Medallia: Buy The Dip

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About: Medallia, Inc. (MDLA)
by: Gary Alexander
Summary

Shares of Medallia have dropped to new post-IPO lows after reporting Q2 results, despite beating Wall Street's estimates on the top and bottom line.

Investors are concerned over Medallia's deceleration; the company's revenue growth slipped to 27% y/y this quarter, down from 32% y/y in Q1.

Still, with Medallia estimating <1% market penetration, there's plenty of opportunity for future growth.

Long trading at a double-digit forward revenue multiple, Medallia is now trading at ~8x forward revenues. Recall that rival Qualtrics was purchased for 16.5x forward revenues.

It's been about one quarter since Medallia's (MDLA) IPO, and like most IPOs this year, the stock's general trajectory has been downward. The customer-experience (NYSE:CX) software company was a smashing hit on its IPO day, rising 76% from an IPO price of $21. Since then, however, Medallia's gains have flagged, and ever since the company reported Q2 results, the stock has hit new post-IPO lows.

Chart
Data by YCharts

In my view, Medallia's post-earnings dip gives investors a great buying window into a rare growth stock. Yes, it's true that Medallia's Q2 release raised some questions, particularly around deceleration. Q2 revenue growth decelerated five points, and potentially even steeper deceleration is expected into Q3.

However, we find some compelling counterbalances to Medallia's slowing growth rates. The first is that alongside slowing revenue growth, Medallia is also making tremendous gains in profitability. Over the past several quarters, Medallia's pro forma operating margins have hovered near or above the breakeven point - which is incredibly rare among recent SaaS IPOs. Growth, after all, hinges on a profitability lever that companies can choose to turn - by cutting down on sales and marketing expenses, Medallia may have sacrificed a few points of growth, but it has also massively improved its bottom line.

The second is that Medallia still has plenty of head room for future growth, and even if the company doesn't sprint (at the ~40-50% y/y growth rates that some SaaS companies are hitting) toward filling its available market, Medallia's market opportunity is large enough to support sustained growth.

Figure 1. Medallia market opportunity Source: Medallia Q2 earnings deck

As seen in the chart above, Medallia estimates its TAM at $68 billion, indicating that at its current revenue scale, the company has only penetrated into ~1% of its total market opportunity. It's also important to note that Medallia has cited a long-term growth target of 25-30% y/y in its subscription revenues, which is roughly in-line with this quarter's growth rate - indicating that management is favoring more of a steady, consistent growth pace rather than the all-out sprint that many peers are chasing.

Additionally, Medallia's lower valuation presents yet another catalyst for investment. At present share prices near $31, Medallia is trading at a market cap of $3.86 billion. After netting off the company's $417.4 million of cash, Medallia has an enterprise value of $3.44 billion.

Over the trailing twelve months, Medallia has generated $356.8 million of revenue. If we assume a 20% y/y growth rate over the next twelve months (note that Medallia is projecting a 23-24% y/y growth rate for FY20 as a whole), we arrive at a forward revue estimate of $428.2 million. This gives Medallia a current valuation of 8.0x EV/forward estimated revenues.

Recall that Medallia's most prominent rival, Qualtrics (XM), was scooped up by SAP (SAP) at a 16.5x forward revenue multiple. In addition, Medallia's current revenue multiple puts its valuation below that of many other SaaS peers in the ~20-30% y/y growth range:

Chart
Data by YCharts

In my view, Medallia is worth at least 10x forward revenues, in line with peers - implying a price target of $38, or 23% upside from current levels. Stay long here and buy the dip.

Q2 download: slowing growth tempered by improved margins

Let's now dive into the details of Medallia's second-quarter earnings release:

Figure 2. Medallia 2Q20 earnings Source: Medallia 2Q20 earnings release

Revenues grew 27% y/y to $95.7 million, beating Wall Street's expectations of $91.3 million (+21% y/y) by a wide six-point margin. Still, this growth rate represented five points of deceleration relative to 32% y/y growth in Q1.

What perhaps concerned investors more than this quarter's deceleration, however, is the fact that the company more or less guided to continued deceleration. For Q3, Medallia's revenue range of $95-$97 million represents a growth range of just 17-20% y/y. For the full year, Medallia guided to $385-$388 million in revenues, or +23-24% y/y. This implies that revenues for the second half of the year will be $195.7-$198.7 million, or just 17-19% y/y growth.

Still, we like where Medallia's other top-line metrics are heading. The company ended the quarter with 613 total customers, representing 26% y/y growth:

Figure 3. Medallia customer trends Source: Medallia Q2 earnings deck

Leslie Stretch, Medallia's CEO, also commented on the Q2 earnings call that the company has recently expanded its go-to-market strategy to target mid-market enterprises, as well as pushing harder on reseller partners to drive sales:

We created a mid-market product and sales capability under Rory Cameron's leadership to exploit the opportunities presented there. We have done this because we see significant demand for our capabilities in organizations of all sizes. Thirdly, we are developing deeper relationships in our partner ecosystem. These partners helped Medallia extend our geographic and vertical coverage, accelerate the usage and adoption of our platform, augment our platform with complementary technology, promote thought leadership and provide additional implementation resources."

It's also important to recognize that part of the reason that Medallia is expecting lower growth in the future is because it's pushing on its reseller channel. Roxanne Oulman, Medallia's CFO, commented as follows:

We are focused on enhancing our partner channel as part of our growth initiatives. This includes transitioning more services and assisting our partners in expanding their consulting practices. This may impact our professional services revenue and margins in the future."

When Medallia offloads its professional services work onto its partners, it is losing professional services revenue (which grew 38% y/y in Q1). However, it's highly margin-accretive for Medallia to outsource this work, because Medallia does this work at barely over cost. In Q2, GAAP gross margins for professional services clocked in at a measly 4%. Like many other SaaS companies, Medallia views professional services as merely an "enabler" to encourage subscription deployment - even though the company may sacrifice its optical growth rates by transitioning more of this work to partners, it's not losing any margin in the process.

Also offsetting Medallia's lower growth rates, as mentioned earlier, is a huge bump in profitability. The company's margins have been on a tremendous upswing since 4Q19, and in Q2, Medallia achieved more than twenty-five points of margin improvement, hitting pro forma operating margins of -2.5% in the quarter.

Figure 4. Medallia margin trends Source: Medallia Q2 earnings deck

The primary driver of this improvement is greater efficiency on the sales and marketing front, where total sales expenses fell to 40% of revenues on a pro forma basis (netting out stock-based comp), down nine points from 49% in 2Q19. This is in spite of the fact that Medallia's annual customer conference happens in Q2, and the company spared no expense this year.

Medallia's pro forma EPS of -$0.06 also squarely beat Wall Street's expectations of -$0.15, while the company's operating cash flows improved to -$20.6 million this quarter, up from a loss of -$34.6 million in the year-ago quarter:

Figure 5. Medallia OCF Source: Medallia Q2 earnings deck

Key takeaways

There's a lot to like about Medallia, especially after the stock has shed ~25% off recent highs. In my view, the company's slowing growth rates are counterbalanced by the fact that Medallia is vastly improving its margin profile, as well as the possibility that it's giving up lower-margin professional services revenues to third-party resellers.

When we consider the fact that Medallia's closest competitor got bought out at twice Medallia's current valuation, Medallia looks like an incredibly compelling opportunity. Use the dip as a well-timed buying opportunity.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in MDLA over 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.