- VEEV's focused product offering has allowed it to rapidly accumulate marker share in the life sciences application market.
- There are early indications that Veeva has started to develop competitive advantages through network externalities and customer captivity.
- Entry into additional markets will expand the Total Addressable Market which will allow Veeva to realise its current market value.
Veeva Systems (NYSE:VEEV) provides cloud-based software services to companies within the life sciences industry. The company's solutions help life sciences companies streamline their operations across the entire product life cycle - from product development to commercialisation. Their solutions address a range of needs including multichannel customer relationship management, content management, master data management, and customer data. In addition to their online services the company provides consulting services to firms within the life sciences industry.
VEEV operates within the global life sciences software application industry. In 2016 it was number two in market share with 6.7% of the overall market - SAP (SAP) was the market leader at 8.0%. VEEV's focused approach has allowed it to rapidly accumulate market share and I see this trend continuing going forward. The industry is highly fragmented with the top 10 companies accounting for 45.0% of total market share. VEEV's superior product offering should allow them to consolidate the fragmented bottom end of the market going forward, presenting a strong growth opportunity for the firm.
One of the main risks that VEEV is facing is the slow growth rate of the global life sciences software sector. The industry's CAGR is forecast to be 2.5% over the next 5 years. Under these circumstances, if VEEV was able to consolidate as much as 30.0% of the total market then using a bullish DCF model, the share should be around $50-$55. The share price at market close 2nd of March 2018 was $73.77, making VEEV look grossly overvalued in this scenario.
As with all technology firms, investors need to factor in more than just the current market environment and look at possible paths of disruption. A clear example is that of Facebook (FB) where many investors did not factor in that they were not only operating within the online advertising industry but would go on to disrupt the entire advertising industry. VEEV's current market focus is on the life sciences industry and it is moving from aggregation in this market to product development. Software firms generally operate in a three-stage cycle of aggregation, product development and monetisation. VEEV has successfully completed the aggregation phase within the life sciences industry which is evident from the diverse customer base of leading names in the industry. They are now in the product development phase which will produce customer captivity which is evident from strong growth in their subscription-based revenue stream.
One of VEEV's main strengths in its life sciences product offering is its focus on the regulatory aspect. If we expand their TAM to include other regulated sectors such as chemicals, consumer packaged goods and utilities their opportunity set grows almost four times. Last year Veeva has signed a leading consumer packaged goods company and a top 30 chemicals company. Investors should now focus on how well Veeva executes within these new sectors in terms of aggregation and product development. If there is evidence of Veeva being as successful in these industries as they are in the life sciences space, then Veeva's current share price is justifiable with some upside still to be had.
Source: Personal workings
One of VEEV's main attractions as an investor is its financial performance thus far. The company has experienced strong revenue growth since it launched in 2007. On top of the high levels of growth the company has managed to maintain a high level profitability with its return on invested capital (ROIC) far exceeding its cost of capital. Here ROIC is measured as NOPLAT/Average Invested Capital including Goodwill.
Source: Personal workings from Capital IQ data
We need to look at what has allowed VEEV to achieve this level of profitability and more importantly, if it will be able to sustain it in the long run. In their book Competition Demystified, Greenwald and Kahn outline an approach to assess a company's competitive advantages and highlight two forces that are more powerful than all others, customer captivity and economies of scale.
For software companies there are two stages that allow them to develop customer captivity, the aggregation and product development phase. The aggregation phase allows a successful firm to develop network externalities. Each new client that uses VEEV's product offering will enhance the value of those products and as VEEV aggregates clients across the industry, the value add becomes even higher. The feedback they get from each new customer is crucial for their future product development initiatives. On top of this, the more firms using VEEV's systems in the industry the more that are likely to use them. As individuals develop experience using VEEV's software it may become the industry standard and a prerequisite for certain roles within the industry. VEEV's Vault system is already in use at 35 of the top 50 life sciences companies including Abbott (ABT), Amgen (AMGN), Bayer (OTC:BAYN), Merck (MRK), Novartis (NVS), Novo Nordisk (NVO) and Pfizer (PFE). Its 600+ clients span 180 countries and cover the full range of life sciences firms from biotech to big pharma.
Customer captivity will be developed during the aggregation and product development phase. This is closely linked with the development of network externalities. As VEEV increases their product range it will become more valuable to customers. Over time, the combination of network externalities and customer captivity will lead to high switching costs leading to strong barriers to entry for new firms. There has been strong growth in the company's subscription-based revenue over recent quarters which points to increased customer captivity. Management has been actively pushing to increase these advantages through the launch of new products such as Vault electronic data capture and Vault eSource.
Through its SaaS operating model the company can achieve scale which will contribute to further improvements in its operating margin. Veeva has experienced strong margin growth over the last few years and analysts forecast the company to achieve an EBIT margin of 25.3% over the 2017 fiscal year. I feel that analyst forecasts may be too aggressive over the medium term as there will be a need for substantial R&D spending to successfully enter new target markets which will impact operating margins over the medium term.
VEEV's product positioning is also one of its strengths. It has addressed an untapped area of the life sciences technology sector. The company portrays itself as a strategic technology partner and in so doing avoided stepping on the toes of the larger names within the industry. By entering as a partner to and not aggravating ERP giants like SAP it has been able to avoid being pushed out by the larger players in the industry. Should VEEV's superior product offering improve and if they are able to successfully enter new markets, it would not surprise me to see them become a buyout target for one of the larger technology companies.
To value the firm, I have used a discounted cash flow model using three scenarios (bull, base and bear) and assigning probabilities to each of these. Each scenario captures a different level of customer captivity across the four main industries that VEEV can target. The operating profitability is assumed consistent across the three scenarios. In the DCF, I have used a 10-year explicit forecast period on the firm's free cash flow. Below are the underlying assumptions around market share capture and terminal values for each scenario.
Source: Personal workings
The Bull case is one in which VEEV is able to successfully consolidate the life sciences industry and gain traction across the other three markets. The base and bear case assume that Veeva can achieve consolidation and enter new markets but that it does so less successfully.
When I began looking at this stock in October 2017 it was trading around $58.40 and subsequently fell to $54.00 after a reasonable (but poor by VEEV's high standards) Q3 earnings announcement. Since then the stock has climbed 36.6%. It is now trading within 10.0% to 15.0% of the price range estimated above and, in my opinion, is no longer a strong buy.
VEEV's business model is strong and their financial performance illustrates this. The main concern for investors is that the current valuation of the firm seems excessive. The above lays a blueprint for the possible scenarios that justify the current share price. Technology investments in high quality companies are usually expensive when viewing traditional multiples. The key to identifying successful investments is identifying high quality companies and then assessing what is the potential upside for the firm and what the likelihood of that being achieved is. Given VEEV's current share price there is a limited margin of safety in holding this stock, most of the growth potential has already been priced in and any negative news going forward should see a sharp fall in the share price. It is at that point that I will consider entering the stock.
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