as a result of a 20bps increase in pricing for integrated payment processing solutions in the 1Q23.

Valuation

My previous model suggested a price target of $19.43 in FY23 based on $492 million revenue in FY24 and 6x forward revenue multiple in FY23. I believe the 4Q22 results has proven my thesis right so far and there are clearly momentum in both the business and the stock (stock is up 50% since the lows in December 2022). In light of the new growth momentum and valuation, I have revised my price target upwards to $29.62 in FY24. The huge delta in price target is largely due to the multiples slowly reverting back to historical levels (6x to 8x) and a higher revenue in FY25 ($580 million).

Conclusion

In conclusion, the thesis regarding the stock performance of ESMT remains unchanged and appears to be working out, as indicated by the stock’s recent strong performance. The company’s 4Q22 results were impressive, with revenue exceeding consensus estimates and an increase in the number of customers. The growth in the SMB and Enterprise markets, as well as the increase in ARR per SMB customer, suggest that underlying momentum will continue. Guidance wise, management has provided optimistic guidance for FY23, including expectations for revenue growth and improved profitability. While the valuation of the stock has risen, ESMT’s growth and profitability profile should support this increase in the near-term.