LeonidKos
Procore: Its cyclicality was more a matter of time than a surprise
At the start of November, Procore reported results of its Q3 operations. The quarter itself was a noticeable upside compared to prior guidance and expectations. In fact the quarter was the largest beat since Procore has been a public company. The shares initially fell by about 17% after earnings, but have subsequently recovered more than half of that fall in the recent tech stock melt-up. That said, this is not a trading call, and after the strong performance of IT shares the last few weeks, some kind of sideways pattern or consolidations seems a reasonable expectation. On the other hand, many market commentators are focused on employment data to be reported this week; I really have no special insight into the specifics of those numbers, and they seem likely to be most significant in driving the market for IT and for Procore shares in the very short term.
This is a recommendation to buy the shares of Procore, at current prices, despite the guidedown. The shares are modestly cheaper now than they were before the guide down and the EV/S ratio has declined to about 8X. The trajectory of free cash flow is actually getting better. And the company is maintaining and perhaps expanding its competitive advantages.
Many think the construction industry is hyper-cyclical. The chart on pg.7 of this investor presentation suggests that while the industry is cyclical, the degree of cyclicality is probably overrated . Right now, some elements of the construction space are at a low ebb, with little activity to be seen in the construction of commercial office buildings and home building also stressed. There are, of course, many other components of the construction industry including roads, pipelines, government housing. Landscaping, heavy engineering, HVAC and IT infrastructure amongst others.
It has been about 10 months since I first reviewed the company and its outlook on the pages of SA. Since that time, the shares have fallen marginally while the tech/software ETF IGV has risen by more than 35%. On the other hand, the WCLD, an ETF mainly composed of “cloud” stocks has risen just around 7%.
At the start of the year, the outlook for the construction industry was guarded but not entirely negative. I was surprised at how resilient construction spending as a whole seemed to be, and just how fast Procore was growing. It wasn’t that management was unaware of the potential for macro headwinds, and indeed, the company’s forecast was set at explicitly conservative levels because of those headwinds. But customers back in February were still buying based on usual levels of reviews and most of its customers were willing to make substantial long term commitments.
That’s changed now. Gravity has won out. The company had been suggesting that was a possibility for some time, but it seemed to have significant visibility within its user base and thus the bookings results of the September quarter were a negative surprise, with expected deals not closing when forecast. Overall, the company’s larger customers, and renewals and upsells were proceeding on arrange, while some smaller potential customers were unwilling to make longer-term commitments. The slowdown was broad-based from a geographic standpoint.
How long is this slowdown likely to persist? Since the causes of the slowdown are essentially entirely macro related in its entirety, the end of the growth slowdown will most likely take place when macro headwinds are seen to be abating. At this point, while there seems to be an increasing consensus with regards to a 2024 recession, or growth slowdown; when such a slowdown or recession might end is hidden in the mists of the future. Of course it depends on public policies such as a rate pivot, or dare I use the word, fiscal stimulus.
There will be very few enterprise IT vendors who are not impacted by the macro. What seems most likely to be the case is that while percentage revenue growth will continue to moderate, free cash flow margins will rise, and valuations are also likely to boost. At least that is how I read current market action of the many IT companies reporting growth slowdowns.
I think the shares of Procore can be attractive, partially because moderating growth still leaves that metric at a reasonable level, and because it appears that the forecast has been notably de-risked by a company that has a track record of very conservative forecasting. It also has a significant business initiative, in terms of payments and construction financing that might be a unique growth tailwind for the company
A quick review of most recent results and guidance for Procore
Procore’s prior guidance for Q3 had been: Revenues of $233 million, and a non-GAAP operating margin of -5.5%. For all of 2023 the company had forecast revenues of about $923 million.
Actual Q3 revenues were revenue of $248 million and non-GAAP operating margins of 3%. The company is now forecasting full year revenues of $938 million, with full year non-GAAP operating margins of 1%.
In other words, Q4 revenues are now forecast to be $248 million with non-GAAP operating margins of 3%. The new forecast for Q4 calls for no sequential growth but is consistent with the prior calculated forecast for the period. Q4’s forecast year on year revenue growth rate is now forecast to be 22%-23%.
