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monday.com (NASDAQ:MNDY): Is it worth a premium valuation?
October sees falling leaves-but it also has seen a fall in monday.com’s share price, down by almost 13% since the start of the month, and down by 18% since just after earnings were announced 2 months ago. That compares to a decline over the same span of 6.6% for the WCLD ETF and to a 2% gain for the IGV tech software ETF. (all prices as of 10/24/23 market close). monday.com shares which had been up significantly in the first half of the year, now have a year-to-date gain of less than 16%.
Most recently most asset classes have fallen; the very strong risk-off sentiment has been almost palpable. Investors seem to be focusing on geopolitical issues and are not really focused on individual stocks. Stocks are moving based on war news, apparently, and on interest rate angst.
Much has been written about the valuation of IT shares. To a certain extent the commentary seemingly ignores the extraordinary growth in free cash flow margins which is particularly true for monday.com, but then what seems to this author to be irrational pessimism, most often ignore balanced views of those proverbial glasses-half full is empty, and even what appears to be a full glass can also be considered empty depending on who is doing the considering.
With regards to IT demand, overall, my impression is that there was no material change in growth rates quarter to quarter. Activity remains constrained and there continues to be a high level of scrutiny and deal downsizing when it comes to enterprise IT spending. That seems to be anomalous compared to headlines about employment and retail sales, but I would be surprised for this to be a quarter in which many IT companies choose to be terribly optimistic with their guidance. A lot of beats and reaffirms.
I do expect that monday.com will report a strong quarter. That isn’t because of anecdotal insights, but simply a result of looking at corporate behavior. Just after the end of last quarter the company announced the promotion of Dean Swan to the position of General Manager for the APJ region. Previously Swan and been a regional VP. The company also announced the promotion of Jamison Powell to the position of General Manager of the North American region and the company’s Senior VP of Sales. Previously Swan had been VP of sales of the Americas.
It would be almost unheard of for a company to promote sales leaders within an organization to greater responsibility after the close of a quarter if they had not achieved sales attainment above their prior plan. And the internal plans for sales leaders always add up to more than 100% of a company’s total articulated sales forecast. While APJ is still a small fraction of monday.com’s total revenue, North America accounts for more than half of the company’s customers and a greater proportion of revenue.
About a week ago, the analyst team at UBS, including Taylor McGinnis and Daniela Campo, launched coverage of the workflow management space which includes monday.com (MNDY), Asana (ASAN) and Smartsheet (SMAR). (Just by way of disclosure upfront, I own shares of both Smartsheet and monday.com and recommend them to Ticker Target subscribers in the portfolio I publish weekly.) The analysts maintained in their initiation report that the good news for monday.com shares in terms of superior growth outlook has been priced in. They believe the growth prospects of the space are waning, at least over the coming year, and they wanted to embed some conservatism in their valuation to account for competitive risks to the company’s growth potential.
A few days before the report was published war began between the Hamas terrorist organization and Israel. This is neither a report nor a commentary about the war. I am certainly not enabled with the second sight necessary to determine how the conflict is resolved. Hopefully some of the apocalyptic scenarios that have been publicized will become fiction. But for now, investors are concerned as to how the war might impact monday.com’s operations.
monday.com is physically headquartered in Tel Aviv, Israel. It also has substantial presence in other locations including a significant space in New York City. At the end of last year about 65% of the company’s 1550 employees were located in Israel, with most of the other employees located in North America. Since that time the company has continued to grow its employee count modestly; it was 1,646 at the end of the last reported quarter. Most of the company’s administrative and development operations are based in Israel. The company’s executive employees, other than in some of the regional sales functions, are all Israeli.
On the other hand the company’s largest shareholder is Insight Partners, a VC who owns about 29% of the shares and which is headquartered in New York City and Sonnipe, Ltd., another VC incorporated in the Isle of Man, a UK ruled tax haven, which owns about 9% of the shares. The company has not recently reported sales by geographic location. Its most recent press release indicated that more than 50% of its customers were located in North America, and as they tend to be the largest customers, monday.com’s North American revenues are the majority component of the total. Most of its top customers are American although it has some well recognized large customers headquartered in Japan and in the EMEA region. It doesn’t list any significant Israeli enterprises as references.
