GitLab: Four Reasons To Buy (NASDAQ:GTLB)

Since its October 2021 IPO, GitLab (NASDAQ:GTLB), the cloud-based DevOps platform that helps software developers share their code and collaborate on projects, has lost around 47.5% of its value while the S&P 500 has gone up by more than 17% during the same period.

One of the reasons for this underperformance is annual revenues have increased but at a slower pace since 2021, it is loss-making and has been consuming cash in operations. However, progress was made on cash flow generated from operations and profitability in the fiscal year 2024 (FY’24). Additionally, thanks to three growth drivers for FY’25, this thesis aims to show that it can perform better than guided during the fourth quarter (Q4) results in March.

To start with and given its inability to sustain growth, I provide insights into how the company is adapting to this highly competitive space, one filled with giant cloud service providers enhancing their product offerings through artificial intelligence.

Maintaining A Leadership Position in a Competitive Industry Despite Facing Giants

Initially known as the main competitor of GitHub, which was acquired by Microsoft (MSFT) in 2018 for $7.5 billion, the company also competes with Atlassian’s (TEAM) Bitbucket. These three companies have been named as leaders in Gartner’s Magic Quadrant in an industry also including International Business Machines’ (IBM) RedHat, Alphabet’s (GOOG) Google Cloud Platform, and Amazon’s (AMZN) AWS, just to name a few as shown below.

For investors, the DevOps concept promotes collaboration between two professions that tend to work separately, the software developer (Dev) and the admin in charge of IT infrastructures (Ops). Traditionally, the Dev team designs applications before delivering them to Ops for deployment in the production environment. However, most of the time things do not work as intended as often a software code that worked well in the developer’s environment ends up facing challenges in production, causing repercussions on application delivery.

This is where companies like GitLab fit in, proposing the DevOps approach through platforms to help break the communication barrier between Dev and Ops and ensure that the two teams work together with other project stakeholders. Now, with its gross profit margins of nearly 90%, GitLab’s platform approach has enabled it to deliver subscription services to the IT community while maintaining costs of sale very low. However, EBIT margins are negative for this loss-making company and show that operating expenses (including marketing efforts) remain relatively high. This makes it important to dive deeper into the competition to extract factors that can differentiate it.

In this respect, a comparison on Marker.io which rates these three leaders according to ten criteria including code repository, security, bug tracking, and other features finds them to be more or less of the same strength except for the platform side where GitLab is credited with having an extensive one. Moreover, when the comparison was made in April 2023, only Microsoft boasted an AI-powered feature, but things changed in May last year when GitLab released its intelligent DevSecOps platform. The “Sec” stands for security compliance, a key feature considering that there may be flaws in the software development process that can constitute vulnerabilities, which hackers can exploit.

The 3 Growth Drivers including Duo AI Chat

Subsequently, GitLab went a step further in AI integration with the launch of Duo Chat, which is also relied upon as one of the growth drivers (table below). That was last month and the tool distinguishes itself by its ease of use and improvement of software development times while also emphasizing the security aspect.

Looking across the industry for potential product differentiation for AI-assisted software development, GitLab’s Duo had the most features according to Omdia Market Radar. This is important for obtaining product traction and may be why it was selected by companies like NatWest, Ultragaz, and Magic Leap as shown in the table below.

In addition to Duo AI Chat, the second growth driver is security and compliance. This ensures safety measures are implemented at every stage of the software development process for protection against malicious attacks and breaches, including adherence to IT standards. Prominent companies that have signed contracts include T-Mobile (TMUS), Southwest Airlines (LUV) and others.

The third is EAP (Enterprise Agile Planning), allowing companies to use the same platform for engineering (software) and planning. In this respect, one 3D modeling company has opted for EAP, and this was at the expense of a competitive product called Jira, according to the CEO. Now, Jira was developed by Atlassian to perform bug and issue tracking and includes Agile Project management.

