HubSpot Inc. (HUBS, Financial) outperformed both the S&P 500 and the Nasdaq 100 in 2023, climbing nearly 100%. Earlier in the year, I had anticipated the business performance would be lackluster as the macroeconomic backdrop pointed to a slowdown in Europe as well as in the overall small and medium-sized enterprises sector. But HubSpot defied my concerns and had a stellar year.
However, with the stock currently trading at a forward price-earnings multiple of 82, I believe the valuation of the company has gotten extended, which leaves little to no upside at the current price point, given management's financial guidance.
A primer on HubSpot's business model
HubSpot develops and distributes cloud-based software that helps customers acquire users via an intelligent sales funnel. The core objective of the company is to facilitate business growth strategies for their clients that help them acquire and retain customers. HubSpot's cloud platform offers its customers six product hubs that they can use: HubSpot CRM, Marketing Hub, Sales Hub, Service Hub, Content Management System (CMS) Hub and Operations Hub. In addition, it also provides customers with native payment solutions that facilitate e-commerce transactions for their customers while collecting a take-rate per transaction.
While the company's business model is freemium-based, where it allows anyone to use its products for free, the usage is capped for free users, pushing them to upgrade to premium-tier subscriptions. HubSpot makes almost all its sales from subscriptions.
As per its third-quarter earnings, the company grew its revenue by 26% on a year-over-year basis in constant currency. Subscription revenue constitutes close to 98% of all revenue, which also grew 25% on a year-over-year basis. Meanwhile, the GAAP operating margin narrowed from -7.3% in the third quarter of 2022 to -3.7% in the most recent quarter. On a non-GAAP basis, the operating margin improved 700 basis points to 16%. The company managed to beat consensus expectations for both the top and bottom lines by 4% and 28%.
The good: Growing TAM and a robust product portfolio
HubSpot operates in a large and growing total addressable market, with plenty of opportunities to gain market share.
Based on HubSpot's recent analyst day report, the evaluation of its TAM stood at $51 billion. If the company meets its revenue expectation for 2023 at $2.15 billion, the company would then have a 4% market share in its existing TAM. From here on, management projects its TAM to grow at a compound annual rate of 9% to $77 billion by 2028. This assessment encompassed various sectors under their umbrella, including marketing, sales, service, CMS and operations.
While the company has grown its revenue at a CAGR of 33% between 2019 and 2023, revenue growth is expected to slow down to 24% in fiscal 2023, as per management's latest guidance. Consensus estimates from analysts suggest HubSpot's revenue is expected to slow down even further in 2024 as the company is projected to grow its revenue by 18%. While there is still a strong pace of growth, I believe HubSpot's days of an over 30% growth rate are over.
Therefore, if I assume HubSpot grows its revenue by 15% to 18% between 2024 and 2028, the company will generate close to $5 billion in revenue by 2028. This would translate to the company capturing 6% of the market share, relative to 4% today. In other words, there is more room for growth as well as expanding opportunities.
HubSpot has a robust product portfolio and is using a bi-modal go-to-market strategy to land, expand and innovate.
As we move deeper into analyzing HubSpot's revenue, I see evidence of a diversified and robust growth strategy and product portfolio. Its Marketing Hub is growing by 20%. Close behind is the Sales Hub with a 30% growth rate. The Service Hub is showing expansion at a 40% year-over-year rate. Both the CMS Hub and the Operations Hub have growth rates of 25% and an explosive 100%, respectively.
In order to go to market, the company has implemented a bi-modal strategy that allows it to drive volume at the lower end of its customer segment while driving value in the upmarket segment with a multi-hub adoption strategy as customers consolidate on fewer platforms to drive better visibility across marketing, sales and service. Currently, upmarket deals constitute 26% of total annual recurring revenue, but it is growing. Overall, there is still opportunity for multi-hub product adoption, as just 33% of customers are currently on three-plus hubs, contributing to 50% of ARR.
I believe HubSpot's ability to cater to a broad spectrum of businesses, from startups to large enterprises, through a tiered product and pricing strategy ensures a wide market reach. The company's drive toward system consolidation and offering multi-hub solutions responds to a clear market demand for streamlined, platform-centric solutions. As businesses continue to seek efficiency, integration and actionable insights, the company's direction aligns perfectly with these needs. Thus, looking ahead, I expect it to maintain steady double-digit growth and enlarge its footprint in the customer relationship management and marketing software domains.
Further, the company continues to innovate toward artificiail intelligence and refine the sales hub. In the recent earnings call, CEO Yamini Rangan said, “40% of enterprise customers have already used HubSpot AI features, along with 20% of pro customers. About 2/3 of AI users are leveraging AI assistance to craft marketing emails and blogs.”
Most of these innovative tools are set to be available to a wider audience by early 2024. While many of these tools will be available at no cost, HubSpot envisions revenue generation from advanced features through premium user tiers or add-on components.
The bad: An uncertain macroeconomic environment, a ferociously competitive landscape and a valuation that doesn't support the fundamentals
While the outlook for the macroeconomic environment is improving with cooling inflation, there are uncertainties around whether the U.S. will tip into a recession in 2024. If the U.S. economy experiences a sizable slowdown in 2024, it would hurt small and midsize enterprises disproportionately, which is the core market segment for HubSpot. While the company has so far navigated the choppy macroeconomic environment well, the CEO noted in its latest earnings call that the sales cycle has gotten longer as there are more decision-makers involved in the process, more budget scrutin and continued optimization of spend. I am highlighting some of his commentary that I found quite compelling, given the weakness that still persists on Main Street.
