Join Motley Fool contributor Brian Stoffel and Motley Fool analyst Emily Flippen as they dive into a recent IPO on today's Wildcard Wednesday show.

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This video was recorded on Nov. 3, 2021.

Emily Flippen: Welcome to Industry Focus. Today is Wednesday, November 3rd, and I'm your host, Emily Flippen. Today, I am joined by The Fools' Brian Stoffel, and we're going to be talking about a newly public leader in search engine optimization and online marketing SEMrush (NYSE:SEMR). Thanks for joining, Brian.

Brian Stoffel: You're welcome. Thanks for having me, Emily.

Emily Flippen: Yeah, it's good to have you on. This is the second time here on Industry Focus, we had so much fun last month that we had to do it again.

Brian Stoffel: Yeah. I survived my first one. I was nervously waiting to see if there will be a call back.

Emily Flippen: [laughs] You did more than that. This is a really interesting business, one that you brought my attention when I pinged you and said, "You have any ideas for Industry Focus next week?" How did you find SEMrush?

Brian Stoffel: Brian Feroldi and I have a series that we do for Backstage Pass, and it's called IPO Stocks from Scratch. We start off knowing almost nothing about a company and we take it through our frameworks and we do real-time making tons of mistakes and looking like idiots because I think that that actually helps. I think that's a good thing because if we look like idiots then other people are OK looking like idiots when they're getting started. Then all of a sudden, we demystify the process of investing stocks. We did this. When we did, we realized that this company's scored very well, so well that Brian Feroldi started almost freaking out because the score was so high. So that was how we found out about it.

Emily Flippen: I have to say, I was a little bit of a skeptic myself. I did go back and listen to some of the commentary that you and Brian Feroldi made about SEMrush. But something about it just didn't sit right with me and I couldn't quite put my finger on it and being the complete pessimist that I am, I went and I did my best to rip apart whether it's the management team or their financial picture here. While things aren't perfect, I will say, I didn't find any glaring red flags that will canary in the coal mine that I was looking for. It's certainly an interesting business and it's been a while since we've talked about a business that had been so excited about on Industry Focus, covering the consumer goods show on Tuesday a lot of time for we're talking about companies that maybe aren't performing at quite the level that SEMrush is.

Brian Stoffel: Yeah. But I think you did find some holes that are worth talking about. We can get to that in the company's total addressable market. We can have a nice little debate about how we view total addressable market.

Emily Flippen: I had to get to something. So I decided to harp on the total addressable market. Before we get to that, let's actually tell you what the business does. I mentioned that it was a leader in SEO and online marketing, but they really call themselves an online visibility management platform. Essentially, what they're doing is they're going to corporations and they're getting corporations to pay them just a subscription monthly fee for access to information that better positions their website or businesses for digital traffic. They have offerings like a key word magic tool that helps identify popular keywords, monitor their performance on those keywords versus their competitors, and then also performed things like SEO audits. You can almost think about it like a pumped up version of Google Analytics. They provide information about all sites though as opposed to only your own. Really good for things like competition tracking, which really is a blind spot in the market today.

Brian Stoffel: Yeah, absolutely. While that SEO and that magic keyword is key, I think what really sets them apart is they have this one slide in their deck where they list all the different tools that they have and they show how there are lots of people who are leaders in some of these tools like local SEO, like Yext is really good at that, or listing management, Yext is really good at that. But in terms of social media analytics and social media monitoring and PR, customer relationship management. Those are things that SEMrush is in it follows a theory that I have, which is that as SaaS has become more popular, the companies that can have a large enough umbrella with good enough products are going to win customers. They don't have to have the best and everything, but they have to have enough good enough products to make it easier for a company to just say, you know what, I'm just going to use SEMrush. They've got all that we need and all their tools are good enough. I'm not going to try and cobble together 10 different providers for all these different things.

