Looking at a vendor that is crying out to be either discovered or consolidated
Charleston is one of my favorite cities to visit. Don't laugh but I like the weather in that part of the south with languid long summers and a touch of seasonal change thrown in. There is nothing prettier than the south in the springtime - and I have lived in New England with its breathtaking falls. These days the food in the city can be superb - it is the closest thing we have to real regional cuisine in this country and the coconut cake at the Peninsula Grill is one of the ultimate dishes to be had anywhere this side of heaven. You can order a coconut cake delivered to you and it is about as good a holiday treat as you can imagine. An apotheosis of southern cuisine. So, if you don't like the recommendation in the article - well, at the least enjoy some coconut cake and your inner man will be enriched. The hotel (The Planters Inn) is not a bad place to sleep, either. The people of Charleston are friendly in an almost small town southern way - they have seemed happy to share their life stories with this mongrel from many parts of this country. And gazing out from the Charleston's Battery to the islands in the harbor perhaps brings back pictures in one's mind's eye of the scene as it must have been during the Civil War.
But one thing I never expected to find in Charleston was a best of breed software vendor. But really, why not - if it is a good spot to visit why shouldn't it be a good spot for an entrepreneur to work and to launch a software enterprise? I have been to Charleston half a dozen times and never went to take a tour of the city's high tech corridor, although it is said to exist and there is a website regarding the corridor. But I was intrigued when I was introduced to a company called Benefitfocus (NASDAQ:BNFT) that is headquartered in Charleston.
As software companies go, this one has been around for a few years and its founder Shawn Jenkins remains its CEO at this point and Milton Alpern, another founder, remains as a consultant to the company. The company went public in 2013 and first traded at $42/share, well above the IPO price. A few months later, the shares had a ritual spike in which they hit $77, and since then, the shares have settled into relative stability. The shares are no doubt highly valued, but the company has enjoyed a high growth rate that make it quite typical of many of its mid-size SaaS peers.
The YTD share price appreciation of 14% is just barely beating the IGV index up around 11% over the same period. On the other hand, the shares are up by 34% over the past year and that is significantly greater than the 13% appreciation for the index over that time frame.
The company has been decreasing its losses and beating estimates for some time now and that is progress of a kind. But the company still makes plenty of losses and that trend is forecast to continue through next year (the fiscal year ends on 12/31).
So, why look at the shares of BNFT at this time? For one thing, they are a very dusty corner and get relatively little recognition from retail investors. Although the company is covered by some well-known analysts and its iPO was managed by GS, there have been no articles that have been published on Seeking Alpha for more than two years now. The valuation metrics are far different now than they were when the shares were spiking - the shares are cheaper and the business is larger and the losses are smaller.
Most important, at least to me, is that there is far more differentiation in the space now than there was two years ago and the company has emerged as the category leader. And further to that, the benefits management category has increased in importance and with the various trends in the economy, and with the Affordable Care fiasco, those trends are likely to continue.
And finally there is some significant evidence that the company's path to profitability is being trod and that the company's likely growth rate is beginning to accelerate.
And that leads me to suggest that in this acquisitive environment, it seems reasonable to think that there is a significant consolidation potential. This company provides benefit management. It probably has a more complex and complete product offering than the other players in the space, but it hasn't had the distribution capabilities that could enhance its growth. Obviously, BNFT has multiple partners such as SAP (NYSE:SAP) and others that extend its sales reach, but the company presents an opportunity to create significant sales synergies to potential consolidators. That is surely a formula that is mouthwatering for the many acquirers who are looking for the strategic benefits that owning Benefitfocus could bring.
Its solutions are part of the human capital management (HCM) space. As a result, the company faces some very high profile competitors such as Oracle (NASDAQ:ORCL) and Workday (NYSE:WDAY) along with a host of small competitors that have similar products. Indeed, the number of solution providers in the space is legion because the requirement for a solution that manages benefits is basically universal at this time, particularly because of compliance requirements.
Benefitfocus does actually have a few differentiators when compared to the host of its competitors. It has basically built a marketplace where employees can shop for benefits and carriers can offer their services. At one point, the carriers were the company's principal clients. Now its growth business is with employers.
The company's valuation is no bargain - at least not in any rational sense of that term. Based on the current consensus forecast, the EV/S is 5.3X which is expected to fall to 4.3X next year. On the other hand, as mentioned earlier, the company is not and has not been profitable since it began reporting results after its IPO. At this point, the company doesn't generate any net cash given its non-GAAP losses, has relatively low levels of stock based comp and isn't generating any increase in the deferred revenue balance. While the company has a reasonable balance sheet and minimal requirements for capex, there is no immediate sign that the company is going to generate any significant level of CFFO in the near future. The company is forecasting that it will burn about $35 million in cash which suggests that the cash flow burn will decrease by about one-third in the second half of the current year.