Based on read-throughs from other Israeli companies and my interpretation of this posting on the company’s web site, my belief is that operations at monday.com are proceeding normally. There is no indication that any monday.com employees were amongst those massacred in the initial terrorist attacks.
From the company’s Twitter/X post
We unequivocally stand with Israel and its people as the country endures one of the most difficult moments in its history. We are heartbroken by the horrific events taking place and we grieve together with the families who have lost their loved ones, those who are still missing, or held captive. Acts of violence and terror have no place in any society. Driven by our core values and our commitment to action, we are taking all necessary steps to ensure the wellbeing of our employees in Israel, for the safe continuation of our global business operations, and to provide any support we can to the communities affected by this crisis. The monday.com Emergency Response Team together with Digital Lift, our non-profit arm, are working on-the-ground with civil organizations, NGOs, and relevant authorities to assist with crucial tasks like mobilizing aid, managing supplies, blood donation, coordinating transportation, raising funds, tracking missing persons, and keeping communication flowing smoothly. Over 200 employee volunteers are assisting with these efforts to bridge the digital divide wherever possible. We look forward to peaceful days ahead.
We all pray for a rapid end to these hostilities. In the meantime, I think the risks of owning monday.com shares because the company has an Israeli domicile have been exaggerated. No doubt some monday.com employees have been called to the IDF. And other have apparently volunteered for humanitarian roles. But I would be surprised, based on everything I can read, if this has had more than a peripheral impact on the company’s operations. The company has scheduled its earnings release for 11/13/23, pretty much the same date as the earnings release of the prior quarter. This is a reiteration of a recommendation to buy Monday.com shares at this time and at this price.
Why do monday.com shares deserve a premium valuation?
Simply put-a differentiated product portfolio coupled with a rapidly improving business model. When I initially read the UBS initiation report I was surprised that the company talked about commoditization and failed to look at some of the major initiatives that monday.com has taken in order to sustain growth.
This is not another paean to the impact of generative AI on potential growth. monday.com has started to release generative AI functionality and so have its competitors. Generative AI will indeed have a positive impact on the CAGR of the space over time. I don’t think we have enough data to determine how the infusion of AI into workflow management apps is going to change the competitive paradigm. A focus on AI is necessary which is highlighted by the differentiated results of Microsoft (MSFT) and Google (GOOG), but handicapping winners and losers at this point seems premature to me. The link here shows one generative AI use case involving the creation of formulas. This is likely to be more of a game changer as I understand it, then some of the other apps that have been released.
One of the points in the UBS rating of monday.com has been its assertion of slowing growth in the workflow management space. That is probably accurate-at least for the next couple of quarters. I think that the workflow management space has seen slowing growth. There are many reasons why growth has slowed down from the hyper levels of 12-18 months ago. The most salient explanation for the growth slowdown is macro headwinds.
While the linked study here suggests a CAGR of 33% for the workflow management space, I personally doubt that revenues have been growing that fast over the last 2-3 quarters. It appears, based on what I can describe as somewhat random anecdotal checks, that users for this class of software along with many other classes of productivity and infrastructure software tools, have been trying to optimize their spending, thus leading to lower growth for the vendors in this space. I think that will persist for the next 2-3 quarters. I would be surprised if the companies in the space did not indicate that demand growth has been flattish over the last few months. The results of Atlassian last quarter were somewhat of an outlier to this viewpoint, although because of that company’s transition to a subscription model, its underlying growth percentage can be a bit difficult to determine. But Atlassian has already seen slowing growth and one quarter of a snapback is not indicative of a change in overall workflow management demand.
But I do not think the space is becoming commoditized as is suggested by the UBS analysts. I don’t pretend to know all there is about the use of workplace collaboration tools. It is a category that has emerged in the last couple of years and has become essential for the success of many projects, both inside and outside of tech. Workflow management software comes in more sizes and flavors than any Escoffier menu. What works for some organizations is unacceptable for other workgroups.
