Medallia: Buy Before It Heats Back Up

Summary

• Shares of Medallia have shed ~20% since reporting Q1 results, despite beating Wall Street's expectations.
• Though we've seen Medallia's revenue growth decelerate since the beginning of the pandemic, the company's valuation correction right-sizes for that reduction in growth.
• Medallia is also a good growth/profit balance story, with positive cash flow growth.
• Medallia also retains substantial liquidity on its balance sheet.

With the market having almost fully recovered to year-end 2019 levels after a sharp recovery in April and May, it's almost getting difficult to find bargains to invest in again. This is especially true of the tech sector, where the NASDAQ has outperformed all year as investors piled into companies less susceptible to retail closures and lockdown orders.

The same, however, cannot be said of Medallia (NYSE:MDLA), a recent IPO (the company went public almost a year ago in July at $21 per share) that is still down ~20% for the year and about 45% from all-time highs. With valuations running away from most stocks, this makes Medallia especially worth looking into at current levels.

Data by YCharts

Of course, Medallia has been hit hard by the coronavirus, perhaps more than other software stocks that may even have benefited from the conversion to remote-work. Medallia specializes in customer-experience software, and companies have been aggressively taking down marketing and customer outreach expenses as an "optional" use of cash that needs to be conserved during the pandemic. In addition, in terms of sector exposure, some of Medallia's slowdown owes to the fact that its second-largest vertical is Retail & Auto, representing 20% of revenues:

Figure 1. Medallia industry mixSource: Medallia Q1 earnings deck

In my view, however, Medallia's steep decline since the beginning of the year right-sizes the stock's valuation against lower growth expectations. The company is also profitable on a pro forma basis and generating free cash flows, on top of having substantial liquidity - which certainly differentiates Medallia against most SaaS stocks, especially amid an uncertain macro environment.

We also like the fact that, in spite of current global turmoil, the majority of Medallia's customer base are large blue-chip companies, which rarely ever cut their software subscriptions. In spite of challenges, we haven't heard of Macy's (M) or Gap (GPS) - two of Medallia's big retail clients - announcing bankruptcies just yet. New business may be impacted for awhile, but too-high churn is unlikely. Also note that Medallia is FedRAMP certified, giving it access to federal government deal opportunities.

At current share prices near $25, Medallia trades at a market cap of $3.39 billion. After netting out the $407.5 million of cash and $43.0 million of debt on Medallia's balance sheet, we're left with an enterprise value of $3.03 billion.

In the face of near-term uncertainty and like most other SaaS companies, Medallia has withdrawn its full-year guidance, which had previously called for revenue of $474-$483 million in revenue for the year (+18-20% y/y). Wall Street consensus is now calling for revenue growth that's a touch lighter, at $463.1 million (+15% y/y) per Yahoo Finance. Against this revenue view, Medallia trades at just 6.5x EV/FY20 revenue.

Multiples have moved higher since the April recovery, and most of Medallia's peers that are expected to grow in the ~20% growth range now trade at high single-digit multiples (Avalara (AVLR), whose guidance calls for just 19-21% y/y growth for this year, is a clear outlier that shows how high even ~20% growth stocks can go).

Data by YCharts

In my view, Medallia should be able to comfortably rise to 8x forward revenues, implying a $30 price target and 22% upside from current levels. Use the near-term dip as a buying opportunity.

Q1 download: while growth slowed, profits inched higher

Let's now dive into Medallia's first-quarter earnings results - which, looking back, weren't at all terrible compared to expectations.

Figure 2. Medallia growth trendsSource: Medallia Q1 earnings deck

The first thing to flag, of course, is that Medallia's growth decelerated. Revenues grew 20% y/y to $112.7 million, decelerating sharply from last quarter's 28% y/y growth rate. We note, however, that this is substantially better than what Wall Street expected ($109.2 million, or +17% y/y growth).

There are three things that make us optimistic on Medallia's growth going forward, however.

• First: billings. As seasoned software investors are aware, billings represents a better long-term view of a company's growth trajectory. Medallia reported 23% y/y billings growth in the first quarter, which suggests that the 20% y/y revenue growth in Q1 may have been a fluke and revenue growth may be poised to trend higher in future quarters.
• Second: an expanded sales force. In 2019, Medallia noted that it has hired and ramped its sales department to add 40% more productive heads. For a relatively young company like Medallia with a huge ~$70 billion TAM, sales coverage is usually the only major constraint to growth. 40% headcount growth leads us to believe that Medallia should be able to post better than the ~20% revenue growth this quarter once the coronavirus pressures ease.
• Third: headwinds from the virus may be fading. Management sounded bullish on recovery trends, with CEO Leslie Stretch noting as follows on the Q1 earnings call:

Our own usage metrics reveal some important trends that I'd like to highlight. For example, from early March to the end of May, we had seen an increase in overall feedback in the retail, insurance and healthcare verticals, with retail digital volume increasing over 140%. In addition, 50% of our conversations customers have seen an increase in messages during this timeframe. We also completed 40% more deployments in Q1 over the year ago quarter proving our team's ability to successfully deliver for our customers remotely. Our remote working capability coupled with the increased automation and our vertical best practice packs enables customers to get live quickly with sophisticated operational feedback systems."

As the economy begins to re-open, disproportionately benefiting retail and travel names (which form a large part of Medallia's revenue), we should expect Medallia to see re-accelerating revenue growth; Wall Street's current ~15% growth target for the year is likely too conservative.

And even as revenues slowed down, Medallia showed some positive progress on profitability. Medallia's pro forma operating margins grew one point to 3% this quarter, as shown in the chart below; the company's outlook for the second fiscal quarter is also calling for ~2% margins versus -2% in 2Q19, or a four-point improvement.

Figure 3. Medallia margin trends

Source: Medallia Q1 earnings deck

Cash flow looked healthy as well. Q1 operating cash flows grew 27% y/y to $23.1 million, and as previously mentioned, Medallia's robust ~$400 million of balance sheet cash versus minimal debt means that we don't need to be worried about Medallia's liquidity in the short term.

Figure 4. Medallia cash flow trendsSource: Medallia Q1 earnings deck

Key takeaways

Customer experience tracking remains a large and greenfield market. It's good to frequently remind investors that SAP (SAP) purchased a direct Medallia competitor, Qualtrics, at 16.5x forward revenues right before its planned IPO in 2018. Of course Qualtrics at the time was a much faster-growing company (~40% y/y revenue growth) and so it's unlikely to think that Medallia will ever touch high-teens multiples, but it still does serve as a good reminder of how valuable the space is with global software giants investing into it.

Take advantage of near-term dips to buy.

Analyst’s Disclosure: I am/we are long MDLA. 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.