Medidata's architecture, reporting and analytics - a straightforward growth strategy
Most investors including myself are constantly looking at screens for new ideas. It may be that there have been fewer IPOs lately than the historical norm, but that does not mean that there aren't plenty of IT names, far beyond the abilities of my brain to encompass, that are worth a look.
A very useful tool for screening that I have found recently comes from the team that covers the IT space at Credit Suisse (NYSE:CS). CS has a team that exclusively covers SaaS software vendors. The team has developed a tool based on linear regression that portrays a method of valuing the companies in their universe. The results of their work is a graphic that plots what they describe as the unit economics of 37 different vendors who sell their software on a subscription basis. The graphic illustrates a plot of the unit economics, i.e. the customer lifetime value/customer acquisition costs as defined by the analysts against their EV/S ratios as forecast for the next 12 months. It sounds far more complicated than is really the case. I like the tool developed by the analysts as providing some kind of reality check in terms of looking at a wide variety of software vendors addressing different markets. It is a tool that relates to both growth and efficiency, one of the most difficult analytical conundrums with which to deal. It replaces the conventions of accounting that do not properly account for the economics of the new software world and which lead many observers and commentators into a land of pointless nay saying that leads to conclusions that ultimately do not work out.
The tool shows Veeva (NYSE:VEEV) and Atlassian (NASDAQ:TEAM) at the high end of the graphic but with high levels of customer life time value and low costs per customer acquisition. It is a proprietary methodology and I think it is definitely worth the time to review its construction. I have linked the report here, and while it is not a substitute for specific knowledge, it certainly seems to be a good representation of how SaaS vendors are valued. Their study suggests that there is more rationality involved in valuations than some may perceive, although like any quantitative formula that is built on only a couple of variables, it will have its limitations.
The favorite name of these analysts expressed in their article is Ultimate Software (NASDAQ:ULTI). I have written on ULTI in the past and this might encourage me to revisit a name that is more than a bit controversial and which has earned condemnation as a fraud by a commentator on this site.
But besides ULTI, the graphic suggests other names and one that I had never heard of before was Medidata Solutions (NASDAQ:MDSO). Medidata is obviously not the cheapest name to be had in the CS analysis or anywhere else for that matter, but it does present some interesting value parameters. The company has been public for a bit over seven years at this writing. The shares languished for the first few years this company was public. The shares took off in a steady climb back in 2011 and reached a high of above $60/share less than three years later having appreciated almost 8X from the low value made in the middle of 2011.
Since that time the shares have essentially backed and filled despite steadily improving financials in terms of both revenues and EBITDA. The shares are up by more than 18% in the last 12 months but have not yet made a new high. According to most market analyst studies presented by the company at its analyst day in November, the TAM that Medidata currently addresses is in the range of $10-$12 billion vs. current revenues projected to have been $462 million for in 2016.
The company has a comfortable level of non-GAAP profitability and it has achieved positive cash flow generation. It is covered by 10 analysts with a mildly positive consensus consisting of six buys, a strong buy, two holds and a sell. The consensus price target is about 16% above the current price.
In the company's last reported quarter, it continued to record decent financial metrics. Revenue growth was 5% sequentially representing a modest acceleration compared to the first half of the year. Year-over-year comparisons were muted to a degree because of the impact of a contract modification in the 2015 period that increased reported revenues a bit in the year earlier period. Adjusted for that timing issue, year-over-year revenues showed a 20% growth for the period.
Most observers tend to look at calculated bookings as a better indication of sales performance for a company like this. Calculated bookings grew 29% in Q3, accelerating from bookings growth of around 20% in the first half of the year. Overall, billings were slightly greater than reported revenues during the period.
Gross margins were 75.6% compared to the year earlier level of 77.8%, mainly a function of a modest decline in gross margin on services revenues in the period. Sequentially, gross margins rose noticeably and clawed back some of the decline seen in the first half of the year.
On the other hand, GAAP operating expenses fell significantly as percentage of revenue from 67% to 63% led by very positive trends in sales and marketing expense ratios which fell from about 25% of revenues to 23% of revenues. At 23% on a GAAP basis, sales and marketing expenses are one of the lower expense ratios achieved by almost any company in the IT space, let alone one of this modest scale. It suggests that the value users perceive from the solutions offered by Medidata is such that it is relative easy to sell the products and that the company could be managed to achieve significantly more rapid growth.
