Semrush Holdings: Splendid 3Q23 Results Provide Optimism For Near-Term Growth (NYSE:SEMR)

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Investment overview

I give a Buy rating for Semrush Holdings (NYSE:SEMR) as I expect the business to continue growing at 20% for the foreseeable future, driven by its price increase strategy and driven towards the upmarket (Enterprise level). I also believe the stock’s valuation should gradually improve as SEMR improves its profitability relative to peers.

Business description

With the help of SEMR, businesses and individuals can increase their online presence and garner better insights into current market trends. Simply put, SEMR enables the user to zero in on his or her ideal customers and then reach out to them through the best channels. To do this, SEMR makes use of in-depth analysis and market trends to advise companies on how to increase the quantity and quality of their online visitors. Because of this, businesses can gauge the success of their digital marketing campaigns and provide highly personalized content to their customers. Looking at the financials, I view SEMR as a fast-growing company, as it has more than tripled its revenue base since FY19. Not only is the company a fast-growing one, its gross profit margins have also expanded along with the strong growth (from 75.5% to 82.7% in the LTM period), which is a very healthy indicator of the business’s financial performance as it means high profitability over the long run. Given the strong growth rate, I believed it was reasonable that the business continued to reinvest in the business, which can be seen in the growing sales and marketing expense line, which has put pressure on the business EBIT (which remains in the negative region despite the revenue tripling). SEMR also has a strong balance sheet, which allows it to continue making these investments as it has held a net cash position ever since it became public (current net cash position of $219 million, with $230 million in cash and $12 million in debt).

3Q23 earnings results were splendid

Total revenues rose by 19.6%, or by 30bps faster than in 2Q23, thanks to successful cross-selling and up-selling as well as a price increase experiment. See the 3Q23 earnings transcript here. Gross margins expanded 230bps vs. 3Q22 to 83.5%, largely driven by continued robust revenue growth (sustaining at ~20% levels) and operating leverage (non-GAAP operating expenses remained at around $60 million while revenue grew ~20%). Non-GAAP operating margins were 8.8% higher as a result. Notably, this is SEMR’s first profitable quarter according to GAAP standards since 1Q21, when it posted operating income of $2.7 million. As a result of this stellar performance, adjusted EPS came in at $0.06.

ARR growth remains at a healthy level

I keep a close eye on ARR as a leading indicator of SEMR because it is a major metric. 3Q23 ARR growth was 21%, up from 20% in the previous quarter, and net-new ARR was $20.4 million, up 38% year-over-year. However, to be fair, 20% of the net-new ARR growth is attributable to the price increase implemented (discussed below). If I were to adjust for the price increase, 3Q23 ARR would still grow at 19% (a marginal drop from the previous quarter). I am confident that SEMR should be able to sustain this ~20% growth level in the near term, as I am optimistic about its pricing strategies and product launch in the Enterprise space, which should translate to 20% revenue growth (ARR and revenue growth mirrors each other as shown in my analysis above).

Positive reaction from price increase should support growth

Although it hasn’t yet been implemented across its entire install base, management talked about a price increase that primarily affected net new bookings. The key thing to note here is that it has not been rolled out to the existing base of customers, which is the root of my optimism about the near-term growth prospects. While management has not given an exact timeline for when this will take place for the existing base of customers, I believe the impact should start to surface in FY24. This is my opinion, and it is based on positive results from a test of price increases conducted by management on a subset of customers. It appears that the price increase has not caused a significant decrease in adoption, as both net adds and retention have continued to perform in line with management’s expectations and recent trends. I view the result very positively and believe this reflects the value of its offering as well as the customer’s willingness to pay for the solutions and benefits that SEMR offers.

If SEMR keeps adding value to their products, I have faith that consumers will be willing to pay a higher price for them. Take the recently launched Enterprise Edition product as an example. Management commentary highlighted the significant opportunity Enterprise provides to increase ARPU, with Enterprise accounts expected to generate 10x–15x the average ARR per customer. Notably, the product received positive feedback, and it has already attracted a number of customers. These are very encouraging early responses, which give me insight into the potential increase in ARPU and ARR per customer as SEMR works to refine and popularize the product.

But enterprise provides a meaningful opportunity for us to inflect ARPU upwards. And on average, we expect our enterprise accounts to generate 10x to 15x our average in terms of average ARR per customer. So it’s a great opportunity for us – 3Q23 earnings presentation

Importantly, as SEMR continues to gain traction in the upmarket, their new enterprise product offers features that cater to their more sophisticated clientele. These features include customizable dashboards and sophisticated workflows that automate labor- and resource-intensive tasks. While this is a new avenue of product development for SEMR, aside from the potential ARPU step-up, I also see this as a very positive initial step to expanding the addressable market and also making the business more diversified across SME and large enterprises.

Valuation

Based on my research and analysis, my expected target price for SEMR is $10.73.

• Revenue should grow by 20% for the modeled period, supported by price increase and increase adoption of its newly released enterprise module
• While I did not model GAAP EBIT as it is not a meaningful valuation metric yet, it should continue to increase as revenue grows in this 20% range. This will be a critical metric to monitor, as I believe it determines when the valuation gap vs. peers will close.
• Stock is currently trading at 2.8x forward revenue, and I expect this to gradually move upwards towards peers such as Trade Desk and DoubleVerify, which are trading at 13x and 7x forward revenue, respectively. I believe the valuation gap mainly stems from the difference in profitability, where peers are operating in the 7% to 13% EBIT margin range and SEMR is barely profitable so far. As such, I modeled a marginal improvement to 3x forward revenue

Risks

1. Price increase risk: SEMR has decided to conduct a price increase initiative, which is a positive thing from my view. However, I should also note that the feedback so far is from a small cohort, which might not be representative of the entire customer base that SEMR has. In a bearish situation, the price increase might cause customers to churn and reduce the rate of SEMR adoption, thereby slowing growth
2. Macro risk: SEMR growth is in some ways tied to the health of the economy as it relies on businesses that require insights to marketing to adopt its solution. If the macro situation worsens, businesses might reduce marketing expenses to keep their lights on, which will impact SEMR growth

Conclusion

In conclusion, SEMR demonstrated splendid 3Q23 results. The feedback from the recent price increase is very positive and I expect it to flow through to the existing customer base. The release of the Enterprise Edition product also signifies promising opportunities for increased ARPU and a diversified market presence. The business should be able to continue growing at the current level of ~20% for the foreseeable future.