I am not going to try to evaluate the detailed features offered by the three most prominent offerings in the space-in the section on competition below, I will link to industry analysts who do lay out features and functions of the major competitors. There are literally dozens of features that are of significance to team leaders and administrators using workflow management software and in terms of an investment evaluation, understanding the details of functionality between competitors really will not help all that much.
But that said, monday.com recently launched MondayDB. It actually was formally launched earlier this month with a release schedule that goes through 2024 and into the first part of 2025. So, the revenue impact will build over time, rather than appear as a single step function.
DB is basically the new data infrastructure behind the company’s Work OS flagship. DB is 5X faster, and its initial speed allows the software to load very large boards in 4 seconds. It’s very scalable with 10X the capacity of the precedent products. The product is facilitating monday.com’s push to offer users solutions beyond traditional workflow management capabilities. It can filter large datasets in less than 1 second, it can support custom formulas in automations and eventually it is going to support a wide range of APIs. When it comes to this space performance claims are extensive and contradictory. I don’t want to suggest that MondayDB is some kind of superman software offering. I do think it will create some significant demand tailwinds over time as is the case for most other product cycle releases.
DB is going to significantly enhance the capabilities of the company’s offerings beyond workflow management. The company’s CRM offering will be further extended to more closely match the capabilities of far more expensive CRM offerings. The company has a DevOps product that has recently been rolled out. MondayDB apparently will allow the processes enabled through DevOps to run more rapidly and will be able to track a multitude of projects in a single view.
Within workflow management DB is going to allow for the connection of a multiplicity of projects into a single streamlined view with dependencies said to be unmatched in scale and use. With DB, users will be able to improve the scale and efficiency of integrations and analytics on larger data sets.
This is not a commercial for monday.com, or MondayDB. Its competitors are consistently delivering enhancements. In fact, Smartsheet’s latest version seems to have many equivalent performance enhancements at the same level as those available from monday.com with its DB offering. Not all users are going to want or need the level of performance enabled by DB.
As mentioned, beyond workflow management, monday.comoffers two products that the company’s competitors do not. monday.com Sales CRM is very cheap-just how cheap? The standard edition costs $14/seat; presumably enterprise deployments cost less. Just as a point of comparison, Microsoft Dynamics 365 CRM costs about $20.month, but only if it is one of many Dynamics applications. The foundation for the MondayCRM was the workflow management tool that the company has sold. It has altered that tool substantially so that it now offers the functionality and performance required by most customers in this space. In the last couple of quarters monday.com has begun to offer Sales CRM to about half of the monday.com’s installed base of 180k users.
monday.com dev left beta test at the end of April, 2023. It is integrated into GitHub, probably the most widely used DevOps tool, which is offered by Microsoft. It is also integrated into GitLab, thought by many to be the gold standard in the DevOps space. monday.com dev is not a traditional tool to develop applications. It is really focused on the project management component of the software development process. It has been in gestation for a considerable period. The company called out brisk demand for the product during its last conference call. Given its pricing, which is just $9/mo./seat, I think most of the revenue will be generated from monday.com’s installed base, more in the nature of an upgrade of capability than a completely new sale.
I would stress one further consideration: monday.com’s CRM and DevOps are part of a platform, and MondayDB will improve the functionality of that platform. The platform approach seems to resonate with many users. As of the end of last quarter, 1656 monday.com accounts that had started with workflow management had ultimately bought an additional product-the vast preponderance have been sales of the Sales CRM offering. These accounts apparently were seeing additional users from different functional areas emerge when they buy monday.com’s CRM offering. Presumably the same phenomena will be seen as the DevOps product becomes significant. These days, just about every company worth its salt, talks about their platform offering. In the case of monday.com, even at its relatively small scale, the company actually has a real platform of several offerings and the opportunity to accelerate its growth by selling more products within its installed base.