At this point, Medidata spends a bit more on research and development than it does on sales and marketing, a relationship that is likely to please some observers. Spending 23% of revenues on research and development is one of the higher ratios seen for IT companies and suggests that building new products and enhancing existing solutions as opposed to sales and marketing spend is a conscious strategy that appears to be successful at this point. That is really a function of the philosophy of the two founders and is a less acknowledged component of the success of the company.
The company has managed stock-based comp expense far more efficiently than its peers. Stock-based comp expense fell by 14% last quarter and by 18% year to date. That progression prevented non-GAAP margins from increasing, although at 24% in Q3 they were at relatively reasonable levels for a company of this size that is achieving strong growth.
Overall, stock-based comp represented 41% of reported non-GAAP operating income last quarter, compared to 58% in the prior year, one of the better trends this writer has seen amongst IT companies in some time.
Through nine months cash flow from operations declined noticeably, although it was still comfortably positive. During the course of the conference call, management said that much of the decline was related to a couple of larger receivables where collections which slipped into Q4 and were mainly collected the first day of the just past quarter. Looking at the first nine months of a year as a whole, cash flow was impacted by a smaller growth in deferred revenues as well as the decline in stock-based comp.
That being said, deferred revenues rose slightly in this past Q3 while they declined in the year earlier period. Capex rose noticeably over the first nine months of the year, but declined substantially in Q3. Overall, while CFFO and free cash flow were down through the first nine months of the year, they showed a bit of a turnaround in Q3 and increased from year-earlier levels. On a trailing 12-month basis, CFFO has grown marginally, and given the trend in bookings, Q4 CFFO ought to show positive trends as well, barring significant additional changes in balance sheet items.
What does Medidata do for its supper?
The name is a hint. I will briefly reprise some of the company's major solution sets simply because this is not a well-known company or one that has been much discussed on the pages of Seeking Alpha. Although not a direct competitor of Veeva's Vault and Veeva's Clinical Data Management Solutions, Medidata offers somewhat similar technology. As mentioned, the company has a cloud-based platform that addresses clinical study design and planning. Specific technologies that have been productized include protocol development, clinical site collaboration and management, randomization and trial supply management, the management of mobile health devices, the tracking of lab reports and imaging systems, quality management and safety event capture.
Basically, Medidata raison d'etre is the automation of clinical trials and studies. It is a system that automates all of the data that needs to be collected to successfully comply with FDA standards for new drug approvals.
The company's growth strategies have been to sell multiple products in its suite to its customers (land and expand), to acquire new customers and to use its integrated platform to enhance efficiency, simplicity and speed. The company has conducted studies in which users have said that the integration of the various solutions and the ability to use what is called cross-sponsor data is more important than the functionality of specific products. The success that this company has enjoyed these last several years in selling its solutions suggest that it is providing what users want to buy.
It would be tiresome in the extreme to go through all of the different products that the company offers. I'm not totally sure that there is one standout amongst any of the solutions. But what does stand out I think is that Medidata can leverage real-time data across its platform increasing accuracy and speed. Further, its platform facilitates the development of compliant infrastructure that allows the integration of patient-centric data. In short, for this company the sum of the parts is far more value than the individual solutions and that is really the moat is has that has allowed it to build a very profitable company than runs with a minimum sales and marketing effort.
Medidata calls its most well-known solution Rave. It is said to be the leading unified solution involving electronic data capture and clinical data management. It can integrate readily with the other MDSO solutions. There are several components to Rave and depending on the particular interest of the customer, there can be different competitors including Oracle (NASDAQ:ORCL) and IBM (NYSE:IBM) which have entered the market through acquisition. Other key products are called Coder, which is a solution that pretty much does what its name implies and Balance which is the latest generation of randomization and trial supply management capabilities. The company's newest significant product is something called Payments. This product, which runs on the company's unified platform automates reimbursement to clinical trial sites.
Does Medidata have the ingredients to support its $1 billion aspirational goal?
I would be the last to assert that my knowledge of software that supports life sciences enterprises is deep and of long duration. There is a fair amount of highly specific domain expertise that is needed to understand the product details. There are a dearth of third-party studies or MQ analysis to validate competitive claims. And there are simply more niche software vendors in the space than one can keep track of, even if I had the knowledge to evaluate all of the different product claims.
Medidata recently released a solution that is aimed at the market for clinical trials of genomics. Sounds like lots of fun. The company also announced what it calls eConnect at its analyst meeting. At least I can get my old mind around that one. But I am not too sure how understanding the details of the software helps to evaluate the health of the shares and their investment merits.