Therefore, as a leader in DevOps, GitLab is expanding its platform with more features and has embedded AI into its product offering while integrating features like security and planning. Thus, it is a strong player to contend with, ready to tap into the DevOps market which from $9.3 billion at the end of 2023, is expected to be valued at $57.3 billion by 2032, or grow by a CAGR of 20.5%.

Now, to harness these opportunities, the company can rely on its “land and expand” strategy, whereby it wins a new customer by selling one product before upselling (or selling other products). In this way, the dollar-based net retention, which measures the degree to which a SaaS company both retains its customers and derives more money from them (by drive upgrades), was 130% in Q4. This figure was only 128% in Q3, showing a strong customer base expansion.

Deserves Better But There Are Risks

In addition to its growth drivers, the company has raised prices and recruited a new head of go-to-market to focus on the largest customers in regulated industries or those where compliance is needed. This is exemplified by T-Mobile, which operates in the regulated telecom industry.

Therefore, with so many levers, the management guidance of $725 million to $731 million (or a midpoint of $728 million) seems to be conservative. Thus, analysts have a higher consensus estimate of $734.4 million, representing a growth of over 26.6%.

Now, achieving this higher target is feasible after considering the broader picture. In this respect, the executives mention that they are observing normalization in buyers’ behavior and expect their “guidance philosophy to be less conservative this year than in the first two years” as the environment evolves. Noteworthily, this idea of normalization is aligned with Gartner which forecasts IT spending to increase by 6.8% in 2024 with even higher growth of 12.7% expected for software.

Thus, I am bullish on the stock. Another reason is despite its trailing price-to-sales multiple of 14.22x exceeding the median for the IT sector by 384%, it is still 16.86% below its five-year average. Therefore, adjusting for the discount, I have a target of $62 (52.94 x 1.1686) based on the share price of $52.94. This target remains within the $40 to $80 range the stock has been trading since July last year and remains conservative relative to Wall Street’s average of $72.67 but, is still fair because of the risks.

First, the macroeconomic environment remains tough, and inflation and interest rates remain above 3% and 5% respectively. This may result in CFOs remaining cautious with spending, especially if the Federal Reserve does not shift to a more dovish stance later this year. Second, enthralled by the launch of new products, one should not forget that it takes time to build a pipeline and convert it into deals. For this purpose, the executives revealed that they are recruiting sales staff during Q4’s earnings call, which could indicate that the marketing effort to win more customers is still underway.

As a result, the company could miss topline consensus estimates, and, given the market sentiment about the stock whereby it has lost more than 45% of its value since publicly listed, some more risk-averse investors may wait for the management itself to raise guidance during the forthcoming earnings call before investing.

On the other hand, for those willing to take on the risks, GitLab generated $35 million of cash from operations in FY’24, in contrast to consuming money every year since its IPO as shown in the chart below.

This is positive for the balance sheet, which held $1 billion of cash and equivalents at the end of the last reported quarter but, equally important, may reduce the need for issuance of common stock, with a total of $781 million worth of equities sold since 2020, with the bulk ($680 million) effected in 2022.

GitLab is a Buy As It Generates More Cash

For this matter, the operational cash contributed to positive FCF during the last reported fiscal year, with the same expected for FY’25. However, this excludes one-time non-recurring taxes as part of the Advanced Pricing Agreement currently negotiated with the Netherlands authorities and the IRS.

Thus, if it continues to generate cash and consumes the same low Capex or only a total of $11.2 million since 2020, GitLab should continue to deliver positive FCF, and this, without issuing common stock. This should result in the share not being diluted further, potentially contributing to an upside.

In conclusion, in addition to the three growth drivers, improvement in cash generation constitutes another reason to buy the stock, and, is making progress on the profitability front too. In this respect, FY’25 is expected to be the year of break even with non-GAAP operating income of $5 million to $10 million, building on a positive trend seeing losses decrease to $1.4 million in FY’24, down from $87.1 million in FY’23.