The Federal Reserve pivot that everyone is waiting in 2024 has already done its magic on the stock market. Both the S&P 500 and the Nasdaq are flirting with all-time highs once again, and many of the growth stocks that were all the rage in 2020 and 2021 have greatly appreciated just in the last couple of months. One great example is MongoDB (NASDAQ:MDB): the stock cratered an astounding 70% since inflation spiked and the Fed had to raise interest rates rapidly; the recovery in 2023 was however amazing on its own as the stock has basically doubled in the last 12 months. We are now in a situation akin to the pandemic days, with shares of MongoDB trading at sky-high valuations and investors wondering if they missed the boat or if it is just the beginning of something bigger.

My opinion is that MongoDB is a potentially wonderful company trading at a horrible valuation. The stock will trade based on the company’s growth, sure, but will absolutely follow the market sentiment and will get knocked down if the economy takes a wrong turn.

A great track record

MongoDB’s mission is to “empower innovators to create, transform, and disrupt industries by unleashing the power of software and data”. The basis of all the company’s work is a general purpose database that is built on a document-based architecture, an improved version of SQL. I believe that there are very few doubts on the quality and success of MongoDB as a service provider given their amazing track record since the company was founded in 2006.

Since then, MongoDB evolved into offering several enterprise, database-as-a-service solutions to its customers that transformed it into a $28 billion company with a projected revenue for FY2023 of $1.65 billion.

The most recent quarter saw the company post once again great numbers: revenue grew about 30% to $432 million, while total number of customers grew 19% to 46,400. Those are solid numbers, even better if we only consider customers contributing over $100,000 in annual revenue which grew 28% YoY. For what is worth, several Wall Street analysts have expressed a mild concern over the deceleration of the company’s trajectory, which paired with its insane valuation might potentially spell trouble on the horizon.

How crazy is the valuation?

MongoDB is a great company, growing fast and providing a service that is loved by the developers. However, investors have to reckon with the fact that shares are currently trading at a valuation that is far from reasonable, at least from a fundamental, value-oriented point of view. There are no GAAP profits to rely on, while the company only recently has been starting to report positive free cash flow: these two metrics are therefore rather useless to value the company. As far as revenue goes Price to Sales sits at 17.5x, not quite an insane level as during the COVID-induced market bubble (when MDB reached highs of 45x) but still around the top of market valuations. Does MongoDB deserve this valuation? Does any stock, actually?

Hard to say. Growth stocks are beasts of their own, often trading on momentum, carried by narratives and excitement. The rock-bottom interest rates of the last 15 years are a thing of the past, however recent exuberance regarding a potential interest rate cut by the Federal Reserve has actually pushed MongoDB’s share price not that far from all-time highs, all things considered.

With growth stocks in my view it is very important to first understand if there’s actually meat on the bone. I do think that MDB has the potential to be the real deal and provide another decade-plus of relatively high growth. But how fast exactly should it grow to justify the current valuation?

In the trailing twelve months the company recorded about $88.7 million of free cash flow, translating to about 5.5% FCF margin. The company is only starting now to somewhat reliably be FCF positive, however I think this will soon become the norm rather than the exception. Thanks to amazing gross profits and scale, I think MDB will most likely reach about 20% FCF margin when fully optimized, which is in the range of SaaS businesses in the cloud space.

Now we do a bit of an imagination exercise. Let’s imagine that MongoDB is fully optimized today, and already boasts a great FCF margin of 20%. Based on $1.5 billion of TTM Revenue, the current imaginary FCF would be about $317 million. In order to justify the current valuation of $28.2 billion, while assuming a discount rate of 10% the company would need to achieve about 29% of FCF growth every year. Naturally, as today MongoDB is only achieving about 5.5% of FCF margin, the real growth rate needed to justify the current valuation is actually much higher than that, but it is impossible to know how quickly MongoDB will be able to fully optimize their operation, reign in expenses and operate at maximum profitability.

I personally would not recommend investing into anything at such valuation. At these levels expecting any additional return coming from multiples expansion seems foolish, therefore any future return must come directly from the business performance; however, MongoDB has to knock it out of the park simply to achieve an expected annual return of 10%, at least based on the hypothetical cash flow model outlined above. Too hard for me at these prices.

Slowly becoming profitable

Despite the very steep valuation the stock is trading at, the company seems still far from consistent profitability. On a GAAP basis, Operating margin and Profit margin are still very much negative but the picture is slowly improving. The most recent reading shows TTM operating and profit margins at roughly -11.7% and -14.8%, translating to a net loss of $235 million in the trailing twelve months.

However, as with many other tech peers this is hardly the whole story. The company relies heavily on Stock-Based Compensation (”SBC”) to reward its employees, which is not a cash expense. By stripping out SBC and other non-cash adjustments, the company in the last four 4 quarters managed to be free cash flow positive in three of them, maybe proving that they finally turned a corner and started to reliably earn positive cash from their operations.

Another indication that they might have turned a corner is the rate of growth of their operational expenses. For the past four quarters, both cost of revenue and total operating expenses have consistently grown much slower than total revenue. That means that the company has started to be more efficient in their operations, and any of the future growth will accrue more and more towards their bottom line. I fully expect free cash flow to be consistently positive from now on, while for the net income to turn positive will require a much longer time due to the high nominal value of the SBC issued by the company every year.

Funnily enough, the area where MDB more consistently profits is from the interest earned on their $1.4 billion invested in marketable securities, most likely short-term Treasuries or money market funds. That is quite ironic considering that rising interest rates has been the most important reason that caused a growth stock bloodbath during 2022, but now actually allows MongoDB to earn pretty good returns reliably: after taking into consideration their minor debt obligations, in the last 12 months the company earned $64 million from interests on their investments, an amount comparable to their actual free cash flow but arguably even better as it’s more reliable and predictable.

In any case, an inescapable drag when companies extensively rely on SBC is shareholder dilution. During the last 4 full years (2020 to 2023) MDB has increased the number of shares outstanding by a yearly average of 6%. One could argue that this is irrelevant given that the stock price more than doubled in the same time frame, however this can expose investors to real pain if the market stops trading exuberantly, or if MDB makes some mistake along the way that either changes the narrative around them or directly impacts their results. At the very least dilution is something that investors should be aware of, and take it into consideration when assessing how risky an investment is.

Conclusion

MongoDB is a great company and has the potential to become a wonderful one someday. That might be enough for some investors to initiate a position, maybe even at any price. For me however, I just cannot justify an investment at this valuation in pretty much anything.

I like how MDB is showing significant improvements in their profitability and I would be surprised if they won’t be consistently FCF profitable already next year. The numbers clearly say that they provide services that customers love, and are able to do it consistently above 70% gross profit margin which is an amazing indication of potentially high profitability in future.

The risk however of buying something at 17.5 times sales is that any bump on the road might push your position in the red for many years. I think it’s too great of a risk for me, which makes MDB just a wonderful addition to a not so exciting watchlist.