Description

Short Hubspot, HUBS.  HUBS is priced for more than perfection at this point.  Even if everything were to go perfectly for HUBS, it would still be hard to justify this valuation.  Since there are numerous challenges associated with its business model it is very likely that it will end up coming up well short of expectations.

HUBS is a cloud based marketing and sales software platform focusing on the SMB market.  Traditionally, businesses have marketed via outbound techniques to generate leads, like cold calling and direct mail.  However, customer habits are changing and people are blocking out these traditional tactics and using more technology to find products and services.  HUBS enables businesses to deliver an “inbound experience,” which means that it attracts and engages potential customers with more relevant and personalized content and information, that is also less intrusive.  Its Marketing Hub is an all in one platform that manages marketing automation (campaign workflow, lead scoring, etc), content (website and blog management etc), social media, SEO, etc. HUBS recently launched a CRM product and plans to launch customer service in the near future.

HUBS had a good year in 2017.  Revenue grew 38.6% with over 600bps improvement in operating margin due to successful international expansion and build out of its Growth Stack, which is a bundle of its core marketing product with more recently launched sales product.  Net revenue retention increased to 100.5%, breaking 100 for the first time due to the successful roll out of the CRM product. There are reasons to believe that its best growth days are behind it and retention could revert back to more historical levels.  

Trading at $115, the stock is valued at 11.1x 2017 EV/sales and 8.6x 2018, based on consensus estimate of $485 million in revenues, an increase of 29%.  Profitability will remain immaterial for the foreseeable future.

It is often useful to look at some sell side models when shorting to see what is baked into the valuation.  MS has been a bull on the stock, but recently downgraded the stock from overweight to equal weight. The MS base case target for HUBS is $105, which is derived from revenue CAGR of 19% for the next 10 years (!) with operating margins expanding from non-GAAP 2% (FYI GAAP margin is -10.7%) to 27% (!!) in 2028, and then applying a 19x (!?) FCF multiple to 2028 estimates, and then discounting back at 10.9%.  The bear case results in a target of $65, which is based on revenue growth of “only” 17% per annum over the next 10 year with operating margins “only” scaling to 24% and then applying “only” 18x to FCF in 2028.

Not all SaaS businesses are created equal.  When done right a SaaS business model can generate a long lived annuity like stream of cash flow after the upfront customer acquisition cost is sunk, creating significant operating leverage.  There is quite a bit of uncertainty about the future as end markets, technology, and competition change. Understanding what the right customer acquisition cost is and what the actual lifetime value of a customer is can be difficult.  As investors what we really care about is the present value of future free cash flows, but with high growth SaaS businesses those cash flows can be so far out that they are difficult to model, so industry participants have two general rules of thumb for SaaS success: LTV/CAC > 3x and months to recover CAC < 12.  

HUBS used to disclose CAC, but no longer does so, along with a lot of other KPIs, but it has generally been increasing over time, which does not bode well for a company that specializes in inbound marketing.  Due to its focus on SMB and company specific issues it has had structurally higher churn than most public SaaS companies. As a result its LTV/CAC could be in the 2.5x range and it could take nearly two years to recover CAC.  Given the lack of disclosures and the quickness with which the market is changing one has to make a lot of assumptions, but it does not appear HUBS will ever be able to earn a return on its investment in growth.

The competitive landscape of HUBS’s market is fragmented and increasingly competitive.  CRM in particular is focusing more on moving down market into the SMB space.

HUBS has had a substantial increase in its net retention rates in the last couple of years, which could reverse.  SMB focus inherently results in higher churn, but HUBS strategy has resulted in significantly higher levels of churn than others that focus on SMB, like MKTO, ZEN, and NEWR.  In 2017 Nucleus Research did a study that showed that 23% of HUBS customers plan to switch to another solution in the next year and 52% plan to switch in the next 5 years.

Ironically, despite its expertise on inbound marketing, 40% of HUBS’s revenue is through partners.  The reliance on the partner channel to such an extent is problematic for a variety of reasons. HUBS is not an exclusive vendor and partners have their own incentives that may result in pushing sales to competitors.  HUBS also does not have a direct relationship with a very large part of its customer base. This situation could also result in partners competing with HUBS for sales. More problematic, however, is that the partnership program seems a little bit like a multi-level marketing scheme.  Partners become customers and then also sell the product. Loans are also available to partners. It seems like the only requirement to becoming a partner is buying some software from HUBS, and many appear to have limited financial flexibility and high employee turnover. HUBS utilizes the partner channel in an attempt to lower CAC, but it comes at a cost, which is a commission of 20% of annual subscription revenue.  

Its products are priced at a premium to comps.  High prices are a common reason for a customer to go with other products.  At the low end there are a variety of products that do many of the same things as HUBS for free or much lower cost, but this would require having multiple vendors/tools that would not be as easy to manage.  At the higher end, software vendors offer much more functionality than HUBS provides. As a result, HUBS addresses a niche of the market where the customer is small and relatively unsophisticated without the ability or desire to manage numerous point products, preferring to pay up for the convenience of one stop shopping that is easier to manage, and without the budget to pay up for more functionality.

Focusing on the SMB market also mean that more growth has to come from increasing new account wins, instead of ARPU expansion via up and cross selling.   Its focus on businesses with with 10-1,000 employees means that its ARPU is capped around $1,000/month due to limited budgets. To date HUBS has been successful in adding new customers.  However, it has to add an ever increasing number of these smaller account as its revenue base grows to maintain its growth rate.

Incremental investment in R&D and S&M in 2018 will weigh on any operating leverage one might expect from such high growth rates and operating margins are now expected to be flattish excluding the impact of accounting change, ASC 606.  So profitability remain elusive, slipping further into the future.

One of the biggest customer complaints about HUBS is its rigid contractual billing.  Many customers that are unhappy with the product unwittingly get stuck paying for a second year.  Some complain that contract terms are not well disclosed. These customers should be better at managing their own businesses, but as stated earlier many are unsophisticated and end up disgruntled that HUBS is unwilling to work with them to resolve the issue.  This practice could lead to churn being artificially depressed during periods of higher growth, which could then reset to a more normalized level. Consequently, LTV could be lower than expected.

New Sales Professional offering could also have created a one time to boost to retention, as well.  At $80 for 5 users, pricing was somewhat promotional and drove some demand, which could have caused some pull forward in demand as some small customers might not have 5 users and will have to grow into it.  

The third part of HUBS’s Growth Stack will be the launch of customer service.  The launch of CRM products have been successful. However, the automation of contacting customers is a natural extension of inbound marketing, whereas resolving customer service issues is quite a different thing altogether, so it might not be as easy of a sale and could lead to disruption

Given the limited TAM and ARPU leverage, it is an unlikely takeout target.  Acquisitions have also averaged 6-7x sales, so its current valuation also makes it unlikely.

Also of note, there has been constant insider selling.  The CFO is resigning to spend more time with his family.  And in 2016 they switched auditors from Deloitte to PWC, not that PWC are tremendous slouches or anything, but worth noting, given the CFO move.

Risks:

My shorts often double before going down.  Mitigant: I already have a decent loss in the one.

New customer additions and increasing ARPU via the Growth Stack could continue recent strength.  Profitability could improve if ARPU, CAC, LTV improve. Given the challenges laid out this does not seem likely.

Catalyst

slowing customer additions, increasing churn, increasing competition, earnings misses