HubSpot Stock: A Fantastic Business With A Premium Price Tag (NYSE:HUBS)

Investment Thesis

HubSpot (NYSE:HUBS) is a solid company growing at a fantastic rate. I believe that it is well-positioned to continue its strong performance even if the economy pulls back.

But the company is struggling with profitability. Shares are trading at a very expensive valuation with high stock-based compensation. I’m optimistic about HubSpot’s prospects, but I’m still cautious right now.

HubSpot Is Well-Positioned For Strong Growth

HubSpot has continued to report strong results, even as the economic environment declines. The company added over 15,000 new customers in the first half of the year alone. These customers fueled another quarter of year-over-year revenue growth of over 35%. The business projects 25% and 22% year-over-year growth for the next two quarters.

I believe that HubSpot is well-positioned to succeed in the current environment. The company has done a good job of expanding its offerings. In the last few years, the company has launched services to streamline sales, customer support, marketing websites, and CRM functions. Strong partnerships and integrations also bring more users into the ecosystem.

Management has been effective at upselling these services to existing users. The company ended last year with 60% of its customers adopting multiple products. This is up from 34% in 2017.

HubSpot provides a wide selection of critical business services. Its clients are unlikely to unsubscribe even during an economic downturn. I think that the company may even benefit from consolidating IT spending. A business aiming to cut costs will likely prefer HubSpot’s integrated suite of services. Management discussed these opportunities on their last earnings call.

As I talked to our customers, it is clear that SMBs need to do more with less as they navigate the current macroeconomic environment. They’re looking for ways to consolidate their fragmented tech stack of point solutions, improve efficiencies, and get better visibility into their customers’ journey. As a result, HubSpot’s connected, easy to use platform is mission critical for our customers…

During the pandemic, solving for the customer was all about helping businesses become digitally enabled. Now, it is about helping customers become digitally powered, by helping them consolidate on a single platform to drive efficiencies.

This consolidation strategy is why I believe HubSpot will continue to report strong growth. The company is consistently expanding its ARPU, growing 10% year over year. Right now, I think that the business’s fundamentals are low risk compared to its peers.

For example, the company’s international business is continuing to report strong growth. In the last quarter, the segment reported 49% year-over-year growth in constant currency. Reported revenue grew 34% in Europe even as the region experienced a severe relative slowdown. I believe that this shows that HubSpot is better positioned than many of its peers.

Profitability Is Still A Concern

HubSpot has reported consistent GAAP losses since its 2014 IPO. On an adjusted basis, the business has reached a single-digit EBIT margin. But this is still well off of the company’s long-term goal of 20% to 25% adjusted operating margins.

HubSpot’s gross margins are fantastic. The company achieves gross margins above 80% on its core subscription products. These are brought down by the company’s training and consulting segment. I think that those costs act as a subsidized sales and marketing expense.

Sales and marketing expenses are by far the company’s largest costs. GAAP sales and marketing expenses were over 53% of revenue in the last quarter. Management said they plan to continue growing sales headcount in the second half. This may create issues if demand falls below projections. But the company is reporting a net revenue retention rate of above 110%. This is a major improvement over its 2019 NRR of below 100%. I think that HubSpot has clear operating leverage to increase profitability if necessary.

HubSpot’s Valuation Is Very Expensive

HubSpot has a very expensive valuation. Shares are trading at a forward P/S of 9 times and a forward EV/adjusted EBIT of 102 times. This is a very expensive valuation. Yes, the business has very solid fundamentals. But this makes me worry that these are already reflected in HubSpot’s valuation. At the current price, the business would need to retain its high growth rate for years into the future.

HubSpot is in good financial shape. The company generated $225 million in free cash flow in the last four quarters. It has $1.25 billion in cash on hand and investments. These should easily cover the company’s ongoing operating costs.

But these metrics don’t account for the company’s high stock-based compensation. In the last quarter, the company paid out over $81 million in its shares. This is about 19% of revenue and a huge 78% jump quarter over quarter. Management addressed this in their last earnings call.

Yes, you’re right. So Q2 stock comp expense every year is a high watermark for us as a percentage of revenue, because we do a catch up and expense for two quarters. And so that 19% in Q2 will be the high watermark for 2022. The increase is driven by a few things. One, there’s an impact, we had a bunch of notable executive hires over the last six months, and that is that impact.

And then the other big change is that we made a shift in our RSU investing from four years to three years for all of our employees…we pay a lot of attention to stock comp as a percentage of revenue. We also pay a lot of attention to dilution. And we look at our management of those relative to our peer companies. And we still compare very well against the software companies in general.

It’s good that management is keeping an eye on dilution. I’ve been highly critical of companies that try to pretend that SBC isn’t a real expense. But there is still a decent amount of dilution. The company expanded its shares outstanding by 10% over the past two years.

The market has high expectations for HubSpot’s future earnings. This valuation at least partially accounts for HubSpot’s great fundamentals. I’m bullish on the company’s performance, but the high price lowers the potential returns.

Final Verdict

I believe that HubSpot’s fundamentals are solid. But the company’s valuation and dilution are major concerns. I don’t see a catalyst for a major upwards rerating in the near term. An unexpected decline in growth could cause a large and permanent capital loss for investors. Management was clear that their current guidance doesn’t plan for another step-down.

For these reasons, I’m still being cautious. I think that this may be a good time to start a small position. But I recommend waiting for more clarity before taking a larger position. I will be watching the company’s upcoming Q3 and Q4 earnings reports for these details.