Emily Flippen: I will say one of the things that I found really interesting in the space was that, again, my skeptical mind was like, "Okay, well, sure nobody is quite the leader that SEMrush is. They are [inaudible 02:32:27] on all the segments that they offer from big to small businesses. But aren't there just a ton of really well-capitalized competitors in this space?" I like the fact that management was pretty upfront there. They said, "Yeah, look, we go up against businesses like Google and Facebook." But the difference between us and them is that we are inherently neutral. Some of the capabilities that they're talking about, they don't have an incentive to provide traffic from certain sites over others. They're just content-neutral. That's actually been a value proposition that for businesses like Roku, again, going up against really entrenched leaders, managed to make a name for themselves because of that inherent neutrality. So I like to back that SEMrush is like, "Hey, look, we know, we know we're not as well capitalized as some of these multi-billion-dollar businesses out there, but we do have neutrality and they will never be able to compete with us on that."

Brian Stoffel: Exactly. You know, I would even say, you could compare to Shopify. Say that you have a killer product that people love and you want to sell it online. You could go on Amazon, but you could be cannibalized by Amazon. They could see what you're doing and they can create similar product for cheaper. Or you go to Shopify who has no interest in selling any goods. Then it makes it a no-brainer. The same thing here, you could go with Google and Facebook, and I doubt that this is an either or proposition. I think that it can be in both proposition. You can use some Google Analytics and SEMrush. Because the other thing we haven't really touched on is that the prices are, this is not some super expensive product, they're very reasonable prices.

Emily Flippen: It was actually one of the things that I understood why it was a reasonably priced products, but I wish it almost wasn't. Because you'll notice that when you look through their financials, they have a ton of free users under their freemium model and a very small subset of paid users. They have over 400,000 free users. That was up 21 percent year-over-year in 2020, but only 67,000 paid users. That is growing faster. Again, that growth is accelerating in paid users, and it's really valuable to have that baked top of funnel where you bring people in for relatively low cost and then up-sell those users as they trickle down. But the prices aren't that high. The prices range between the $100 a month to $4,500 a year, and that's not including this one-time add-ons. With how reasonably priced that product was, I was surprised to see less than a 100,000 paid users. It just struck me as very small in relationship to especially how management views their opportunity.

Brian Stoffel: Yeah, and I mean, it can be two sides of the same coin. You can look at that and be like we're looking how much room there is for growth because it is so small. That's one of those things that we'll only know which person was telling the right story five-years from now.

Emily Flippen: Exactly and one of the things that you and the Brians called out was just how efficient this business model was. This was a business that was founded by two co-founders; Oleg Shchegolev and Dmitri Melnikov. I apologize if I'm pronouncing their names incorrectly, but they founded the business in 2008. I believe they've only raised a handful of cash since going public, less than $40 million since it was founded over a decade ago. That's just crazy.

Brian Stoffel: It's bananas. The other thing that I really love about it is that these two have known each other for a long time. They've been friends for 30 years before they founded the company. They built this tool for themselves. Their story, the way that they pitch it, which they do a good job of doing is that they think the ability to market is really important in today's world. They wanted to create a tool to help them market themselves. So again, I'm going to hearken back and I'm not saying that business is going to have Shopify like returns. Let's get that off the table. That is not a promise being made here, but Toby Lütke, he started building snowboards for Shopify. The only reason that Shopify is would've been a stay is because we couldn't find any way to sell those snowboards online. That was easy and allowed him to focus on the snowboards. The same story here, but really, the same story with a lot of products we love. The first customers for SEMrush were the founders. It was a product they built for themselves. Then they realized, oh, the thing that we built just help us do something else that might actually be the real product that we should move forward with.

Emily Flippen: I know we're not saying it's like Shopify, but I like that analogy because it applies to so many different aspects of this business. Another Shopify-esque story being told here is just how many of their customers are really small enterprises. Ninety five percent of their customers are small to medium-sized businesses. Very familiar to what Shopify experience when they first went public. Again, catering to businesses that were otherwise overlooked by the existing players. While they do have a lower average revenue per user for those smaller users, they also have really strong international diversification. This is already a business that is doing more than half of its sale outside of the United States. Again, really good start, I'll say.

Brian Stoffel: Yeah, and just one other point that I'll add onto that is that when you were catering to small and medium-sized businesses, it's not uncommon for your net revenue retention to be really low. If you look at some companies like a CrowdStrike, for instance, you're used to seeing that net revenue retention be like 130, 140, 150. When you're talking about companies that cater to small medium-sized businesses, if you can hit a 100, that's good. HubSpot is a great example. HubSpot has been a killer investment and they do really well for their customers. Their net revenue retention it's really good if it's like a 102 percent, which means that existing customers are spending about two percent more every year after churn. The churn is high just because that's what happens when you have a small and medium-sized customers, they got a business like the founder, something happens in their family and they can't run the business anymore. Then HubSpot loses that customer through no fault of their own. SEMrush is catering to those same customers and their net revenue retention is a 121 percent. I think that's phenomenal given the way that they operate.

