|Shares Out. (in M):||44||P/E||0||0|
|Market Cap (in $M):||1,152||P/FCF||0||0|
|Net Debt (in $M):||152||EBIT||0||0|
|TEV (in $M):||1,000||TEV/EBIT||0||0|
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SendGrid (NYSE: SEND) is a recent SaaS IPO with a misunderstood growth profile, a unique moat, and an efficient business model. The Company offers 3 products:
Transactional Email API: SendGrid is the largest provider of transactional email services, helping companies send billions of emails to recipients. This is SendGrid’s flagship product (83% of 2017 sales).
Marketing Campaigns: This is SendGrid’s ancillary product, which helps customers manage marketing campaigns for promotional and targeted email (14% of 2017 sales).
Expert Services: In addition to sending transactional and marketing emails, SendGrid provides consultation to customers to help them optimize delivery results. (4% of 2017 sales).
SendGrid has a simple business model based upon self-service efficiency that drives low-cost customer acquisition. Onboarding is fast and affordable. 99% of customers purchase SendGrid through a self-service channel and can start sending mass emails without talking to a service rep. The product is low cost ($9.95 per month for entry level email API) and represents only a tiny fraction of an IT department’s budget. Clients like SendGrid because its product is (i) reliable with 99.995% uptime, (ii) highly scalable, and (iii) extensible whereby SendGrid’s platform can extend beyond transactional email to other functionality (e.g. marketing campaigns). SendGrid has a broad, diversified base of ~69k customers with no single customer representing more than 2% of revenue and the top 10 clients represent only ~10% of revenue. Clients range from small SMBs to large enterprise clients such as Uber, Deloitte, AirBnb, etc.
SendGrid’s business model is highly unique within the SaaS industry because its low touch, low-cost platform is able to attract and retain enterprise level clients without a large salesforce. As such, the Company’s investment in sales and marketing is significantly less than other fast-growing SaaS businesses.
Once signed on, customers rarely leave. I spoke to an email industry veteran recently, who said “Email is like the plumbing in your house. Once installed, you don’t think about it anymore, rarely touch it, and only make changes under unusual circumstances.” I think this is one of the key misunderstandings about SendGrid – the Company reported a churn rate of ~9%; but the vast majority of churn happens within the first 30-90 days because SendGrid actively weeds out spammers/phishers from its own platform, and once this is settled churn rates are actually in the low single digits on an annualized basis.
A low cost, low touch acquisition model combined with best in class customer churn results in industry leading SaaS unit economics. The business has significant reinvestment potential given the large TAM (only 3% penetrated) and attractive unit economics: SendGrid recovers CAC relatively quickly within one year with LTV/CAC >10x.
SendGrid also owns a scarce asset that is essential to maintaining its competitive lead: a large block of IPv4 addresses. The Company has tens of thousands of IPv4 addresses versus other email service providers that just have a couple hundred. To provide some historical context, IPv4 addresses were the very first IP addresses that were available from the start of the internet. There is a limited supply of IPv4 today and the world has run out of these addresses. Broadly speaking, there are two classes of IP addresses (IPv4 and IPv6), but email traffic does not work well with IPv6 and the interconnectivity between IPv4 and IPv6 is weak. Having IPv4 is thus essential for email service providers.
This distinction is important to sophisticated customers to be able to get their own dedicated group of IPs. By having a large block of IPv4 addresses, this allows SendGrid flexibility to segment their IP addresses into different groups for shared infrastructure. Large enterprise clients care a lot about not having the quality of their traffic or deliverability effected by neighbors sending their own email. As such, SendGrid can command a price premium for sending traffic over a dedicated IP address vs. forcing that customer to send from a shared pool. At the same time, other email service providers are unable to provide their customers the option of choosing dedicated IP addresses because they have limited IPv4 addresses in supply (a structural advantage favoring SendGrid).
Mailbox service providers such as Yahoo Mail or Gmail are strict about protecting their users and often apply filters to analyze and block presumed unwanted mail for recipients. In fact, a key reason why some customers switch from one email service provider to another is if the overall email stream gets too polluted from phishers and spammers. This is what happened to Mandrill (shuttered operation in 2016), which had difficulty keeping bad actors off their platform. If an email stream gets too polluted, the bad stream of traffic jeopardizes the delivery of good traffic.
SendGrid is the largest player in the industry, and scale is critical for growing and upkeeping high deliverability rates:
First, the major mailbox providers have limited resources and time to maintain relationships with hundreds of email service providers, so they focus on the largest players. These major mailbox providers oftentimes have a postmaster who sets the rules for the mail coming in and out of the system, and SendGrid would meet with these parties periodically. As such, trust/brand becomes important between the mailbox providers, making email an ecosystem product.
