HubSpot’s Valuation Is Outstretched, Leading Me To Downgrade This Stock (NYSE:HUBS)

Introduction and Investment Thesis

HubSpot (NYSE:HUBS) has been on a tear since it last reported its Q3 FY23 earnings on November 8th, 2023. That company reported a strong quarter in its Q3 quarter while also boosting its full-year FY23 guidance on top-line and bottom-line estimates. The optimism portrayed by its management improved the sentiment for the stock, which has rallied ~38% since the Q3 earnings call, outpacing the S&P 500 Index by three times the pace, as I have noted in the chart below.

However, I believe that the valuation is severely extended at the moment, limiting upside for the stock. For reasons that I will further elaborate on in my post, I rate this stock currently as a SELL.

About HubSpot

HubSpot is best known for providing holistic Customer Relationship Management (CRM)-based cloud software that enables online businesses to manage the full lifecycle of their customers, from acquisition to conversion, engagement, and support. The company mainly caters to mid-market businesses by helping them acquire and lead their clients’ customers effectively through the sales funnel into full conversions. HubSpot offers its products and solutions via their CRM platform that allows its mid-market clientele to choose between one or more product hubs on the CRM platform: their core CRM hub, Marketing hub, Sales hub, Service hub, CMS hub for content management services, and Operations hub.

As per the most recent 10-Q, the company counts over 194K enterprises as its customers, which grew by 22% YoY. HubSpot focuses on acquiring its own clients via a combination of freemium-based sales, inbound sales, as well as sales from its solution partners.

In terms of its revenue model, HubSpot follows a subscription-based revenue format. In this post, I will examine HubSpot’s target market and use a top-down approach to evaluate HubSpot’s prospects.

The good: Growing TAM along with robust product innovation

While reviewing HubSpot’s Analyst Day presentation and other management commentary, I observed that management has expanded its product offerings by deploying AI capabilities into its hub-based CRM product platform that I described in the earlier section. I have added a slide below that illustrates how HubSpot’s AI offering, Smart CRM ties into and unifies its existing product portfolio.

In fact, when asked to talk about Smart CRM on the Q3 earnings call, HubSpot CEO Yamini Rangan mentioned that Smart CRM increases productivity and efficiency, but by separating the value offering of Smart CRM, the AI product offers the differentiated value of unified customer records for HubSpot’s clients. To me, this seems like a smart approach because it gives existing customers a way to expand product usage by using Smart CRM while also expanding the target market size for HubSpot.

Per the Analyst Day presentation, HubSpot’s current estimate of its target market stands at $51 billion. When accounting for market augmentation from its AI products, HubSpot’s target opportunity should grow at a CAGR of ~9%. As per the consensus estimates, HubSpot is projected to grow its revenue by 24% YoY to $2.15B. If HubSpot were to achieve their revenue targets, that would indicate 4.2% market penetration. From here on, if the company grows its revenue in the high teens between now and FY28, HubSpot will generate ~$5B in revenue in FY28. This would translate to a market share of 6%, which is 2% higher than now. In my view, this additional gain in market share will be achieved from the company’s AI product usage, which the management is expected to expand throughout the year.

The bad: Macroeconomic uncertainty, outstretched valuation & competitive landscape

Despite the economy being resilient through FY23, uncertainty still persists in certain pockets of the economy, especially among small and medium-sized businesses. I had mentioned earlier how HubSpot’s primary focus on its target market is medium-sized businesses. Any volatility in the economy affects spend patterns for small and medium businesses, which will also act as headwinds for HubSpot as its clients optimize spend on HubSpot’s platform. As of the last earnings report, management noted that the environment continues to be murky. They also pointed out that they expect to continue to see similar trends in H2 of FY23 as they saw in H1 of FY23. I have added an excerpt below:

It’s not gotten better and it’s not gotten worse. And when we are looking at our pipeline and we have conversations with customers, we see more decision-makers involved in the process, more budget scrutiny, continued optimization of spend. Deals are definitely closing, but it takes more conversations, more demos and more time.

Similar trends were also later reflected by Salesforce (CRM) in their earnings call, one of HubSpot’s competitors in the CRM space, where Salesforce’s management mentioned that they “did continue to see the macro trends affect our business, in particular, our professional services business.”

Moving forward I will be monitoring if management has seen any improvement when they discuss their full-year FY23 results in the upcoming call on February 14th, next week, and what their macro outlook is for FY24. So far, there have been no updates from the company, nor has the company participated in any tech conferences since its Q3 earnings call.

For now, I will assume growth will continue to slow to consensus expectations of around 18% in FY24, while expectations project the company’s EPS to grow ~17% this year. Currently, HubSpot trades at a forward P/E of about 94, which in my opinion is too high given the projected growth rate in FY24 as per consensus estimates.

Nevertheless, while looking over a five-year horizon, I believe that the stock’s valuation is far extended, leaving no room for upside for a long-term investor. Let me explain. For the purpose of my valuation, I will assume the company will grow at an average annual growth rate of 18% over the next 5 years. As the management has pointed out during their Analyst Day, they expect to streamline operating expenses and improve non-GAAP operating margins from 14% in FY23 to 20–25% in their long-term operating model. In my valuation, I will assume that HubSpot will be able to expand its non-GAAP operating margin to 22.5% by FY28. In this case, HubSpot will be growing its earnings by 27–28% annually every year over the next 5 years, faster than revenue growth.

With these assumptions in place, I believe that HubSpot should be trading at a forward price-to-earnings ratio that is 2x the S&P 500’s forward price-to-earnings ratio. As per FactSet, S&P 500 companies grow their earnings by 8% over an average period of 10 years, with an average forward price-to-earnings multiple of 15–18. In this case, HubSpot should deserve a forward price-to-earnings multiple of 34, as it sees its earnings growth mature and trend more or less in line with revenue growth as the company realizes the full potential of its operating leverage. This would translate to a stock price of $462, which represents a downside of 23% from current levels.

In addition, I also see that competition is fierce in the CRM industry, which may add downward headwinds to HubSpot’s target market. HubSpot faces competition from some deep-pocketed players such as Salesforce, Microsoft (MSFT), and Adobe (ADBE), as well as newer players such as Freshworks (FRSH) and Klaviyo (KVYO). Were any of these larger players to make further advancements in HubSpot’s mid-market customer segment, it would lower the prospect of HubSpot’s growth trajectory.

Conclusions

While HubSpot is an impressive company with a noteworthy suite of products, the top dollar investors currently pay in terms of valuation multiples to invest in HubSpot today is not justified, per my analysis. I expect to see a drawdown in the market capitalization of HubSpot soon and rate this stock as a SELL.