Emily Flippen: Well, it shows just how critical the product is management does think that there's some existence of a flywheel effect here where the more customers they pull in, the better data they get about what keywords are working and what products are attractive. Then as their products improved, thanks those customers and they should theoretically get even more customers, I'm not sure if I really agree with that. I'm not sure it proves itself out the way it does with other businesses, but it is to say that that net revenue retention rate does show that there is an element of necessity that exists behind what SEMrush does, that doesn't seem to be going away anytime soon.

Brian Stoffel: Yeah, I agree. What you're really talking about is management saying, there's a network effect that helps our AI. I've said this many times, that is the theme for the next five years for investors is figuring out which companies are full of it when they are talking about AI and which ones are actually serious, "Hey, we have a real advantage here."

Emily Flippen: I think at this point here now, Wednesday, November 3rd, we can say Zillow might have been a little bit full of it with their AI driving the algorithms.[laughs]

Brian Stoffel: I think we might have enough evidence to say that our Zestimate is not the most reliable price to use when figuring out how much a home is worth.

Emily Flippen: It does go to show that you really never can tell what's happening behind the scenes here. The same thing could be true for businesses like SEMrush. It could be true for Riskified which is the last business that you and I talked about on Industry Focus or with Lemonade, or all of these other businesses that are making very real investment into things like algorithms, artificial intelligence. They don't always work, but when they do, they do to an extreme extent. With that being said, let's talk a little bit about this market opportunity for SEMrush because I have to say, I'm pulling apart, I'm grasping at strengths here. This is what I found that I thought was a little bit egregious, it was how management defined their total market opportunity, their TAM, they get to $13 billion a year in terms of total market opportunity, which is actually reasonable when I saw that number off the back, I thought, "Yeah, that sounds about right." I'm actually surprised it's on higher. Then I went through the assumption that they made to get to that number and I was just a little bit put off. In order to get to $13 billion a year, they take their average revenue for small, medium, and large sized businesses. They multiply that by 100 percent of every large business in the world, 100 percent of every medium-sized business in the world, and 50 percent of every small business in the world to get to that $13 billion. Then management goes onto assert that that's actually conservative. 

That they think if they get a whole 100 percent of every small business in the world, that would be a $20 billion market opportunity. Now, I realize that in defining the addressable market, that is just the addressable market. It's not them saying we're going to have every single customer in the world. But it was crazy to me that in order to get to just $13 billion, they had to go out and look at every single business and define the market opportunity is every single business in the world. I wish they had made a more concerted effort to narrow that market opportunity down, maybe to businesses that have built-in marketing budgets. Anything to narrow it beyond every business in the world. I hate seeing that as an investor.

Brian Stoffel: Here's where I said we can bet this around. Total addressable market. I am a little bit of a black sheep. I don't pay any attention to it at all. It's funny because the other Brian, Brian Feroldi said as the first time you said is that because you think management overstates it. I said, "No, I don't pay attention because I know that one or two investments is all you need to reach your goals." If you want investment in Shopify in 2016, you can have 10 other investments that are pretty bad and you're still in really good shape. The point is that, I think that if you are a long-term investor, you can invest in companies and they have no idea what they're, what did the Amazon say their total addressable market was in 1999?

Emily Flippen: I'm sure it was not what it is today. [laughs]

Brian Stoffel: Right, I don't have any idea what it is and I don't think Jeff Bezos knew either. Even Elon Musk, I bet when they went public, there's no way they could have said, "Oh, our total addressable market is X compared to what it is today." The point is, I'm more of a psychology student to notice that is one thing that I've learned that I really believe is true is that we adapt better than we assume we will to the things that scare us. The reason that I'm using that analogy is that, if they realize that maybe the market isn't as big as they thought. I think that they can adapt in their efforts to fulfill their mission better than anyone might be able to assume. When that happens, then the addressable market ends up being when you look backwards much bigger than we thought it would be.

