Shares of leading inbound marketing software company HubSpot (NASDAQ:HUBS) have been on fire for a long time. Over the past three years, as HubSpot has grown revenues at a 35%-plus compounded annual growth rate and expanded operating margins by more than 1,000 basis points, HUBS stock has rattled off a 200%-plus gain.
But, this bull thesis misses one critical component: valuation.
HUBS stock trades at almost 12 times forward sales and 97 times forward earnings. Those are big multiples. Sometimes, multiples that big are warranted. But, if you look at the most realistic growth trajectory for HubSpot over the next several years, those big multiples don’t seem warranted today.
As such, valuation risks could short-circuit the big rally in HUBS stock. They already have. HUBS stock is down 20% from its late August 2019 highs, and the fundamentals imply that this sell-off isn’t over yet.
HubSpot Is a Great Company
There is no denying the simple truth here: HubSpot is a great company.
The company offers enterprises of all shapes and sizes all-in-one inbound marketing, sales, and service software which helps them broadly grow more efficiently. That is, they provide various software tools across the marketing, sales, and service verticals which enable companies to increase customer exposure, identify valuable sales leads, track various growth initiatives with analytics, streamline sales outreach, and organize and track customer communications, among various other things.
In a nutshell, they are a next-gen enterprise software service which every company with an online presence could use. To be sure, this enterprise cloud software market is very crowded. But, HubSpot has differentiated itself as the inbound marketing leader, and has leveraged this leadership positioning to successfully expand into the sales and service verticals.
The numbers speak for themselves. 35% compounded annual revenue growth rate from 2016 to 2019. 16,000-plus new customers every year. 80%-plus gross margins. Several hundred basis points of opex rate expansion each quarter thanks to increased scale.
Better yet, the growth narrative is just getting started. HubSpot counts 65,000 businesses as customers. There are 3 million businesses in Canada, Europe, and the U.S. alone which have a website and could use HubSpot’s services. Thus, this company is tapping into only ~2% of its addressable market — and spend per customer is going up, too, because HubSpot is consistently adding in new hubs like sales and service.
Big picture: HubSpot is a secular growth software company which projects a huge revenue and profit grower over the next several years.
HubSpot Stock Is Overvalued
Although HubSpot is a great company, HubSpot stock is overvalued at current levels.
This overvaluation shouldn’t come as a surprise. As noted above, HubSpot has all the ingredients of a long term winner. But, HubSpot is also in an intensely competitive industry, with slowing top-line momentum and margins that are getting close to being maxed out.
Here are the numbers. HubSpot grew revenues by 49% in 2016, 39% in 2017, and 37% in 2018. Revenues rose 33% last quarter. They are projected to rise 29% in 2019 and 24% in 2020. In other words, while this is a big growth company, it is also a slowing growth company. The laps are getting tougher, the competition is getting stiffer, and unit revenues are maxing out.
At the same time, HubSpot expanded operating margins by about 900 basis points in 2016, about 670 basis points in 2017, and around 400 basis points in 2018. Operating margins expanded approximately 310 basis points last quarter. They are projected to rise just around 190 basis points in 2019. While margins are expanding, the pace of expansion is consistently slowing.
Both of these trends — slowing revenue growth and margin expansion — should persist. HubSpot projects as a 15-25% revenue grower over the next several years, with strong but slowing margin drivers.
HUBS stock isn’t priced for that reality. Assuming 15-25% revenue growth and healthy margin expansion, HubSpot could realistically hit $6.50 in EPS by fiscal 2025. Based on an application software sector-average 33-times forward earnings multiple and a 10% annual discount rate, that equates to a fiscal 2019 price target for HUBS stock of under $135.
HUBS stock trades hands north of $160 today.
Bottom Line on HUBS Stock
HubSpot is a great company. HUBS stock is an overvalued stock. It’s that simple. So, beware of valuation risks here.
To end, I’ll leave readers with one more word of caution.
In a recent study, Professor Partha Mohanram of the University of Toronto, alongside Brian White and Wuyang Zhao from the University of Texas at Austin, found that the more stock-based compensation a company pays out to its employees, the more overvalued the accompanying stock tends to be, and less well that stock performs relative to stocks with less stock comp.
HubSpot doled out a whopping 18% of its revenues to stock-based compensation last quarter. If you exclude that stock comp from HubSpot’s adjusted numbers, the company run a huge loss last quarter — as it has on a GAAP basis for a long, long time.
The takeaway? There are various valuation red flags on HUBS stock. Enough to warrant staying away for now.
As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.