As mentioned earlier in this article, Medidata spends a huge amount on R&D (23% of revenues these days), it has been investing in the space for more than 15 years and its revenues seem to be increasing more rapidly than those of the relevant market as a whole. Trying to measure a TAM on the basis of a current snapshot will likely lead to inappropriate conclusions. Even though Medidata has achieved strong penetration rates, it would seem that its ongoing product development will serve to provide the company with loads of additional worlds to conquer.
The most germane studies that I have found suggests that the market CAGR is about 14% through 2020. The TAM that Medidata cites - $10-$12 billion in aggregate - is a bit harder to validate, depending as it does on the ability the company has to sell integrated solutions. I think the basic question here is the length of the runway the company has to achieve its objectives. I think the new customer additions and the increased revenues per user suggest that the runway for the solutions that Medidata sells are at least as long as runways in better known verticals. The company presented a metric in which it asserted that nine of the top 10 selling drugs globally were developed on Medidata technology. That suggests to me that if drug discovery and Medidata's growth are correlated, that seems to be a good support for the company's $1 billion aspirational goal.
The market into which Medidata sells is seeing an exponential growth in trial complexity with the number of what are called case report form pages increasing by 3X in the past decade. There has also been an explosion in the number of vendors producing siloed solutions with 200 different competitors vying for a piece of the pie. And data volumes are growing as fast as almost any other vertical at 48% but with insights from the data not keeping pace due to poor data quality, lack of standard and insufficient integration.
It is the integrated platform developed by the leading vendor in the space (Medidata) with an emphasis on data and analytics and a very broad ecosystem gives credence to the runway for Medidata's solutions. I have no reason to believe that lack of market will slow down Medidata's potential growth anytime in the foreseeable future.
I started this article by referring to a valuation analysis done on 37 SaaS vendors by a team at Credit Suisse. Whether one agrees with all of the details of the methodology, the analysis certainly suggests that MDSO shares are attractively valued, not because of how they rank on traditional valuation metrics but because of the relationship between EV/S and the unit economics of its solutions. But I do think it is relevant to note that the study cited suggests that the correlation found is just 62.5%, better than anything else, but certainly not dispositive.
One thing to note that was during the course of the October conference call, the company suggested that it had 98% coverage starting the quarter in terms of contracted revenue. The mid-point of revenue guidance for the year was $462 million and the consensus for the period from 10 analysts forecasting that metric is just above $463 million. Given the bookings momentum, and the many new products that have been introduced and the seasonally anomalous increase in deferred revenue, it seems highly likely that the company will report an upside to Q4 when it reports results in a couple of weeks. Given that the revenue base is likely higher than heretofore, I suspect that guidance for 2017 will wind up being above the consensus. But for now, I will use the consensus estimates for 2017 in putting together valuation metrics.
At this writing, Medidata has a market capitalization of just less than $2.9 billion. Its cash balance is about $225 million net, leaving an enterprise value of $2.675 billion. The current consensus forecast for revenues this year (2017) is $553 million which yields an EV/S ratio of 4.8X, fairly reasonable for this level of growth.
The consensus EPS forecast for 2017 is $1.23. That yields a P/E of 41X, perhaps not a bargain, but at least there is a P/E about which to comment. It is the relationship between growth and earnings that represents the bargain.
In 2015, the company generated $87 million in cash flow and it spent $19 million on plant and equipment. The trailing 12-month CFFO is running a couple of percent above year-earlier levels on a trailing twelve-month basis, although the results for the first half of the year produced negative cash flow comparisons. Given the A/R timing issue discussed earlier, I think it is probably reasonable to believe that CFFO for the year will come in with modest growth and reach $95 million. I think that cash flow in the current year will be $120-$125 million. With capex running at $20 million this leaves free cash flow at just above $100 million and a free cash flow yield of 4.1%, again not an exceptionally strong figure but one that is reasonable relative to the company's growth performance.
Overall, traditional growth metrics suggest a company whose shares are reasonably valued in its space - it is the company's remarkable level of sales and marketing expense ratio, and the concomitant efficiency it has in acquiring customers, that stands out as a fundamental reason to own the shares. The company has evidently built a variety of better mousetraps for its users, and as a result, it needs less cheese to attract the mice. That, I think, is a good formula for the company to achieve better share price results this year on a relative basis, and to generate positive alpha.
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.