Path to Profitability?
To be sure, there are signs that the company has been climbing the path to profitability, but it is probably still several quarters away from achieving the objective of reporting breakeven results on a non-GAAP basis. Last quarter the company saw an improvement in gross margins from 45% to 49% year over year. Operating expense metrics also saw meaningful improvements both sequentially and year on year.
Sales and marketing costs declined to 26% of revenues from 37% the prior year. Research and development costs dropped from 31% of revenues to 25% of revenues and general and administrative costs fell from 15% of revenues to 14%. Overall, operating losses in the last quarter were 15.7% on a GAAP basis compared to 38.4% in the prior year and to 20.7% in the prior sequential quarter. As the quarters do show some modest seasonality with Q3's lower and Q4's higher than trend, it seems likely based on historical performance that the December 2017 quarter will be at or above breakeven. The company is forecasting that it will achieve EBITDA profitability in Q4 this year and the current trends are supporting that forecast.
The company had sequential growth of 7% last quarter and that compares to negative sequential growth in comparing Q1 to Q2 in 2015. Some of the strong growth in Q2 was a function of revenues associated with delivering forms 1094 and 1095 to the IRS on behalf of those customers who use the company's services with regards to tracking compliance with the Affordable Care Act. Those revenues had been expected so the quarter was a beat when compared to the prior forecast. In the future, revenues from preparing and reporting Affordable Care Act compliance will be recorded ratably through the course of the company's financial year.
As it happens, Q2 2015 was a strong quarter for the company which exceeded forecasts in terms of securing 94 net new large employer logos in that period compared to 62 new logos in the June quarter this year.
The company signed one of its largest deals just after the close of the June quarter for 120,000 employees. There has clearly been a significant improvement in growth as the company has shifted its focus from sales to insurance carriers to sales to employer clients. Last quarter, the company derived 63% of its revenues from software and services delivered to the employer market, with 37% of revenues coming from the insurance carrier customer segment. The growth in revenues from the employer segment was an impressive 75% or in the high 50% range when eliminating the one-time impact of recognizing revenues from employers using BNFT as their provider of ACA compliance data.
The company continues to forecast conservatively and it is forecasting no significant sequential growth this quarter, perhaps reflecting the lack of the ACA revenue boost that marked Q2. It is then forecasting sequential growth of about 12% in Q4. Q4 growth in 2015 was about 20% sequentially so it seems to this writer that the company has chosen to use very conservative assumptions in its presentations. Given the very large deal closed early in the quarter, that is the size of three "normal sized" enterprise transactions, it would seem that overall expectations have been set at levels that can readily be beaten, although it should be pointed out that most of the revenue from this deal is expected to be seen in 2017 due to the timing of the implementation.
At this point, many investors/traders seem to anticipate that the company is going to beat the published consensus. The shares had a moderately positive reaction to the last earnings release which was clearly a beat and rose 3.5% on the day after - a day on which the IGV closed marginally higher. At this point, BNFT shares are marginally below the point they were prior to the last earnings release while the IGV has appreciated by a couple of percent. Based on the numerous factors that relate to short-term performance, and knowing that the earnings release is probably at least three weeks away, I think this is a reasonable entry point into the shares.
What is the current investment case for the name?
One factor that I sometimes look at in determining if a particular name might make a time worthy investment is software job postings. Several investment banks provide data on job postings by looking through the sites of various software vendors. At the least, it would seem that companies doing lots of hiring probably do not have a bad business outlook. On the other hand, correlations are anything but perfect. And it also can be the case that the hiring companies do sets the table so to speak for longer-term increases in growth that may not be reflected in the current quarter or two.
The inverse is often not the case. For example, the fact that Tableau (NYSE:DATA) has reported 54% lower job postings in Q3 is almost surely not correlated with current business trends but correlated with the hiring of a new CEO and the unsustainable increase in operating expense. Tableau may or may not have achieved its revenue objectives in the quarter, but the decline in job posting is unlikely to be correlated with that metric. Other companies that have seen material declines in their job postings would all seem to have unique factors propelling their job posting declines.
BNFT increased job postings by 30% after quarters in which postings were down 40% and 27%, respectively. Some of those postings are almost certainly related to the on-boarding of the 120,000 user transaction which is of a size not normally seen by this company. And the fact that job postings had declined by more than 65% in just two quarters was probably more than might have been planned or intended. But the reversal in Q3 suggests to me that the company saw business trends positively during the quarter and was willing to increase the pace at which it advertised for jobs.