I don’t pretend that I can quantify the extent of the value of the differentiation. Obviously the potential for cross sells is enormous based on just the size of monday.com’s current user base which was 186k last quarter. The company understandably doesn’t release seat data, but the scale of the opportunity is apparent. The company had almost 1900 customers with ARR of greater than $50k at the end of last quarter which was up 63% year over year, and up by more than 12% sequentially. My estimated 3 year CAGR for monday.com is in the low-mid 30% range, and I imagine that a CAGR of that level will be significantly above the actual growth in revenues of the workflow management space. My expectation is that DB, Sales CRM and DevOps will provide the company with a fertile field to sell new name accounts and to increase the expansion rate of existing users.
What about the macro Environment
This is not an article on the macro environment in which to sell enterprise software. More than few brokerage analysts and economists do write such articles; sadly many of their predictions are not particularly accurate, although of course, some do manage to achieve better than average success in their predictions. And yet having said that, I do have to acknowledge that sentiment is often driven by pronouncements from brokerage analysts. It would be more than a bit naïve to imagine that shares of monday.com, despite anything I might write, or what might be the case in terms of the company’s operational performance, will achieve significant share price appreciation unless sentiment pivots, at least to some extent from its current strong risk-off bias.
A lot of sentiment recently has been driven by the trajectory of long-term interest rates. Most recently high growth IT stocks have moved more or less in lockstep with longer-term Treasury yields. These have ticked up-or at least they have done so until the last couple of days. Their rise, while unwelcome is also not terribly surprising. The federal deficit, as the Fed Chairman has pointed out, is on an unsustainable trajectory. And the Fed is shrinking its balance sheet, i.e. selling bonds at a $95 billion/month clip. In addition, as the Fed Chairman indicated in his speech last Friday, there are other technical factors boosting long-term yields such as an unwinding of the recent yield inversion. Neither shares of monday.com, nor of other high growth IT stocks, amongst many others, are going to show significant appreciation as long as long term rates continue to rise. And I am not about to make some call about long-term rates when many others have made attempts that haven’t worked out all that well. I will simply observe that the high visibility calls of Bill Ackman and Bill Gross earlier this week that suggest that long term rates have reached their apogee resonates with me.
The analyst team at Piper Sandler, led by Brent Bracelin, lowered its ratings on several IT stocks and cut its price target and its estimate on others on Monday, October 23. His thesis relates to 3rd party data, basically SI surveys, showing a demand erosion in September, which may mean that estimates for 2024 are too high. These surveys weren’t particularly centered on monday.com, but on companies such as Datadog and Snowflake. But the ratings he actually lowered were on Salesforce (CRM), Unity (U), Asana (ASAN), Alteryx (AYX) and Matterport (MTTR). He also thinks that users are going to prioritize AI and not buy other categories of software.
This is an article about monday.com, and not the software industry as a whole, or about AI specifically. While the analyst didn’t lower his buy rating on monday.com, he did lower his price target and earnings estimate for the company. Ironically, at least on the day his report was published, monday.com shares rose noticeably making back a bit of lost ground. And the next day, Microsoft reported that Azure usage was a bit above its projections, and that it was seeing strong orders in its commercial space. But the question remains: will macro conditions inhibit growth for companies offering workflow management software? The simple answer is that macro headwinds have already impacted growth rates for all the major competitors in the space. That has been true for Atlassian, for Smartsheet, for Asana and for monday.com as well. Current estimates most recently provided by the companies have all incorporated some element of conservatism to account for negative macro conditions. The quote below comes from the CFO of monday.com.
We still see some pressure with the new customers’ expansion, with mostly expansion with regards to decision makers are brought to the table and longer sales cycles
Top funnel activity remain healthy. We still see a very healthy stream of new customers that joining monday.com, also having in mind the fact that we now have CRM and Monday Dev is out of beta, it definitely contributes to the fact that we are bringing a healthy stream of customers.
In looking at Monday and its growth rate, I think that estimates need to account for both macro issues, but also consider the specific products that the company has launched into the market. Currently, monday.com’s guidance is for growth of about 33% for the quarter it will report next month followed by 30% growth in the final quarter of the year. The published First Call consensus calls for revenue growth next year of 28%. While that is noticeably faster than major competitors in the space (Atlassian projected revenue growth is in the low 20% range, revenue growth of Smartsheet is in the range of about 20% and Asana revenue growth is projected to be about 14%) it also reflects a cautious evaluation of demand, particularly for core workflow management products.
