Rapid7: Positive Profitability Improvements, Stock Appears Fully Valued

seekingalpha03-28

Rapid7's stock has underperformed and been volatile, currently down -10.3% YTD.The company's fundamentals are decent, with non-GAAP profitability and operating cash flow improving.Rapid7 aims to focus...

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I have covered RPD a few times in the past. The most recent one was last year in June 2023, where I rated the stock neutral due to relatively unattractive risk reward. With RPD only seeing 7% upside since my last coverage, I believe I made the right call. YTD, the stock has underperformed and been relatively volatile. Having trended upwards and reached a YTD high of $61 towards the start of the year, share price has continued to trend lower since. Today, RPD trades at $49, down -10.3% YTD. I maintain my coverage with a neutral rating. My 1-year price target of $48 suggests that the stock appears fully valued today, considering the current trading price of $49. Financial Reviews YChartsFundamentals are decent. RPD’s growth has declined from 25% - 30% in the last few years to just 13.5% in FY 2023, but operating cash flow (OCF) has grown significantly. RPD generated over $104 million of OCF in FY 2023, a massive improvement from five years ago, when RPD still burned through $1.4 million of OCF. Over time, this has helped RPD maintain a steady liquidity position. In FY 2023, RPD’s liquidity stands at over $380 million. If RPD can maintain its uptrend in OCF generation, it should also be less reliant on external financing going forward, in my view. Over the past five years, RPD has primarily relied on debt issuance to boost its liquidity. RPD mainly used its cash for acquisitions and debt repayments. company presentationThough RPD has been unprofitable from GAAP standpoint, net loss margin has been steady around -20% level. However, I believe RPD can do better to drive GAAP profitability, in my opinion. Looking at the considerable non-GAAP operating margin expansion since 2021, there is an indication of a high level of share-based compensation / SBCs across operating expenses. To improve GAAP profitability, RPD may need to further reduce its SBCs. Catalyst Based on its guidance, RPD will aim to focus on a profitable growth strategy for 2024. RPD has provided a revenue guidance of $848 million to $856 million for FY 2024, which implies a slower growth of 9% to 10%. However it will also expect to deliver around $160 million of free cash flow (FCF). In 2024, I believe the continued trend on IT security tool consolidation should serve as a key catalyst that supports RPD’s objectives for FY 2024. I believe the trend will be manifested in the stronger ARR per customer, driven by the reorientation of RPD’s sales team towards consolidation-focused customers. company presentationOver the past five years, RPD has delivered a 13% CAGR on its ARR per customer. Though ARR per customer saw a slower growth last year possibly due to weak IT spend environment, RPD has continued to maintain a decent uptrend. I believe RPD will continue to see an uptrend here in 2024 as it executes its consolidation-focused sales strategy. Effectively, higher ARR per customer may not only help growth, but also translate into potentially longer multi-year contracts and larger deal sizes, which drive FCF generation.   votiroThe interest in IT tool consolidation among corporates has been increasing since 2020, which I believe could be started by the pressure to optimize overall cost structure due to broader demand shock during COVID 19. The survey done by Gartner pointed to an already relatively high share of organizations (75%) looking to consolidate their IT security tools in 2022, compared to just 29% in 2020. I believe the figure will continue to increase in 2024, signifying future demand for further consolidation. Aside from the obvious improvements in efficiencies that should help reduce IT spend, I believe the demand for IT consolidation may also be driven by several other external trends, such as the increasing difficulties in hiring key talents to manage complex cybersecurity threats. A report by CBRE suggests that the growing demand for cybersecurity talents has outpaced the supply of adequate talents. This makes it sensible for organizations to consolidate a number of cybersecurity tools into fewer ones and then put them under the monitoring of fewer, but qualified cybersecurity professionals: Over the past 10 years, the 115% increase in the U.S. cybersecurity workforce has not nearly kept pace with an 855% increase in job openings for these workers, according to labor analytics company Lightcast. This sizeable supply-and-demand imbalance creates challenges for employers when scaling their cybersecurity workforce, making a thoughtful location strategy essential to any employer seeking to hire and retain this type of talent. Source: CBRE. Risk Though the consolidation trend remains strong, I believe the drawback could be the potentially longer sales cycle on new clients.   company presentationIn Q4, ARR growth from new clients is already slower than expansion growth, even as revenue contribution from new clients was relatively minimal, implying that RPD started with a smaller base. In FY 2023, for instance, revenue increased by over $92 million, but only $2.2 million of that, or just around 2%, actually came from new customers. Moreover, based on the CEO’s comment regarding the demand environment, there seems to be a good possibility of the market remaining conservative when it comes to IT spend. Accounting for the expectation of lower sales and marketing spend as a % of revenue for FY 2024 to drive margin expansions, I may foresee RPD delivering lower-than-expected revenue growth in the worst case scenario, effectively pressuring share performance: Yes, yes. So here's what I mean by noisy. When we talk to CISOs and security teams, we see plenty of demand, like there is plenty of demand. What's been noisy is if you look over the course of last year, there was different points in times where people were having trouble getting those projects funded versus not. And so we don't see a problem in actually security demand. Source: Q4 earnings call. Valuation / Pricing My target price for RPD is driven by the following assumptions for the bull vs bear scenarios of the FY 2024 projection:  Bull scenario (50% probability) assumptions - I expect RPD to achieve an FY 2024 revenue of $856 million, a 10% growth, in line with the highest end range of the guidance. I assign RPD a forward P/S of 4.7x, implying share price increase to $53.6. In this scenario, I would expect RPD to continue benefiting from the consolidation trends. Bear scenario (50% probability) assumptions - RPD to deliver FY 2024 revenue of $840 million, missing the low-end range of the guidance by $8 million. In this scenario, I expect RPD to see a correction to $42.5, driven by potentially longer sales cycle and lingering uncertainty on decision making on IT spend.    Own AnalysisConsolidating all the information above into my model, I arrived at an FY 2024 weighted target price of $48 per share. Since RPD is trading at $49 today, the stock appears fully valued. I give the stock a neutral rating. Conclusion RPD should continue to benefit from tool consolidation trend, potentially driven by the pressure on IT spend and the lack of adequate talents to highly specialize on specific areas of cybersecurity. On the flipside, there may still be lingering uncertainties in the market today in regards to funding cybersecurity projects, which could present a potential headwind for RPD in FY 2024. My 1-year target price model, which projects a price per share of $48 at full year’s end, bakes in these assumptions and suggests that the stock appears fully valued. 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