Second, scale improves understanding of senders and mailbox service providers (e.g. Gmail, Outlook), which helps SendGrid better filter out phishers/spammers, improving its attrition and upkeeping its deliverability rates.
Third, by having more scale, SendGrid attracts more developers to build applications on top of its APIs, and through these third-party apps SendGrid can sell to and reach more end users.
Fourth, SendGrid has great customer service (i.e., providing consultation to customers to achieve high deliverability rates). By having the largest volume and deep relationships with the major mailbox service providers, SEND is in a great position because they can provide the most extensive insight to help customers.
There is a bit of the flywheel effect here: The more volume, the more feedback points across different senders and mailbox providers (e.g. Yahoo, Gmail), the better the deliverability rates, resulting in a more efficient product, which leads to a better reputation/brand, which leads to more volume.
SendGrid has several structural advantages relative to the competition that should enable it to continue growing rapidly and maintain its dominant market position, including:
Product Effectiveness: SendGrid has one of the highest deliverability rates in the industry (94% vs. 80% industry average). Contrary to public opinion, sending transactional email in scale is not easy and this trend is becoming more important over time. Transactional emails such as monthly account statements, receipts, password resets, etc. are operationally critical and necessitate high deliverability for senders.
Brand Recognition: A highly recognized brand among the developer community that should continue driving viral email adoption
Scale: SendGrid is the largest player in the industry by a wide margin. The Company processes the greatest amount of volume and more than 2x its next largest competitors.
SendGrid also has a large share of websites among email service providers. Another set of data compiled by Datanyze indicates that based on websites that incorporate vendor APIs, SendGrid has a market share of 25% of >500K websites analyzed, surpassed only by Mandrill (which likely shares its APIs with MailChimp’s core marketing solution so market share could be inflated).
Existing competitors have unique challenges to their business:
MailChimp (Mandrill): MailChimp is scaling back its standalone transactional email product (Mandrill). MailChimp began as a marketing product and then introduced Mandrill in 2011. Mandrill operated relatively successfully reaching 12-15mm users, but in 2016, MailChimp announced it would only offer Mandrill as an add-on feature to MailChimp’s marketing solution. As a result, Mandrill customers needed to create a MailChimp account – making it more expensive. This move ultimately created room for competitors to poach Mandrill’s customers. One of the reasons why Mandrill shuttered is because the Mandrill team had difficulty keeping bad actors off its platform. If an email IP stream gets too polluted, the bad stream of dirty email traffic jeopardizes the delivery of good traffic, and this is a key reason why many customers left Mandrill. Ultimately, MailChimp decided to pull out of a standalone Mandrill offering because they could not further scale and make their business profitable.
Amazon SES: Amazon’s product is lite on features and customer support is poor. Amazon SES operates at the low end of the market. Their deliverability rates are lower than SendGrid, and Amazon often loses to SendGrid when competing for enterprise customers. According to one industry expert, “Amazon is much cheaper and can help a startup achieve ~80% [deliverability rates] whereas SendGrid is more expensive but can help its clients go the extra 20%.”
SparkPost: Sparkpost was spun out of Message Systems. Structurally, SparkPost has a high concentration of high pupations that traffic from a small number of customers. They have a long tail of many small customers that generate little revenue for them, because of an extremely generous preplan which they had hoped during the Mandrill switch era back in 2016 would lead to many paying customers. If SparkPost were to lose interest from customers, it would have a greater effect on its business than SendGrid because SEND has a larger base of paying customers. Moreover, SparkPost has an architectural vulnerability. They do not own their own IPs but rent from Amazon. As such SparkPost is tied to running their platform on top of Amazon AWS.
MailGun: MailGun has comparable features to SendGrid in terms of features, functionality, user interface, developer focus; but lower deliverability rates (94% vs. 70% Mailgun) and less scale.
Potential startups / New entrants. In general, it is hard for new entrants to break into this industry. In addition to scale requirements, major mailbox service providers are insulated and have limited bandwidth to maintain relationships with all email service providers. Without these relationships, it is difficult for subscale players to achieve high deliverability rates and gain scale.