The relevant portion of CEO commentary with regards to revenue growth is as follows;
From a revenue perspective, we continue to set guidance at a level that we have very high conviction we can deliver on even in a weaker economic environment. While we are disappointed by the headwinds on the top line, we remain more committed than ever to driving incremental operating leverage in the current environment. As a reflection of our increased focus on efficiency, we are guiding operating margins with less conservatism but still with high conviction we can deliver on to give shareholders greater visibility into the margin trajectory that we intend to reach. We will naturally continue to monitor demand trends and we will supply formal guidance for fiscal 2024 when we report Q4 results in February. However, as previously mentioned, we are not anticipating that the demand environment will boost and expect to proceed to the far left side of our financial framework over the next upcoming quarters.
The far left side of the company’s financial framework from the Investor Day chart is for revenue growth in the low 20% range as can be seen on pg.53 of the investor day presentation referenced earlier. With lower percentage revenue growth, non-GAAP operating margin growth is forecast to be in the range of 500-600 bps/ year with slightly lower expansion of the company’s free cash flow margin.
The priority of the company’s CFO is to improve free cash flow per share growth. The company’s preliminary guidance for 2024 implies a revenue forecast of $1.135 billion, an operating margin of 7.5%+ or operating income of $82 million, or EPS of about $.53 based on an weighted average share count of 147 million. As the company is not expecting to be profitable on a GAAP, the weighted average share count does not includes the full effect of dilutive securities and employee stock awards.
In looking at the company’s valuation, I have estimated its 3 year CAGR to be 28%, which is the mid-point of the range projected in the Investor Day presentation. There is clearly room for faster percentage revenue growth than the company has forecast for 2024 and a stronger improvement in Procore’s free cash flow margin based on steady improvements in operating expense cost ratios. With the assumptions I am using the valuation of the shares is marginally greater than average.
The company reports free cash flow using a charge for capitalized software development costs. It ls less common to use that metric these days. At this point, the company’s free cash flow margin calculated on a basis consistent with most other IT companies is running at a greater rate than its non-GAAP operating margin. I have chosen to be conservative in estimating that the company’s free cash flow margin will be about 7.5% over the next 4 quarters, although it wouldn’t be a great surprise if it were somewhat greater.
One positive element in the revenue growth picture that was called out during the conference call concerned the dichotomy that has been growing between renewals and new business. Renewal business was a bit more stable last quarter than in the prior two quarters while new business was apparently weaker. The visibility Procore has is always stronger with regards to renewals, and that, perhaps, is one factor company management expects to see with regards to its revenue forecast conviction.
Procore: A leadership role in construction management software; still its primary growth opportunity
Procore’s basic business is that of providing a wide range of software solutions to various stakeholders in the construction industry. Construction software is probably more complex and multi-faceted than many readers might imagine-and that certainly included this writer prior to trying to better scrutinize the space. I thought that construction software would be similar to that of workflow management with some specifics characteristics relevant to building various kinds of structures. It turns out that there are several unique phases in the construction process. These include preconstruction, project execution, resource management and financial management. Project execution is indeed, similar to a workflow management system for the construction space. The other solutions are quite a bit outside of the sphere of workflow management, although the concept of dependencies cuts across different phases of a construction process. The financial management component of the construction space is far more complex and time consuming than might be imagined and a key component of the company’s new product strategy is to address pain points in the process of sending and receiving payments for contractors and other industry stakeholders. Financial management for the construction industry is far more unique than might be imagined with some very specific and unique pain points and requirements.
Over the past several years Procore has built an integrated platform that addresses many of the specific requirement of the construction industry. The platform appears to be extensive and well integrated and it is the core of the Procore’s go-to market strategy.. Procore would appear to have the most extensive platform in the space and continues to extend it with tuck-in acquisitions such as Unearth, a recent acquisitions that offers contractors a tool that allows users to map out a particular project in order to best facilitate the construction product. Many of Procore’s products essentially allow users to find information faster and more accurately than previous manual processes used by much of the industry-Unearth is another such offering.
