HealthStream's (NASDAQ:HSTM) $225m shelf registration raises questions.
The two major questions are:
Are shareholders ready for significant dilution?
When will the sell side cut 2015 #'s?
We were surprised by HealthStream's $225m equity shelf filing both in terms of its size and the company's need for additional capital. With $112m of net cash on the balance sheet and leverage capacity, why does the company need to raise such a large amount through a dilutive equity offering?
In both its 2013 10K filed in March of 2014 and its Q2 10Q filed in July of 2014, HealthStream stated "we believe that our existing cash, marketable securities, cash generated from operations, and available borrowings under our revolving credit facility will be sufficient to meet anticipated cash needs for working capital, new product development and capital expenditures for at least the next 12 months."
On the Q2 conference call in July 2014, CFO Hayden stated "our cash position and overall balance sheet are strong, further enabling our ability to support growth and development activities." CEO Frist stated "one of our opportunities as we have about $111 million in cash and it's growing through a strong cash flow from operations and we feel responsibility to figure out how to deploy that in the higher IRR projects both organic and inorganic."
Are shareholders ready for significant dilution?
$225m is 31% of HSTM's current market capitalization.
We would expect a deal of this size in a company with relatively low liquidity (average daily trading volume over last 90 days is $3.7m or 149,000 shares) would be done much lower to absorb the significant supply. Using recent trading prices between $22-26, issuing 8.6m-10.2m shares would lead to 31% to 36% share dilution.
The use of proceeds section uses the classic "general corporate purposes" catchall including potential acquisitions, capex and investments. "Pending the application of net proceeds, we expect to invest in short term, interest bearing, investment grade securities." Parking proceeds in cash is (8.5c) dilutive (23%) to 2015 consensus estimates assuming the newly issued shares are outstanding for the full year. We note that the $55m raised in 2011 is still parked in cash since the $30m in cash acquisitions since then could have been funded with the $39m generated in free cash flow.
Does the shelf's size signal a change in strategy to larger acquisitions with increased execution risk?
HealthStream has done modest acquisitions over the past few years with a typical deal consisting primarily of cash with a modest amount of stock. The HCCS acquisition this year is a good example. HealthStream paid $12.5m in cash and issued 81,614 shares of stock for a $15.2m deal value. The DCI acquisition in 2012 was $3.4m in cash and 22,124 shares of stock for a $4m value. The Baptist Healthcare deal was valued at $8.5m and Sy.Med deal at $9.5m. During the past 3.5 years, cash invested in acquisitions was $30m which is less than its free cash flow at $39m. At the recent acquisition rate, it would take years to fully invest the existing $112m net cash. With its free cash flow and recurring, subscription based model, debt at the current low interest rates should also be readily available to finance acquisitions. Does the large shelf signal they must be considering significantly larger sized acquisitions which entail much greater execution risk?
Is this a sign that it is better to raise capital when you can, not when you need to?
At Institutional Investor/SumZero's InvestPitch we compared HealthStream to our 2012 Sohn Idea Contest submission short Acacia Research (NASDAQ:ACTG) at $40. HSTM raising capital when it doesn't need it seems to be similar to ACTG's $181m capital raise in March 2011 at $31.50. Acacia's business model and dilution made it difficult for it to reach the optimistic earnings estimates expected by investors. Three years later, Acacia's $221m net cash warchest for acquisitions remains. ACTG's $4.56 net cash per share has helped provide a floor for the stock in the teens. We expect HSTM's current net cash and any funds raised will partially be invested in acquisitions with the majority raised sitting in cash at low interest rates and ultimately helping to provide a similar downside net cash floor.
What message is sent by recent insider sales with the stock down (19%) YTD?
In another parallel to Acacia Research, insiders have been selling while the company plans to raise capital. Recent filings highlight insider selling by senior members of the management team and the Board. CFO Hayden and CTO Doster both sold 25,000 shares while SVP and former head of sales Sousa sold 10,000 shares. Multiple directors (Gordon, Polley, Stead and Taylor) also recently sold shares.