Emily Flippen: I love that and I agree with everything you said. I think my hesitation maybe comes more from the aspect of how they think about strategy and penetrating new customers. I like when that strategy is really clear and part of that is understanding who is the most likely customer for my business and how do I reach the most effectively? When you're saying that every single business in the world is your customer or could be your customer, that to me doesn't communicate a really clear strategy about how they plan on getting them to become customers. That actually is just one step away from those terrible words that no investor likes to hear, which is, if I only get 10 percent of the market opportunity, I will be at $20 billion business or what have you. I think the reason why we only hate hearing that is because it doesn't matter how big the market opportunity is, if you don't have a strategy with which how to penetrate it. I'm not saying that as what's happening here and your point is well heard, which is market opportunity itself is a fluctuating aspect. Maybe I wish they had a better communication strategy. Because just telling me, "Hey, we're going for businesses." [laughs] It doesn't build up a lot of confidence.

Brian Stoffel: Well, Emily, we're actually in luck then because today's November 3rd, but on November 10th, Brian Feroldi and I are going to be interviewing the Company's CFO, Evgeny Fetisov and we can ask him these questions. We can pin him down a little bit.

Emily Flippen: Wonderful. I can't wait to tune in for that. Is that going to be on Motley Fool Live on Backstage?

Brian Stoffel: I'm not totally sure, but I'm sure that it can be cut up into articles for everyone to watch.

Emily Flippen: Awesome, if your Motley Fool subscriber, look forward to that. If you're just listening to our free content and hopefully we'll that caught up and do bite-size chunks for everybody. But before we sum up here, let's talk a little bit about their financial performance. You mentioned a really impressive net revenue retention rate of over a 120 percent. One the things that stood out to me was their annual recurring revenue per paying customer. It was over $2000 in 2020. It does split up a bit between the small businesses and the large businesses. Large businesses are closer to $4,000, small closer to $2,000. One of the things that felt like it was missing for me though was more information about their customer acquisition costs, the return on investment for those customers. I do wish I had a little bit more color about exactly how valuable this thesis is for the businesses that they pull in.

Brian Stoffel: Yeah, I agree. I went back and I looked. Let's say in the previous quarter, they spent about 41 percent of revenue on sales and marketing, about 53 percent of gross profit. The fact that those are very close tells you that this is a high-margin business which is not surprising. They want to get that sales and marketing down to about 35 percent. Look, that's never going to go away. I think that that is how the world works when you're going after small and medium-sized businesses. When you go after enterprise customers, you can have actually a pretty small sales and marketing budget because you only have to contact four or five people at a business to get all of that revenue coming in. But it's not the same for SEMrush. I agree, there are some details that would give us a better picture. For me, the fact that that net revenue retention is as high as it is tells me enough for me to be bullish on the company.

Emily Flippen: That being said, this is a business that is posting negative operating margins, they are experiencing operating losses. It's only around a five percent loss right now in terms of total revenue. That has been declining over time as the loss is getting smaller, not larger. The good news is they do have positive operating cash flow. In the most recent year, I believe that was almost five percent, pretty strong for a business of this size, I will say. Other thing that made me nervous, was revenue growth. I wanted to see it faster. I don't know if I'm just becoming more picky and there's low yields market where high fliers are just getting hammered by the market right now, but growth is rewarded and slowdown is not. Their revenue growth is up 36 percent year-over-year in the most recent quarter, but it's a slowdown from their five-year CAGR of around 50 percent. They're so small. They're so young, so few paying customers. I wish that was accelerating.

Brian Stoffel: I do too. Full disclosure, I went out and bought a very, very small position in the company after the time period passed, I could do that, but I think you mitigate the risk in that by controlling your position size. For me, it's less than one percent of my overall portfolio.

Emily Flippen: Awesome. Well, with that risk being noted, let's talk about a couple of other risks. This is one that you and Feroldi mentioned, but I think it's really interesting and that's the risk of cookies as a lot of investors and just people may be aware. There is currently, I believe it's through 2023, if memory serves, plan to phase out the use of third-party cookies on things like websites and that's how a lot of data tracking is done right now. It actually powers a lot of what SEMrush's products use in order to determine, again, SEO strategy, the marketing keywords, those sorts of things. What do you think happens to this business when cookies go away?