It is more than a bit speculative to try to forecast the revenue attainment for new products that have never been in the market before or are only now being made available to the entire installed base of monday.com. And it is even more difficult to suggest that I or anyone else might have a firm handle on just how the advent of MondayDB will bolster demand for all of the monday.com products on its platform. At least in the short term, the revenue tailwinds from Monday Sales CRM and Monday DevOps are going to be the most visible and significant revenue growth drivers and their continued roll-out gives me confidence that the current consensus revenue growth forecast for 2024 is not at risk, but can readily be over-attained. I have linked to the MondayDB release here; I would be surprised if this wasn’t a major differentiator for the company over time. Of course I don’t want to pose as an expert on the performance of data infrastructure software in the workflow management space, but at the least, DB is a big deal for monday.com and I anticipate that as more of the functionality is released, it will impact the company’s relative revenue growth rate.
monday.com’s business model-another valuation pillar
It has been a few quarters since monday.com turned the corner and started to generate a significant level of free cash. The process is in its early stages and there is still much more to go. Last quarter’s free cash flow metric was unusually strong, and for now, it should be viewed as an outlier. Still, the quarter was the 2nd in a row with strong levels of free cash generation, most of the improvement coming from improvements in operating margin performance.
Last quarter the company’s gross margins rose by about 100 bps to 90% both year on year and sequentially. Non-GAAP research and development expenses were 17% of revenue compared to 22% of revenues in the year earlier quarter. Non-GAAP research and development expense actually fell marginally in dollars last quarter.
monday.com’s largest operating expense category is sales and marketing. Last quarter non GAAP sales and marketing was 59% of revenue compared to 81% of revenues the prior year. Sequentially, sales and marketing expenses fell both on a GAAP and a non-GAAP basis. Even 59% of revenue is an elevated expense metric. How low can it be? Atlassian spends 18% of revenues on a non-GAAP basis on sales and marketing. Of course it has an unusual model in that it spends 41% of its revenues on non-GAAP research and development. I don’t see that kind of sales and marketing ratio even in the far horizon for monday.com to get to that kind of ratio requires a cash cow industry standard product that Jira, Atlassian’s flagship, has become. Smartsheet’s latest quarter had non-GAAP sales and marketing at a 47% ratio, while its research and development spend ratio was comparable to that of monday.com. I think it is reasonable to believe that over time, monday.com should be able to improve its non-GAAP sales and marketing expense ratio another 1000 bps, essentially doubling its non-GAAP operating margin from what it reported last quarter.
monday.com has also made significant strides in remediating its level of general and administrative expense. The Non-GAAP general and administrative expense ratio has fallen to 8.4% compared to 13.6% in the year earlier period. Sequentially, the actual general and administrative spend declined marginally. Overall, on a non-GAAP basis, operating margins went from a loss of 12% to a 9% margin. Sequentially non-GAAP operating margins went from break-even to 9%. Overall, the non-GAAP opex spend fell by about 3% sequentially.
The company’s guidance for expense ratios for the balance of the year is particularly conservative and would require a hiring ramp that seems unlikely. That is particularly true if revenue for the quarter exceeded the $182 million forecast. For operating margins to decline from 9% to 4% as forecast would take a sequential increase of 10%-11% in opex, and that seems quite unlikely given the current hiring cadence.
As mentioned free cash flow has been unusually strong the past two quarters, mainly because of the improvement in GAAP margins. The growth in the company’s deferred revenue balance increased, but that was only a small component of the company’s cash flow progression. Overall, the company’s free cash flow margin last quarter was 28% last quarter compared to a cash burn the prior year. For the first 6 months of 2023, monday.com’s free cash flow margin was 25%, while it non-GAAP operating margin was 5%. It is now projecting a full year non-GAAP operating margin of 4%, despite forecasting sequential growth in revenue of 7% for the next two quarters. I felt that putting together the forecast for revenue growth and margins simply didn’t make a great deal of sense, and in modelling results I used a free cash flow margin for the full year of 23%, or 20% in the 2nd half of 2023.
