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On November 23, 2011, Healthstream (NASDAQ:HSTM) closed on a 3.25 million stock offering. While issuing 3.1 million shares for general corporate purposes, insiders sold another 150,000 shares as part of the offering. Sometimes this arrangement exists with IPOs as a way for executives to monetize part of their compensation for the first time. However, among longstanding public companies, it is not common practice as far as I have seen. The number of shares offered by executives and directors was less than 1 day of volume, making it doubtful that the reason for selling had anything to do with an illiquid market in the company’s shares. Of the insiders that sold shares in the offering, the amount sold represented approximately 20% of their total ownership (including stock & options). Some executives sold direct shares, while some exercised options with expiration dates over the next two years in order to sell. Somewhat ironic is the fact that shares are up more than 10% since selling.

While not always a bearish signal, its important to pay attention to insider transactions. Generally, executives purchase stock when shares look compelling and begin to sell for one or a combination of three reasons: the options they were granted are coming up on expiration (that was not the case in this offering), executives need to cash out to monetize a significant portion of their compensation (unlikely because multiple officers sold in concert) or the stock is seen as at least pricing in insiders’ most optimistic medium-term projections. From looking at Healthstream on the whole, I think the later is the most likely scenario.

Healthstream provides internet based research and learning solutions to large healthcare organizations including hospitals, medical device companies and pharmaceutical outfits. The company lists some of the largest hospital organizations in the country as its clients. Part of the company’s success, and likely part of the reason that investors have awarded Healthstream a high multiple, is the sequential gain in professional subscribers for every quarter since at least 2007. However, the drastic rise in deferred revenue since 2007 could be a red flag. While not proving to be a problem to date, having a high level of deferred revenue forces investors to take a broader approach than just looking at the income statement when analyzing a company’s valuation. Deferred revenue is essentially revenue that the company has collected, but not yet booked. A buildup in deferred revenue benefits near-term cash flow and makes a certain percentage of next year's earnings certain, but if the business is challenged in 2012, it will not as easily show up on the income statement.

Over the past few years, I have actually owned shares of the company on and off. That’s because before 2010, the company typically traded at 20x forward year EPS, while currently the stock fetches almost 55x 2012 EPS. Additionally, while the stock traded under 1.5x sales from 2007-2010, it currently trades at 4.5x sales.

2007

2008

2009

2010

2011

Forward PE

26x

16x

17x

19x

44x

Forward Price/Sales

1.5x

0.95x

1.1x

1.5x

3.5x

*Both ratios use average price. Sales and earnings are adjusted for one-time events.

Also to take note of, the company capitalizes its software purchases and enhancements. This is an acceptable practice; however, when coming to a cash flow calculation, investors should include software and purchases as capital expenditures.

What makes me truly skeptical is the questionable nature of the company’s stock issuance. Putting aside the insider selling in tandem, why does the company need another $55 million when it already has a net $30 million in cash on the balance sheet? The nature of internet based software is that acquisitions are not needed to be able to grow. Instead, the company spends money on hiring salespeople to market the product and engineers to constantly improve it. In fact, the company has not made any material acquisitions over the past three years. There are only a few reasons that come to mind as to why the company would have issued shares with no visible use for the proceeds; the stock price is at the high end of its historical valuation range, making it irresistible to raise proceeds (even if there is no immediate use), management expects cash flow to be limited in the medium term (highly unlikely given the company’s recent results) or it is to thwart off unwanted takeover attempts.

It’s unlikely that investors will know why the company raised additional proceeds unless the company makes an acquisition in the near future. At a current forward PE ratio of 55x and trading at 12x sales, if the company makes any missteps, such as not producing adequate growth in professional use, the stock could be in for a big pullback.

Source: Insider Selling May Be A Sell Signal In Shares Of Healthstream