Brian Stoffel: There's two things I want to say. One is cookies are going away for everyone who they would be competing with, so it's not a unique thing. By that, I mean, all the tiny start-ups that are trying to do the same thing that SEMrush is doing. SEMrush is going to be losing it and so is everybody else. That's key. Now, is it possible that Google and Facebook could use their data consolidation to really dominate this area? Yes. I mean, one of the most brilliant things that I've seen was a counter take on what Apple has done with their privacy standards. It came from, I think, it's Ben Thompson from Stratechery who said that, hey, everybody is applauding Apple doing this. Look, while it might be good because all these other people can't monitor what you're doing, Apple is going to go into hyperdrive monitoring everything. They are doing it in part so that their advertising revenue can go up, and lo and behold, that's what's happened. Is it possible that Google and Facebook could kill these competitors and people will say, yes, they are not neutral like SEMrush, but I don't really have any other option. Yeah, that is possible. At the same time, that's a problem that management knows about right now in 2021 and they've got two years to figure it out. Again, I control for that risk with position sizing and I think that other investors need to take that into consideration too.

Emily Flippen: It definitely is interesting. I don't think this is thesis-breaking. To your point, if I was interested in investing, which I might give this one just a bit more time to play out. But if I was interested in investing I'm not sure this would be the thing that kept me out. But if I was an investor, I would certainly be keeping an eye on it. With the removal of cookies, there has been a lot of alternatives to replace data tracking in the market and a lot of the big alternatives are coming from the site that SEMrush competes with. We're talking about Google, Apple, Facebook. They are the people trying to figure out what the alternative looks like and it's inherently going to be weighted in their favor if they end up with that industry standard. My hope is that a business like The Trade Desk, which is one that we've talk a lot about here at the Fool, gets a bit more traction that has something called the UID 2.0, Unified ID 2.0 and I hope that something like that which is a different parties I guess strategy becomes a bit more unified and used. But what's SEMrush really needs is a single ID to be shared across all websites. Otherwise, different data trackers go to the largest provider, something like Google in this case. But without having any more insight into what that looks like, management did talk about it a lot. I wish they had been more clear with what they're actively doing to prevent this risk. But in absence of any more awareness in here and recognizing that we have a number of years before this comes to fruition, then I agree with you. I think it's something just to keep your eye on. Be aware of the fact that this is a real risk that could impact SEMrush products. But hopefully, we have a management team that's being proactive here.

Brian Stoffel: The most important thing that people forget is that investing is not black and white. If you're worried about it and you like Alphabet or Google and own a little bit more Google than you do SEMrush, and you've mitigated that risk a little bit just by doing that.

Emily Flippen: Well, the last risk I'll note before I pass it off, if you have any last thoughts here on SEMrush, it's become a thing now for me on Industry Focus, I have to note when we have weak internal controls with businesses. SEMrush is another business that has gone public, whose auditor has come out and said, "Look, the processes in place here aren't going to mitigate some of the risks with material misstatements." In particular, a lot of their valuation. When you come back to what happens internally, asset prices that don't have market prices. That was one of their big weakest spots in terms of internal controls. Always worth noting that whenever we have a business with weak internal controls, you're not going to have, A, as much trust or transparency into their financial statements. But you also can't be surprised if and when there's some material misstatement. I always say that upfront because if you're going to invest, which again, I'm not sure if it's a red flag or a deal breaker for investors out there. Maybe for some people, you should just be aware that that risk exists.

Brian Stoffel: Absolutely. I think that's important because then you're not caught completely blindsided when that statement does come out.

Emily Flippen: Exactly. Well, Brian, thank you so much as always for coming on and providing your insights. This is a super interesting business and wanted to look forward to hearing about more in the future.

Brian Stoffel: Thanks for having me back, Emily.

Emily Flippen: Anytime. [laughs] Listeners, that does it for this episode of Industry Focus. If you have any questions or just want to reach out to say, hey, shoot us an email at industryfocus@fool.com, or tweet at us @MFIndustryFocus. As always, people on the program may own companies discussed on the show and The Motley Fool may have formal recommendations for or against any stocks mentioned. So don't buy or sell anything based solely on what you hear. Thanks to Rick Engdahl for doing his work behind the screen today. For Brian Stoffel, I'm Emily Flippen. Thanks for listening and Fool on.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.