With the stock's 6X appreciation from only $4 in 2010, we would have expected significant wealth creation among the long serving members of the senior management team and Board. Employee ownership is concentrated in CEO/founder Frist's 20.7% stake. We are surprised by the low level of ownership by the rest of the senior management team. The recent filings have CFO Hayden and CTO Doster's direct beneficial ownership at only 2,959 shares and 1,717 shares respectively. Based on the proxy, CFO Hayden had exposure to 88,959 shares including options and RSUs. After selling 25,000 shares, the remaining 63,959 share exposure leads to $1.7m in equity exposure. In the proxy Sousa had exposure to 39,442 share equivalents. After selling 10,000 shares, his equity exposure is now only $765,000 in value.
We also find the senior management team relatively underpaid compared to comparable positions at comparable sized companies. Over the past 3 years, HSTM's senior executives averaged approximately $400k in total compensation with base salaries ranging from $200k-$283k, cash bonuses capped at 30% of base salary (13% average cash bonuses in 2013) and RSU stock awards (5,000 per executive in 2013). We assume stock sales are a way to supplement income which highlights the classic debate: is this really compensation expense? Growth investors are quick to add back stock comp as noncash expense to calculate adjusted earnings and shrug off the equity dilution. Given its magnitude, growth investors can't ignore the dilution from the shelf offering. With the stock not performing well, the extra compensation from options and RSUs lose their incentive value. If senior management's under market compensation is consistent throughout the 780 person organization, we expect upward pressure on SGA to bring compensation in line with peers. This would be another challenge to "margins will magically improve once the catchup growth investments are leveraged by revenue growth" assumptions by the optimistic sell side cheerleaders.
When will the sell side cut 2015 #'s?
We estimate (8.5c) earnings dilution if the company completes the full $225m shelf. 2015 earnings will be hit by a significant increase in the share denominator at the same time revenues are facing a headwind from the ICD 10 "tapering," a nice way to say runoff from a decline in 1X regulatory driven sales which are similar to other empty calorie revenue events like Y2k. If HSTM increases shares by a third, there is only one direction sell side earnings estimate go!
The sell side does not have the most accurate history forecasting HealthStream's earnings. Sell side consensus estimates for 2013 started at 38c and ended with HSTM delivering 30c. 2014 consensus estimates started 53c but are now down to 29c (setting the low bar to "beat"). 2015 consensus started at 54c and are now down to 37c, even before considering dilution from the shelf. The sell side game is to wait for the company to provide annual guidance on the Q4 call and reduce estimates due to "1X growth investments." Despite signaling the share dilution, we believe analysts will wait, especially firms that are participating on any equity issuance, to cut numbers.
What is the business model's earnings power?
If issuing $225m in equity dilutes EPS by (8.5c), it will push consensus EPS to approximately 30c for five straight years (2011-2015). Where's the earnings growth from this "growth" company? Revenues have doubled but EPS are flat due to declining gross margins due to mix and negative operating leverage as the company catches up with investments in SGA and R&D. Share issuance provides another headwind to earnings growth.
Our issue has always been the failure of the business model to translate top line growth into profitability. After 20+ years in business, HSTM still has a retained earnings net deficit. The elusive 50c of earnings power which sell side consensus originally had for 2014 keeps shifting further to the right. The company's dilemma is that it needs to do acquisitions to grow into the high expectations embedded in its multiple but it will significantly dilute shareholders in raising capital to achieve the goal.
What multiple should be applied to a company with flat earnings for 5 years?
Conclusion: We have been public with our short HSTM "$15 by 2015" since the mid $30's (SumZero's Top Idea of the Week of 10/14/2013 at $37, Institutional Investor/SumZero's InvestPitch at $33.60). Our primary thesis has been the headwinds from the ICD 10 taper will lead to revenue growth deceleration which causes real analysis of the underlying business model's earnings power rather than the "just apply a SAAS revenue multiple" cheerleading. Consensus estimates were materially cut in both 2013 and 2014. The company has telegraphed that 1) significant supply is coming to market which telegraphs 2) earnings will be cut from significant dilution. We reiterate our $15 by 2015 investment thesis. Like many thinly traded stocks (IPOs are the extreme example), we expect greater liquidity to remove the artificial "scarcity premium" allowing more efficient price discovery towards normalized market valuation multiples. At 30x its 30c earnings power of the past 5 years, the stock could go to $9 but probably finds a higher floor from its net cash warchest. Our $15 price target is 50X its 30c proven earnings power and 30X our optimistic upside 50c case which assumes significant growth and margin improvement with the wildcard being the amount of dilution from the shelf.
Disclosure: The author is short HSTM.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.