Squarespace Q4: FY24 Guidance Seems Too Conservative

Summary

• Squarespace reported strong operating performance in 4Q23, beating revenue expectations and generating higher-than-expected free cash flow.
• The company's price increases have been successful in driving revenue growth, and further pricing growth is expected in the future.
• The FY24 guidance provided by Squarespace may be too conservative, as it does not account for potential price hikes and underestimates the revenue potential from the acquired Google domains.

Investment overview

I wrote about Squarespace (NYSE:SQSP) previously with a buy rating in December 2023, as I believed SQSP could continue to grow despite the macro headwinds as it continued to release new products and improve its up-selling capabilities. For this post, I still recommend a buy rating as I believe the business remains sound and that FY24 guidance seems too conservative.

Strong operating performance in 4Q23

SQSP reported total revenue of $271 million, a growth rate of 18%, which beat both consensus and guidance expectations of 15% and 14.5% (midpoint), respectively. Although the top line beat, EBITDA came in line with the consensus expectation of ~$65 million (24% margin). The good news is that EBITDA flowed through to the free cash flow [FCF] line at a higher than expected conversion ratio, while SQSP generated $57 million of FCF, implying a 21% margin, beating consensus expectations of $51 million. Other underlying operating metrics also continue to point to good underlying momentum. For instance, 4Q23 net new annual recurring revenue [ARR] grew $92 million, which compares really well against peers like Wix (WIX), which saw 10% ARR growth in 4Q23, and GoDaddy (GDDY), which saw 8% ARR growth in 4Q23. In addition, bookings grew by 23%, accelerating from the previous quarter. SQSP ended the year with a net debt position of ~$422 million.

Price increase to drive growth ahead

The 4Q23 earnings call shed light on the potential for further pricing growth ahead, which SQSP has been gradually implementing in FY22—a list price increase in 1Q22 and a legacy customer price increase in 3Q22. The results were great and apparent; post-price increase for legacy customers by 10-15% in 3Q22, it led to a strong revenue step-up over the next few quarters as legacy customers that renewed their contracts had to adopt the new pricing. This entire process took at least six quarters to come into effect. For numerical reference, 4Q23 ARPU is ~$228 vs. 3Q22 ARPU of $206, which is ~10% increase. Going forward, I believe pricing is going to be a key part of the growth equation, as the price increase has not really impacted customer churn rates at all. This tells me that customers are still perceiving the SQSP offering as below what it is worth (i.e., what they are willing to pay for). I am expecting management to continue raising prices, and with each increase, it would likely take 4 to 8 quarters of digestion before its effective ARPU will reflect this increase, as a large portion (70+% based on the 2Q21 earnings call) of SQSP subscriptions are on an annual basis.

Price increases across our subscription offerings contributed $39 million, representing approximately 27% of our top-line growth with renewal rates supporting strong cash retention. Company 4Q23 earnings call

Guidance seems conservative

I believe the SQSP FY24 guidance might be too conservative. Management is guiding for $1.18 billion of revenue at the midpoint, which implies ~17% growth, which is flat against FY23 growth of 17%. There are 4 reasons I think the guide is too conservative:

1. Note that FY24 revenues will include the contribution from the acquired Google domains (refer to below for background info). Based on management guidance, they are assuming ~$86 million of contribution, which implies that core organic growth is 9.5%. This seems too conservative considering that 4Q23 core business grew 18% and management did not indicate any signs of weakness during the February earnings call, suggesting that 1Q24 performance has not seen major deterioration so far (on a year-to-February basis).
2. The management target of $85–87 million in revenue tailwind from the Google Domains business seems to be too conservative, considering that management noted ~$120 million in potential contribution during the time of acquisition (~10 million domains at an average of $12 per domain). My guess is that management is assuming strong churn rates for the domain business during the upcoming migration (i.e. some domains might leave as they prefer other offers, for instance). This seems odd considering that they expected $120 million just ~7 months ago. Notably, management did not seem to take into account the cross-sell potential for these domains, which clearly underestimates the revenue potential given that SQSP has been talking about cross-selling in many of its earnings calls.
3. Lastly, the FY24 guide did not build in any potential price hikes as well. We have seen SQSP do it before, and management has expressed their intention to continue doing so (in the call, CEO Anthony answered a question regarding pricing, and his comments state that they are constantly doing price test, and if they turn out successful, they are going to implement it. My take is that management is being conservative here as they do not want to assume these price tests are going to be successful).

So as we go into 2024, 18% growth at the top end of the range is really driven, a combination of what we disclosed for Google Domains but that core business coming through, but we are lapping the pricing and so you will see that impact in the 2024 guide as well as, as I said in my opening remarks, we've built immaterial cross-sell for the Google Domains. Company FY23 earnings call

And so, insofar as we can get the list price higher for new customers sustainably, I think that we'll have an opportunity to modestly raise prices for existing customers again. Morgan Stanley's TMT conference

Note to those that are unfamiliar with the Google Domains background, I have quoted from my previous post:

I see the acquisition of Google Domains on 7th September as a major growth driver that should accelerate SQSP bookings and revenue growth. Generally, domains are annual plans, as it is unlikely for a business to buy 1-month-long domains. As such, upon the acquisition of Google Domains, SQSP would immediately see an increase in bookings that would be translated into revenue over the coming months and quarters. The negative aspect of this is that it is going to depress gross margin in the near term due to higher operations costs and an upfront payment related to domain registry fees associated with Google Domains acquisition. However, I expect gross margins to normalize over time as up-front registry costs start to be in line with subscription revenue

Valuation

Based on my research and analysis, my expected target price for SQSP is $51, an upgrade from my previous target price of $45.

• Revenue should grow by 20% for the next 3 years. I expect revenue growth to be 20% in FY24, beating guidance by ~3%, as I think management is being too conservative considering the points I noted above and also the fact that SQSP has consistently surprised its guidance by an average of 2+% over the past 10 quarters. I assumed this 20% would persist through FY26. For comparative purposes, my FY24 growth assumption is higher than my previous model by 200bps

• Given that growth has accelerated, I would expect the valuation multiple to go above the current multiple of 4.2x for forward revenue. However, we do not need that inflection to make a sizeable return on the stock. In my model, I simply assumed the stock would trade at the current multiple, which is the way the stock has basically traded for the past year.

Risk

Given that SQSP has a relatively short history of raising prices, we do not know the “cap” that customers are willing to pay. If the maximum price that a customer is willing to pay is, say, 10% away and SQSP raises the price above it, we could start to see churn metrics go up. If that happens, then the growth runway for SQSP shortens incredibly, as they must rely on cross-selling and unique subscriber growth to grow the business.

Conclusion

I give a buy rating for SQSP given that the business still shows strong fundamentals. I believe that the FY24 guidance is too conservative, given that it implies strong deceleration in the core business, includes no pricing and cross sell potential, and also assume massive churn from the Google Domains. My take is that growth will come above guidance, just like it did historically, and strong growth should persist forward. The key risk lies in customer price sensitivity. If price increases exceed customer tolerance, churn could rise, impacting growth.