In looking at Procore, it is worth noting, even at this point, that its product offerings extend well beyond the bounds of what traditionally is called construction management software. The linked research here says the TAM for construction management software is a bit greater than $10 billion currently, with an expected CAGR of 10% through to the end of the decade. But the definition of construction management software in this research essentially is restricted to just project execution. The other components of the space in which Procore competes probably have a TAM greater than that of project execution, at least collectively, and are almost certainly growing more rapidly. No one investing in, or owning Procore shares considers a CAGR of 10% as any kind of reasonable expectation for long-term growth for this company. During its latest Investor Day presentation linked earlier, the company displayed a chart in which it spoke to a market penetration 22% in the specific areas for which it offers solutions. The company has projected a CAGR of around 30% with a range of revenue growth between the low 20% in years of macro headwinds to mid-30% growth in years of macro tailwinds. The low 20% growth expectation is the current expectation for growth both in this current quarter and for 2024. My valuation is based on the mid-point of that range, i.e. an estimated CAGR of 28%
Procore, admire most software companies, has announced a generative AI solution that it has begun to ship. The initial application of Procore Copilot is that of a highly sophisticated and talented explore tool. At this point, the product is in a controlled release, and a waitlist has been established. It is probably premature to try to set up a revenue ramp for the offering, especially as pricing has yet to be established.
The construction space is substantial, representing 13% of global GDP and 7% of the global workforce. Construction spend is growing a bit faster than GDP; it is, cyclical, but not as cyclical as I might have thought. Construction spend contracted massively during the great financial crisis. I have been concerned that it would go through a noticeable contraction as the economy has slowed at the end of 2023 and through 2024.
Until recently, the company’s growth has remained quite consistent, with revenue growth in the low/mid 30% range for the since the end of 2021. During the latest earnings release, the company reduced its revenue growth forecast substantially to take account of macro headwinds.
That said, the growth calculate reduction leaves expected revenue growth for Procore in the low 20% range both in this current Q4 and for all of 2024. That is probably substantially better than some investors may have though possible during a period of declining construction spending. But the fact is, that far from declining, construction spending, overall, is increasing, and construction spending growth increased last month. On Friday, the Census Bureau, which tracks this metric, indicated that construction spending rose by 0.6% from September to October and was 10% greater than October 2023.
The construction industry turns out to bar less monolithic than might be supposed. So while home building, office building and the building of shopping malls has fallen dramatically, this has been more than offset by other categories such as highways, transportation, education, factories, power generation etc. The spending authorized by the Infrastructure Act of 2022 continues to be a factor in overall construction spend. While the macro is a headwind for Procore, it is not of hurricane proportions, and seemingly will allow the company to grow, albeit at more modest rates over the next year.
Procore’s Competitors
Most Procore competitors offer point solutions and are not well known. Again, it is important in evaluating competition to distinguish between project management software where competition is substantial, and the rest of what constitutes the construction software space. Probably the best known competitor in the space is Autodesk (ADSK) which offers its construction cloud. This offering does match up against many of the capabilities offered by Procore.
Autodesk experienced a reject in billings last quarter, although revenue growth at 10% was consistent with prior levels. When the company reported its results just before the Thanksgiving holiday, it indicated growing momentum in its construction software business. (The core of Autodesk is its CAD offering and that has been so for many years.)
Oracle (ORCL) has a project management software offering that is mainly deployed in project management use cases.
In the most recent conference call, the Procore management called out its brand and its customer references as the cornerstones of ability to grow market share and to enter new markets. Procore has been competing with Autodesk for many years, and probably has been growing market share for many years as well, and is certainly growing market share against point competitors.
Overall, the competitive dynamic in the market was unchanged last quarter. The company apparently has continued to grow more rapidly than point competitors. During the conference call the CFO said not much had changed competitively over the past quarter. When measured against Autodesk, the apples to apples comparison suggests that Procore is growing faster but there is not some specific market share reference I can present.