"As both I and Kate (Kate Bueker, CFO) said, the environment continues to be choppy and challenging, and customer urgency remains low. More broadly speaking, what we are seeing in the second half as customer trends is very similar to what we saw in the first half of 2023. 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, and continued optimization of spend. Deals are definitely closing, but it takes more conversations, more demos, and more time."
Looking at the commentary and overlaying the company's top-line performance so far, it definitely looks like growth is slowing. Add in management's own expectations of around 18.6% expected top-line growth in the fourth quarter of 2023 as well as the price to forward sales, and my outlook on this stock further weakens, as can be seen below, as investors continue to pay a higher premium despite slowing revenue growth.
In addition, I am quite certain a deterioration in the macro outlook will force the SME customers to consolidate the software products they use to reduce their spending.
The competitive landscape may also threaten HubSpot's TAM. The company operates in quite a crowded space, in my opinion. Since it operates mostly in the SME space, it directly competes with rival marketing software companies such as ZohoCRM, Pipedrive, ActiveCampaign and startups that have recently gone public, such as Freshworks (FRSH, Financial) and Klaviyo (KVYO, Financial), which also cater to SME customers. In addition, HubSpot faces direct competition from another SME veteran, Intuit (INTU, Financial), which has a deep history of distributing software solutions for smaller enterprises. Intuit also offers marketing automation software via its Mailchimp product vertical.
I think HubSpot understands the extent of differentiation it has to drive in its marketing products to stand out from the competition, and so it has recently started to lean in on the larger enterprise space, where the business opportunity to benefit from higher margins and more stable sales cycles is greater. Unfortunately for HubSpot, there are much larger incumbents in this space as well. CRM software behemoth Salesforce (CRM, Financial) and local competitor Adobe (ADBE, Financial) (Marketo and Adobe Marketing Cloud) already have a large hold on market share here. Moreover, most major players in the large enterprise segment have significant resources at their disposal to keep newer entrants at bay. An even bigger risk is that if these large competitors devise a comprehensive platform that's user-friendly and competitively priced, they could appeal to the mid-market segment, intensifying competition and potentially slowing HubSpot's revenue growth.
For the sake of comparison, I have added a chart below that compares the forward price-earnings ratio of HubSpot versus its peers.
Finally, let's turn our attention to HubSpot's valuation. While the company has delivered strong revenue growth and expanded profits over the last decade, I believe it will grow its revenue in the high teens in the coming decade because of increasing competition in the space. The company is currently trading at a forward price-earnings ratio of 87 based on consensus estimates of 17% growth in earnings in 2024.
If we have to benchmark against the S&P 500, the companies in the index are expected to grow their earnings on average by 10% to 11% in 2024. Meanwhile, the index is trading at a forward price-earnings multiple of 20. Under the assumption that the U.S. economy continues to grow moderately as per the Federal Reserve's projections at 1.4%, with core inflation normalizing to 2.4%, the 10-year U.S. Treasury bond yield should remain anchored at 3.8%. Furthermore, I believe it would be fair to assume the S&P 500 earnings will perform as expected if the U.S. economy grows moderately and avoids a recession. Under those circumstances, I do not expect to see a multiple compression for the S&P 500.
Therefore, if we linearly extrapolate the S&P 500's earnings expectations and its forward price-earnings multiple, HubSpot should be trading at a forward multiple of no more than 35 for fiscal 2024. That means there could be at least a 60% downside in the short term for the stock, as HubSpot's stock is currently trading at a forward price-earnings multiple of 87. Another way to look at it would be the current pricing of HubSpot is factoring in the optimism that earnings for 2024 will surprise at least 60% on the upside. The company has been beating consensus earnings estimates consistently by an average of 35% over the last four quarters; however, the current price-earnings multiple of HubSpot is leaving a lot of room for volatility should earnings or forward guidance come in softer than expected.
Looking over a 10-year investment horizon, I believe HubSpot continues to have no upside at current levels. I expect the company to produce revenue in the high teens for the next five years and then slow down to the mid-to-low teens between 2028 and 2033. Given management's track record of continuing to improve operational efficiency as well as its financial guidance provided in the analyst day, I expect non-GAAP operating margins to improve to 18% 5o 20% by 2026 and then to 25% by 2033. This would mean that HubSpot would produce approximately $2.4 billion in non-GAAP operating income by the end of 2033, which would equate to a present value of approximately $1 billion if discounted at 10%, or adjusted earnings per share of $20.
Taking the above assumptions into consideration, I believe the price-earnings ratio for HubSpot in 2033 will be around 30. Taking the S&P 500 as a proxy, where it has grown its earnings by 8% on average over the last 10 years, as per Factset, with a price-earnings multiple in the range of 15 to 18, I believe that HubSpot should be trading at an earnings multiple of 1.5 times the S&P 500 in 2033. This will result in a price target of $550 for HubSpot, looking at a 10-year investment horizon. In other words, the stock does not offer any upside over a 10-year investment horizon at its current price levels.
Conclusions
HubSpot has a lot of good things going for it. It undoubtedly has a rapidly innovating product portfolio that has found a tight fit in the SME market, where customers are increasingly trying to consolidate across fewer platforms to drive visibility across marketing, sales and service. In a tough macroeconomic environment with a slower sales cycle and higher budget scrutiny, HubSpot has managed to deliver on expectations while boosting its profitability at the same time.
While all the growth levers point to double-digit growth for the company over the next five years, its valuation provides no upside at current levels. Whether I take the S&P 500 as a proxy or evaluate its intrinsic value based on a 10-year investment horizon, there is not a reasonable explanation for the level of optimism that is baked into the price-earnings ratio. As a consequence, there is short-term volatility in HubSpot's stock with little to no upside in the long term.
