HealthStream: Great Business But Expectations Are Unrealistic

| About: HealthStream, Inc. (HSTM)
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Overview and Thesis

HealthStream, Inc. (NASDAQ:HSTM) provides internet-based learning, talent management and research solutions to healthcare providers in the US. The company operates in two segments: Learning and Talent Management, and Research. The Learning and Talent Management provides training, assessment and talent development and management solutions, management tools and finally, training. The Research segment provides surveys, data analysis of those surveys and research-based measurement tools. In addition to this, the company provides recommendations, benchmarking and consulting services to its clients. The company sells these services via a direct sales force to various healthcare providers in the US.

Given that shares are making new all-time highs as I write this, the optimism from the investing community regarding HSTM's prospects is palpable. However, given that roughly half of the hospitals in the US already use HSTM's services and thus, the addressable market in the US is limited, I'll argue that HSTM's growth expectations implied by the current share price are far too high. I'll then try to assign a fair value to shares given the challenges of meeting or exceeding current expectations.

Earnings Model

Before we take a look at HSTM's business I believe it is instructive to understand what analysts think of the company's prospects as this will be central to my thesis that shares are overpriced at present. I will use these and other inputs in my earnings model, which you can read about in greater detail here, in order to compute a fair value for shares. My inputs and sources are as follows: 1) reported earnings, 2) earnings growth estimates, 3) current book value and 4) current dividend rate, all from Yahoo! Finance, 5) perpetual growth rate of 3% and 6) discount rate of 8%, both of which are my numbers. I chose a very low discount rate of 8% due to HSTM's best-of-breed position in its market, implying that existing customers are likely to be retained and new customers are likely to be brought on. In addition, I chose that discount rate because HSTM is very well capitalized, leaving little in the way of liquidity issues that could crop up in the future. I feel this is a very safe business; thus, the low discount rate.

2012

2013

2014

2015

2016

2017

2018

Earnings Forecast

Reported earnings per share

$0.29

$0.34

$0.44

$0.51

$0.60

$0.70

x(1+Forecasted earnings growth)

17.20%

29.40%

16.50%

16.50%

16.50%

16.50%

=Forecasted earnings per share

$0.34

$0.44

$0.51

$0.60

$0.70

$0.81

Equity Book Value Forecasts

Equity book value at beginning of year

$5.18

$4.56

$4.02

$3.53

$3.11

$2.77

Earnings per share

$0.34

$0.44

$0.51

$0.60

$0.70

$0.81

-Dividends per share

$0.96

$0.98

$1.00

$1.02

$1.04

$1.06

=Equity book value at end of year

$5.18

$4.56

$4.02

$3.53

$3.11

$2.77

$2.52

Abnormal earnings

Equity book value at beginning of year

$5.18

$4.56

$4.02

$3.53

$3.11

$2.77

x Equity cost of capital

8.00%

8.00%

8.00%

8.00%

8.00%

8.00%

8.00%

=Normal earnings

$0.41

$0.36

$0.32

$0.28

$0.25

$0.22

Forecasted EPS

$0.34

$0.44

$0.51

$0.60

$0.70

$0.81

-Normal earnings

$0.41

$0.36

$0.32

$0.28

$0.25

$0.22

=Abnormal earnings

-$0.07

$0.08

$0.19

$0.31

$0.45

$0.59

Valuation

Future abnormal earnings

-$0.07

$0.08

$0.19

$0.31

$0.45

$0.59

x discount factor(0.08)

0.926

0.857

0.794

0.735

0.681

0.630

=Abnormal earnings disc to present

-$0.07

$0.06

$0.15

$0.23

$0.30

$0.37

Abnormal earnings in year +6

$0.59

Assumed long-term growth rate

3.00%

Value of terminal year

$11.77

Estimated share price

Sum of discounted AE over horizon

$0.68

+PV of terminal year AE

$7.42

=PV of all AE

$8.10

+Current equity book value

$5.18

=Estimated current share price

$13.28

As you can see, with the inputs I described above, my model produces a current fair value of just over $13. Before you laugh and write me off as a lunatic, hear me out. If we consider that HSTM is trading at 82 times next year's earnings estimate and 44 times 2018's implied earnings number, my fair value doesn't seem so crazy. In fact, I'd argue that the current valuation is what is insane and we'll take a look at why shortly. Just as a point of reference, in order for my model, with the inputs described above, to produce a fair value that equals the current share price, an earnings growth rate of 57% is required. Even the most bullish among us cannot possibly think that is a sustainable and realistic earnings growth target. While I'll concede earnings models are subjective in nature (as they are estimates) the idea that anything close to that growth rate is implied by the current price should be a red flag.

Valuation

There is no doubt that HSTM is a company that is firing on all cylinders. We are seeing an innovative, well-run company that is growing revenues at 30% per year seemingly without much effort. The company has a terrific product that is very much in demand from its customer base and management is executing virtually flawlessly. However, despite how good this business is, there comes a point where a company can become so overpriced that it should not be considered for a long position; I believe we are there with HSTM.