The Procore business model-Still very much a work in process
Procore is currently operating at, or slightly above break-even with regards to non-GAAP operating margins. At this point, operating cash flow margins have been a bit higher than operating margins. The CFO in several recent presentations and on the conference call strongly emphasized that the model is being developed to improve the growth in free cash flow margins. The company’s non-GAAP gross margins have consistently improved, and were 86% last quarter. The other categories of opex showed noticeable improvements as well. Sales and marketing fell to 45% of revenues down from 48%. Non-GAAP research and development fell from 27% to 22% while General and administrative remained at 16%. As is typical for companies of this scale, sales and marketing expense is the most elevated while the non-GAAP gross margin has probably reached an apogee. I expect that in coming quarter, the G&A expense ratio will also resume its reject.
The company presented a slide during its investor day in which it forecast that would be able to boost gross margins by 500-600 bps during years in which the company grew in the low 20% range as it has now forecast for 2024. Much questioning of that kind of results was made by analysts during the conference call and the CFO reiterated that kind of improvement would happen, and even said it would be possible for that range of improvement to be realized even in the event that the revenue growth percentage was below 20%. So long as Procore continues to grow at significant rates, I see no reason why it cannot boost its margins significantly, simply by stopping hiring. The exact impact of Procore Pay, an initiative discussed below, on margins hasn’t been explicitly addressed; usually new initiatives tend to create a small margin headwind in their first year of commercial activity.
Procore uses stock based compensation. Last quarter SBC expense was 19% of revenue compared to 24% of revenue in the year earlier period. I prefer to look at actual dilution when considering the cost of SBC. Dilution has been running at a bit greater than 3.5%/year. My valuation analysis is based on 147 million shares outstanding
Procore Pay/Procore Fintech
I think one of the interesting opportunities this company has is that of becoming a payment and financial hub for its construction industry clients. This is an opportunity still in its nascent phases and it probably is not going to be of adequate size to proceed the needle in 2024 although some revenues from Procore Pay seem likely.
Procore Pay is I believe, a pretty straightforward opportunity. The construction industry has specific payment practices that can be complex, tedious and very time consuming. The Pay product is designed to settle the many payment bottlenecks and pain points and to get the different parts of the construction value chain get paid promptly. The Pay product was launched in Sept. 2023 and is currently available to US-based general contractors who already use Procore’s Invoice Management software.
The company is offering its tool with two different pricing models that appeal to different market segments. Some of the pricing is usage based. The product has been built in partnership with Goldman Sachs (GS) TxB and Modern Treasury. It is said in the linked article that the construction industry loses $100 billion annually due to delays caused by slowness in documenting, approving and communicating payments. Whether or not $100 billion is a realistic figure, the fact is that half of all construction firms have to expect for almost 3 months to procure payments and that kind of delay is built into the costs of a project. Because of the way the industry has been structured, the construction subcontractors have been forced to fund working capital costs for $900 billion worth of commercial construction. Switching to the Procore technology is expected to produce a dramatic ROI for users and evolve major cross sell opportunities.
This is essentially a cross-sell opportunity for existing customers and the strategy is to drive advance adoption of other Financials products. It is likely to help to drive platform stickiness. So far the company hasn’t forecast the precise magnitude of the revenue opportunity or the expected ramp of revenue from the offerings. The company has indicated that it is likely to take as much as 2 years for a typical GC to switch all of their payment volume to the Procore offering. While it seems likely that Procore Pay will produce some level of revenues next year, avoiding making a specific forecast for this is a prudent approach. Obviously there are a multiplicity of payment alternatives in the construction space, although at the moment, manual processes are used most frequently.
Fairly recently Procore set up a Fintech business under the leadership of its former CFO, Paul Lyandres. This is essentially a pre-revenue undertaking at this point, but one which can potentially change the growth trajectory and business potential for the company. Currently the operation consists of two components, Procore Risk Advisors and Procore Capital. Risk Advisors is focused on providing insurance services and evaluation for its construction customers. 30+ carriers are working with Procore. Procore’s principle advantage in the space is the data it has collected as part of its software business. It has deep domain expertise in terms of the risk profile of its own software customers-data that is likely far superior to that readily accessible by insurance carriers who simply don’t have data access comparable to that of Procore.