There is doubtless some uncertainty as to how the current war between the terrorists and Israel might impact expenses. While my best guess is that overall operations for monday.com will be only peripherally effected, it is possible that the costs of some required work-arounds to maintain a development schedule and to keep administrative processes running smoothly might be noticeable. Those costs might minimize the upside I would otherwise anticipate. My guess is that investors have long since incorporated some negative expectations for both expenses and revenue when considering their valuation for the shares. I find that to be an attractive set-up in that to an extent investors are not looking for any kind of significant upside, and yet sales opportunities abound and the company has provided for a substantial growth in expenses in its forecast.
monday.com does use a moderate about of stock based compensation. Last quarter, reported stock based compensation was 16% of revenue compared to 29% of revenue in the year ago period. I prefer, as I usually write, to look at dilution rather than the reported cost of stock based comp.
The company is now profitable, and the accounting convention calls for it to report option shares and RSUs when calculating EPS. This adds about 3 million shares to the share count. Dilution last quarter was about 0.4% or 1.6% annualized. I use a weighted average share count of 52.4 million-that compares to fully diluted shares including options reported last quarter of 51.6 million. .
Wrapping Up-The most differentiated company in the workflow management space
monday.com, in my opinion, is the most differentiated company in the workflow management space, and thus it will continue to outgrow its rivals by a significant amount for the foreseeable future. While growth in workflow management software has apparently slowed down, reflecting both macro headwinds and a growth slowdown in the important high tech vertical, it has probably remained at 20% overall. When the macro environment improves, monday.com, and its rivals will be able to achieve a higher growth rate.
monday.com is growing considerably faster than its competitors because of its forays into product adjacencies such as Sales CRM and most recently DevOps. While still small, these initiatives are adding meaningfully to growth percentages, and seem likely to continue to do so for the foreseeable future. The company also released MondayDB, a new data framework for its applications that will engender substantial cost/performance enhancements and a significant improvement in capacity and functionality.
I believe that the company’s platform approach in which its customers are able to source several solutions for common enterprise problems is just now starting to resonate with users, and is likely to be a significant demand driver for the foreseeable future. While all companies these days talk about a platform product strategy, in workflow management, monday.com comes closest to having the broad range of solutions that users want to acquire from a single vendor. Atlassian, too, has a broad product platform, but unlike monday.com, that is not an explicit component of its sales strategy.
The company has forecast 7% sequential growth for the quarter it will report next month and a further 7% sequential growth for its Q4. It seems likely, based on the promotion of two senior sales execs to posts with greater responsibility, that the company actually exceeded its Q3 targets. I doubt that it will choose to raise Q4 sequential targets based on all of the economic uncertainty in the environment.
monday.com is an Israeli domiciled company and 65% of its employees are located in Israel. While the company is apparently continuing to operate normally, I wouldn’t be surprised if the need to use workarounds for parts of its operation elevated some costs in the short term. But the biggest single cost element for this company is sales and marketing expenses, and those expenses are primarily incurred in North America, and in other non-Israeli geos where sales actually take place.
Since the start of the war against the Palestinian terrorists, monday.com shares, like the shares of many other Israeli based companies have been pressured until the last couple of days. Based on my revenue estimates, and current outstanding shares, the forward EV/S is now about 7.7X.
monday.com has seen an exceptionally strong progression in its free cash flow margins, primarily a function of improved operating margins. Last quarter, free cash flow margins reached 28%, a fairly dramatic turnaround from year earlier cash burn. I have estimated a 12 month forward free cash flow margin of 23% to take account some of the risks inherent in the current environment. The combination of differentiated growth and a significant free cash flow margin has left the shares at a discount to the average valuation of their growth cohort for the first time since I have covered the shares.
I don’t want to suggest that I have a crystal ball with regards to the potential development of an apocalyptic scenario as the current war rages. I simply have no way of handicapping how the war unfolds and finally ends.
I own a position in the shares in the Ticker Target high growth portfolio, and have done so for some time now. I believe the shares will produce significant positive alpha in most scenarios short of a geopolitical catastrophe over the coming year.