I don't know that the increase in job postings necessarily is correlated with Q3 financial results. In the nature of things, especially for subscription software vendors, the acquisition of new accounts often does not have an immediate positive impact on reported revenues which do not start, even on a ratable basis, until customers "go live." The large transaction for 120,000 lives as it is described that was signed early in July is unlikely to have any visible revenue impact on current quarter revenue, although the large renewal that adds $5 million to annual revenues may have some small impact. But hiring more employees is basically a positive sign and that is happening with this company at this point.
Part of the trend in hiring that appears to be positive is that the company has been doubling down on sales hiring because of the success its structure has been enjoying and because of the opportunities that have been forecast by the field reps. While I expect that most managements to be optimistic regarding the sales outlook they have during the course of their conference calls, this management might be said to express surprise at the strength it is enjoying with it new sales structure and the level of opportunity that it has. Body language if you like, but I like body language that stems from large deal acceleration and from the closing of a mega-transaction.
I also think that at this writing it seems obvious that the ACA will have a substantial revision and the most likely path at the moment is that its reach will be extended and the government will be more involved than ever in doling out benefits and subsidizing more and more employees. The impact of this is to lead potential clients of BNFT, and for that matter many other companies in the benefit administration space with significant headwinds, when it comes to the acquisition of clients. The one-time revenue stream that was received by this company in Q2 for filing ACA compliance forms can grow and can become far more regular than one-time in nature. At this point, it is almost inevitable that the rewriting and extension to ACA is going to have a long-lasting positive impact on the market for benefit administration software.
And I also believe that the products that the company rolled out during the course of 2015, in particular improved mobile capabilities, improved analytics, the self-service Benefitstore and the Benefit Service Center have given the company something of a competitive advantage against its larger competitors. It isn't that any of these capabilities is particularly unique. Most of them seem obvious to an outside observer but the ability to get all of them on a single platform and to have them work seamlessly is a significant competitive advantage at the moment.
Finally, the company reported that it had signed a renewal agreement with one of its carrier customers that will have a $5 million annual impact on recurring revenue. Given the size of this company, that is a very large upsell.
Like most companies of this type, there are three metrics at which one looks that play into revenue growth. The one that most people focus on is new customer logos which as we have seen declined a bit in Q2 from record results of that metric in the prior year. The second major metric to look at is the size of the logos that are being acquired. A 120,000 seat logo is huge - this company calls anything over 10,000 seats as enterprise in nature. But the third determinant is how much revenue will the seats that are being sold generate per month. If there is one single key to the finances of this company, it is going to be increasing its revenues per seat. And that is what the $5 million revenue stream is all about. Management spoke to having a significant pipeline of opportunities of similar size. Exactly when and how they are going to feed into the revenue stream is difficult to determine. But it is something that suggests that the product extensions the company put together over the past year or so are finding resonance amongst currently installed users. Being able to upsell the installed base is going to be one of the more significant factors in this company's journey on its path to profitability.
It is, I think, difficult to develop a specific screen of characteristics of companies that seem ripe for consolidation. The business case to sell this company is substantial. The less tangible specifics make handicapping the possibility of a sale much harder to handicap. For one thing, over 56% of the shares of Benefitfocus are held by insiders, including the company's two founders. The CEO has run the business since it started 16 years ago and he is only 49-years-old. Would he be content cashing in and enhancing his role as a civil leader in Charleston?
On another front, while the shares are almost certain to seem expensive to most readers and too expensive to many readers, management is going to look at the price at which transactions have been done by other unprofitable cloud vendors. I think the premium achieve a transaction is going to have to be quite high, perhaps in the neighborhood of 50% or more because the EV/S must seem modest to the founders of this company.
But being a category leader in a rapidly growing category that isn't priced at the top end of a range of valuations for cloud-based application vendors suggests that there is an opportunity here for strategic buyers. The space is under penetrated, and the space is seeing significant technology transitions to mobile, self-service and platform based software. Average deal sizes are increasing significantly and customer retention has proven to be substantial. At the company's present scale, it is spending $60 million a year on sales and marketing and that amount will probably grow slowly going forward as part of the company's strategy to move to profitable operations. As part of a larger enterprise, at the least, it would get more bang for a $60 million sales and marketing spend as that amount would be leveraged in terms of cross-sell and up-sell opportunities that are simply not available these days.
It has a significant sales partnership with SAP already, although certainly SAP has been known to buy partners. Oracle is a significant competitor, but then Oracle has been known to buy competitors. But the list of other potential suitors for this company is simply enormous and too long to even think about recounting. Clearly, the state of mind of the founders is going to be dispositive in determining whether this company gets sold in the current consolidation craze in the software space. But owning BNFT would offer many potential benefits to potential acquirers and I think there is a significant chance for that to happen over the next year.
The shares may seem pricey to some but they probably are priced at levels that would lead to significant higher upside if a bid were to be received.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.