The company is also taking initial steps to build a set of financing solutions for its existing software customers. The company has been experimenting with a materials financing offering and has advanced $50 million of capital thus far to sub-contractors based on their purchases of construction materials. And it is evaluating early pay/factoring to cut the extended time it takes for subs to get paid. The company does not intend to use its own balance sheet as a source of capital for these offerings. The company’s major advantages here will be its data and go through in working with potential clients who are already known to Procore as software customers. Essentially, the company expects to earn a commission from banks and other financial resources for both evaluating and arranging financing. To an extent, this is a similar kind of business model that has been pioneered by Upstart (UPST) and Pagaya (PGY) although based on specific customer knowledge as opposed to exclusive use of AI technology as the animating factor in credit evaluation. The potential for this kind of financing is simply enormous-tens of billions of dollars, so the revenue TAM, compared to the present size of Procore is very substantial.
Will it work? how large is the opportunity? and what is the cadence or the revenue ramp.? Evaluating the probability of success for something that has never been done before is always going to be a stretch. Some of these initiatives will work, some won’t and some will be altered as the company experiments with the opportunities. There is certainly nothing in the company’s forecast either for this current quarter or for 2024 reflecting any material contribution from Fintech. I imagine the pay solution will see some uptake over the course of 2024 but it is not likely to be material.
It would be nice to be able to say with any conviction whatsoever that these two initiatives, i.e. Pay and Fintech, will add a given percentage to the company’s growth, with a certain gross margin and a certain contribution in terms of operating margin development. It would be nice, but not terribly realistic given the nascent state of these offerings and the lack of comparables. I view the initiatives as lagniappe, something extra in terms of opportunity, but nothing that can or should be quantified at this point. The concepts make sense, the market is there, and Procore has some significant advantages. Execution will be the key to success and cadence will be a function of the success of go-to-market strategies and hitting appropriate price point.
Wrapping Up: Reiterating the case to buy Procore shares
Procore is a dominant factor in what is a dusty corner of the enterprise software space. While the company obviously does offer a significant construction management capability specifically, it has differentiated itself from alternatives by developing a platform that includes software to handle preconstruction activities, software to improve the procurement and payment for construction materials, invoicing and much beside. Procore at this point is a true platform company, a capability it has and developed and which most of its competitors do not offer. It seems likely to continue that differentiation compared to most of its competitors for the foreseeable future.
The company has a variety of initiatives in a business segment relating to payments and invoicing in the construction industry and is developing offerings to finance construction activities including the procurement of construction materials and the ability to factor and procure payment for receivables in a timely fashion. This seems likely to accelerate growth considerably over the coming years, but will not be much of a factor in revenues through 2024.
The company has a “copilot” AI offering that should be in general availability in the next couple of months. It is not part of the company’s forecast at this point, and it makes sense to avoid considering Procore Copilot until 2025.
The company’s growth had been defying gravity for some quarters; when it announced results last month it reduced its revenue growth expectations for the current quarter and for 2024 to the low 20% range. This is entirely a function of macro headwinds and not a function of changes in the competitive environment or some change in the long term growth trajectory for construction industry software.
Despite the growth slowdown, the company is expecting to continue gains in free cash flow margin/per share, the metric the CFO has said will be his focus going forward. I have used a free cash flow margin calculate of 8% over the next year based on the specifics discussed in the latest conference call. It could potentially be a couple of hundred basis points higher, depending on the exact trajectory of its Pay initiative and its ability to advance constrain expense growth.
Procore, according to customer reviews, has an excellent reputation in the industry and its platform approach and specific product offerings seemingly have provided it with competitive differentiators that have allowed it to gain share. I expect that trend to continue, and the combination of fintech and a platform has the potential to guide to significantly augmented revenue growth-drag is the term most often used.
I think the de-risking of estimates, and the concomitant reject in Procore’s share price provides readers with an attractive entry point. The company isn’t the absolute cheapest valued investment in the software space, and it has yet to approach the regulate of 40 metric. At this point, the company’s valuation is close to average for a company with a three year CAGR in the high-20s range coupled with a current free cash flow margin of about 8% rising significantly over the next several years.
In considering investment in the IT space at this point, I think those with an already de-risked forecast probably have greater percentage appreciation than companies which are still defying gravity although that needs to be considered on a case by case basis. I believe Procore shares deserve inclusion in a high growth IT portfolio based on relative valuation, rising margins and the potential lagniappe of its Fintech and payment products.