Management reckons that roughly half of the hospital workers in America use HSTM in some way. As I said in the open, HSTM has several avenues that a hospital worker could use in the way of HSTM services. And since HSTM could cross-sell different services to existing users some inherent operating leverage is built into the model. Further, since HSTM is basically selling software there is very little incremental cost involved. Again, I'm not surprised this business model is working so well as it is extremely well-conceived and there are intelligent people running the place.

So if we assume half of all hospital workers in the US are already using HSTM that leaves the other half of that addressable market completely untapped. In order to figure out what that may be worth we can take clues from what HSTM currently collects from its customers. Below is the average annualized revenue per user the company has collected for the past eight quarters.

As you can see not only is HSTM signing up new customers but it is also making tremendous use of the ones it already has. In the past two years HSTM has managed to increase the amount of revenue per user by 31%. That is an astounding figure and I suspect this is a major reason why shares have rallied so hard; nobody knows where the top is for this figure and with revenue per user growing so quickly, it's almost as though adding new users is an afterthought. At any rate, it's easy to see why HSTM's revenue is growing so quickly.

So we know that HSTM is collecting roughly $30 on an annual basis per subscriber from its online services and that contracted subscribers were 3.26 million at the end of the most recent quarter. Thus, we can figure that the company's subscriber base is currently worth slightly less than $100 million in revenue per year. HSTM has other sources of revenue as well but this category is by far the largest so we'll focus on it in terms of projections for now.

The Bureau of Labor Statistics has taken the liberty of providing us with the number of hospital workers in the US and as of last month, that figure was about 4.8 million. Let's assume for a moment that HSTM eventually signed up each and every one of these workers for its online services. We know that the current annualized rate of revenue from each user is about $30 so some quick math suggests this opportunity would represent $144 million in potential revenue. Now, we have seen that the average revenue per user has been increasing quite steadily over time so we'll assume this will continue and that it eventually reaches $45 per user, or up another 50% from current levels. That would make the 4.8 million hospital worker opportunity worth a potential $216 million. Of course, the number of hospital workers is going to continue to rise so that figure would likely increase by a couple of million dollars per year but $216 million is close enough for this exercise.

Now, by my math, HSTM's other services (Research) accounted for roughly $7 million in revenue last quarter out of $32 million in total. Let's assume that HSTM grows this business at eight to 10 percent per year, per management guidance last quarter, meaning that this business would be producing something like $43 million in revenue in five years. If we assume the growth rate of ~27% predicted by management for the Learning and Talent Management business holds true we get a blended growth rate of about 24%. Again, assuming this holds true for five years revenue of $304 million would be recognized in 2017. Based upon the exercise we just did regarding the hospital community we know that even if average revenue per user increases another 50% from current levels and HSTM signs up essentially every single potential user in the US, that revenue number is likely not possible. This is the sole reason why I'm so cautious on HSTM; even great businesses can be too expensive and HSTM is a great business that is just too expensive.

For the past three years, HSTM's operating margins have come in at 10.7%, 13.8% and 13.0%, respectively. This means that even if HSTM reverts back to, say, 14% operating margins on its $304 million in revenue in five years (which I don't think has any chance of actually occurring), operating income of about $43 million is implied. Even at the current valuation of $971 million, HSTM's implied operating income multiple five years from now would still be almost 23! That is my point with HSTM; expectations are completely otherworldly at this point and even 100% perfect execution from the company isn't going to be good enough to meet expectations that are currently set by the market's valuation of the company. Do you want to pay 2017 prices for a company today? I don't and to even get to that 23 times operating income in 2017, you've got to believe that 25% growth is going to be a perpetual occurrence and I'm simply not willing to do that. The addressable market for HSTM, in my estimation, simply isn't large enough for that to be possible, even if it could somehow achieve 100% adoption of its services.

Conclusion

I really like the business HSTM operates. The company has an amazing platform that has proven very popular and successful. In addition, the company sports decent operating margins and is growing at ridiculous rates. However, the market has become irrationally exuberant in forecasting HSTM's potential in the years to come. Right now, even with ~25% growth rates for the next five years HSTM would still be trading at 23 times 2017's operating income. In addition, I simply don't think the company's addressable market is anywhere near large enough to support these kinds of growth rates.

HSTM does have a very strong balance sheet and very talented management at the helm. In addition, very strong insider ownership of about 25% lends itself to very shareholder friendly practices as management's interests are aligned with that of shareholders. The bottom line though is that I think the only possible way to justify HSTM's current valuation is if there was a buyout offer in place. Absent that I think the market has just gotten ahead of itself and if you get long at $36+, you are setting yourself up for disappointment. Don't get me wrong; momentum names like HSTM and others we've seen can seemingly keep going up forever. At some point though, reality will set in and these names will either crash back down to earth or grow into their current valuations. Either way, the potential upside in HSTM is likely limited while significant downside is possible and I would argue, even likely at this point for HSTM. I think shares are worth something close to what my model produced, perhaps in the $15 area based on current earnings expectations. Obviously, we are a long way from there but I think the current price and expectations are a long way from reality.

Disclosure: I 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.