SendGrid has a strong record of maintaining its customers and expanding with those customers over time, as shown by its net dollar retention rate of 116%, 112%, 111%, 117% from 2014 to 2017. Traditional SaaS vendors typically benefit as customers add seats or increase subscription plans, but there is often an upper limit based on the highest subscription package. On the contrary, SendGrid’s net dollar expansion is tied to email volumes (which have no ceiling), so the Company can drive operating leverage on CAC investment spend as customers scale email usage over time. See product pricing charts below:
On pricing, I should highlight that while SendGrid has volume-based discounts with larger clients, I believe the Company has significant pricing power given the mission critical nature of the product, reliability, brand/reputation, supply of IPv4 addresses, and the fact SendGrid’s product only represents a miniscule fraction of an IT department’s budget. Other competitors raised prices in 2017-2018, yet SendGrid has continued to capture additional market share despite having a higher priced product.
Over the long run, SendGrid can further accelerate net dollar expansion by cross selling its Marketing Campaigns product into its customer base. The Company’s Marketing Campaigns product provides a less expensive, more modern solution for large enterprises that typically have been using traditional legacy vendors (e.g. Salesforce ExactTarget, Oracle Responsys). The Marketing Campaigns product was created in 2015 because customers were asking for email marketing capabilities on SendGrid’s platform, and SendGrid’s product could be a one stop comprehensive solution for clients.
Pricing for the email marketing product is ~3.5x the API product so it would be reasonable to expect ARPU to increase over time as customers adopt and increase usage over time. SendGrid management has noted the ramp in spending for Marketing Campaigns customers is similar to the ramp in spending for transactional email customers.
Source: William Blair
The cross-sell potential is significant and early adoption has been strong. Despite the marketing email segment being more competitive with larger incumbents including Salesforce ExactTarget, Oracle Responsys, and IBM Silverpop, SendGrid has already won 10,000+ customers on its platform. The addition of the Marketing Campaigns product was a logical progression and there are synergies associated with the integration of underlying email delivery infrastructure and email marketing.
As customers increase their reliance on SendGrid for email delivery and as the Company gains more traction for its marketing solution, this should increase the stickiness of the platform and enable SendGrid to sustain net dollar retention rates above 100%. Over time, it is also possible for SendGrid to evolve into a broader platform and move into other communication channels, including social, push notifications, etc.
Valuation Discussion / Outlook
At 5.7x consensus 2019E revenue, SendGrid trades at a subpar multiple relative to SaaS peers. However, I believe SendGrid should trade at a premium multiple for several reasons:
The street underestimates SendGrid’s revenue growth potential. Subscription net dollar retention rates are strong, and it is not hard to envision a scenario where street analysts raise their forecasts. If we assume 113% net dollar expansion (in line with Q1-18 reported) off 2017 revenue of $112mm for the next two years, along with 20k customer net adds at an ARPU of $1k for 2018 and 2019, we reach $187mm by 2019 (vs. consensus at $175mm), or a ~30% 2-year CAGR.
As the legacy marketing campaigns product (Newsletters) gets phased out by year end, I believe revenue growth rates will re-accelerate prompting a valuation multiple re-rating. The Company’s headline growth was 31% y/y during Q1-18; however, this included the phase out of the Company’s legacy Newsletters marketing product. The core transactional email product grew 30% y/y and the new Marketing Campaigns product grew 102% y/y. If the legacy marketing product was excluded, SendGrid would have grown revenues 40% y/y.
SendGrid operates with best in class growth and profitability (see Rule of 40 chart below). Management has historically managed the business prudently and will likely continue operating to the “Rule of 40”.
The Company reached cash flow breakeven/positive in 2017. SendGrid has achieved several quarters of adjusted net income positive, suggesting its platform is sustainable.
Potential for gross margin expansion. Approximately 70% of COGS is related to fixed costs investments including their technology operations. Gross margins, currently at 75%, should easily reach 80% (and potentially more) over time as revenue scales faster than hosting costs
In conclusion, SendGrid is a best-in-class SaaS email infrastructure platform with underappreciated business complexity. There are several factors that contribute to why I believe SEND should trade at a premium multiple valuation:
Strong business: #1 market leader, strong moat, structural advantages, economies of scale, brand, reputation, leading deliverability rates, low customer attrition
Significant reinvestment potential: LTV/CAC>10x vs. SaaS industry average at <3x, fast CAC recovery within 12 months, large TAM (only 3% penetrated)
Attractive growth profile: 30% topline revenue CAGR
Operational effectiveness: Reached cash flow breakeven, Rule of 40 efficiency, long term gross margin leverage
A SaaS company with the following attributes above should trade at least 8.5x 2019E revenues, implying a $39 share price (~50% upside from today’s price).
Revenue growth accelerates and surprises street analysts
Success in cross-selling Marketing Campaigns product
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