What’s the Fool’s “little-known stock quietly dominating the social media space”?

We got yet another little teaser pitch from the Motley Fool’s “Investor Digest” email over the weekend that has generated some interest from Gumshoe readers…

“There’s a little-known stock quietly dominating the social media space. And we believe it has the potential to mint savvy investors a fortune.

“You see, this company has returned 102.1% to early investors since The Motley Fool recommended it in August 2020!”

So… what are they talking about? Let’s check out some other clues…

“… this company excels is in providing social media damage control….

“When unhappy customers rant on Twitter, Facebook, or YouTube, this company allows brands to address customers concerns quickly and easily before it goes viral.

“It helps companies mitigate risk, and brands worldwide love them for it!

“The stock has more than 25,000 brands and organizations as clients globally and generates more than $158 million in recurring revenue per year!”

And where do they get that 315X number? By assuming that somehow this company will become a monopoly….

“… the company believes that its total addressable market is $50 billion. Now, when compared to its $158 million in annual revenue…

“Well, our analysts believe we’re still in the early stages of a potential 315X growth opportunity!”

What’s the stock? This is, sez the Thinkolator, Sprout Social (SPT), which has been teased by the Motley Fool before — they pitched it as one of their “Trend Spotter” picks last August, which must have been right after they first recommended it (it was not disclosed as a “recommended” stock as of August 5, but is now).

And yes, the stock has roughly doubled since they teased it in August of 2020 — it was in the low $30s at the time, now it’s in the low $60s. The shares did have the same crazy peak in February as many other tech stocks, but have held up reasonably well since, down about 25% from those highs while some of the sexiest similarly-valued stocks in that “20X sales” valuation cohort have fallen substantially more — and unlike a lot of other tech stocks, it’s still up quite a bit year to date.

Sprout Social had $143 million of revenue over the past four quarters (they just reported their March quarter two weeks ago). As with most Cloud/SaaS companies, they focus more on ARR than on trailing revenues (that’s annualized recurring revenue, the amount they are currently pulling in based on their current subscriptions/contracts), and that number is, as teased, “more than $158 million” — it was $157 million at the end of the fourth quarter, and is now up to $172 million.

Many investors will use that as the basis for their valuation, assuming they see growth potential and either a profitable business or a business that can clearly become profitable if they remain on their current trajectory. So on that basis, with Sprout Social right now you’re buying a company that has trailing revenue growth of about 33%, and you’re paying 19X ARR to own a piece of it.

And they have been improving their margins as they’ve grown — the gross margin has stayed very steady, it costs them about 25 cents to provide a dollar worth of services, but the overhead and R&D expenses have slowly shrunk as a percentage of revenue, from 109% a year ago to 90% now, so there’s a pretty clear trend toward profitability. Analysts see that taking a couple years, which would effectively mean that they’ll be profitable once the business has doubled from here.

The real question, I guess, is whether Sprout can effectively be the leading platform for social media management for large companies. They are the biggest pure-play company in that space, and the Motley Fool tends to really buy into “first mover” companies, so I can see why this would appeal… though I am not an expert on the competition, so perhaps I’m missing some large companies that offer similar (or better) services. They do have a lot of customers, 28,000, so that’s a good endorsement, and they say they can acquire customers at just a sixth of the long-term value of those customers, so their investments in growth seem likely to be worthwhile… but as with other cloud providers, I think the number of large customers is probably the most important indicator. The metric they use is the customers who spend more than $10,000 a year, and that cohort has grown now to 3,514, up by almost 50% in the past year.

At my first glance through their numbers, it looks to me like they do not publicize their dollar-based net retention or their overall customer retention rates, which strikes me as slightly unusual for a SaaS company, and makes me a little suspicious that perhaps those numbers aren’t great… but that may just be some cynicism creeping in, or maybe I missed something in their filings. The growth has been very solid and they do indeed claim to be reaching just 3-5% of their total addressable market… and certainly social media continues to bring both headaches and opportunities for brand-conscious corporations, so they may well have a strong future if they can solidify this position as the go-to “platform” for managing a company’s social media presence. And they do a nice job of selling the story in their Investor Presentation.

So… 30-40% growth in ARR, will probably be profitable in a couple years, emphasizes growth in their larger customers, believes itself to have a huge addressable market, and currently valued at about 20X ARR. Sound familiar? Yep, that’s the blueprint for pretty much all of the highflying cloud/SaaS stocks of the past year.

And unless they do something crazy, that’s probably the most meaningful risk for Sprout Social right now. They’re valued similarly to other small-to-midsize cloud providers like DocuSign (DOCU), Avalara (AVLR), PAR Technology (PAR), Twilio (TWLO), etc. (there are dozens of them, those just come to mind because I own or have recently looked at them). That may be justifiable in the long run, there’s clearly something very appealing about a company with strong growth and “sticky” cloud subscription revenue, particularly if it’s small enough to have a huge potential runway of future growth and a lot of different ways in which they could surprise us with new growth… but we should probably keep in the back of our minds the fact that even really popular stocks have almost never traded at this rich of a valuation before. These rich valuations might hold, and they might soar higher still, but there isn’t a lot of historical precedent to lean on in predicting htat.

Which means that if markets fall and investors lose their lust for those kinds of stocks, as we’ve seen to some degree over the past three months, they’re likely to all fall together even if their operations continue to chug along more or less as expected. (The reverse is true as well, of course, if we go back to a market that wants to buy Shopify (SHOP) at 50X sales, then maybe we’ll see the lesser folks get back to 30-40X sales again… but people don’t generally worry much about their stocks shooting up too fast, it’s the drops that feel painful.)

That’s about all I’ve got on Sprout Social — interesting company, not sure how defensible their niche is, great growth, rich valuation… and a judgement call that I’ll pass along to you. It’s your money, so do you wanna buy it? Let us know with a comment below.

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Disclosure: Of the companies mentioned above, I own shares of DocuSign, Avalara, PAR Technology and Shopify. I will not trade in any covered stock for at least three days, per Stock Gumshoe’s trading rules.

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