Description

Connecture (CNXR) is a timely short.  CNXR is an illiquid, recent IPO that should see significant selling pressure when its lock-up expires next week on June 10, 2015.  The stock has rebounded more than 50% from its reduced IPO price of $8 per share on the back of low float and perceived earnings beat.  We believe this melt-up is unwarranted based on the following:

• SaaS pretender: CNXR is an IT contractor masquerading as a healthcare software company (SaaS) and feeding off investor appetite for perceived Obamacare beneficiaries.

• Poor IPO reception: CNXR lowered its IPO price from $12-14 per share to $8 per share.   Lead underwriter JPMorgan initiated coverage at NEUTRAL.

• Low earnings quality masked by company’s reported “beat-and-raise” quarters.

• Loss of key customers: CNXR has already lost Maryland as a customer and could also lose its medicare.gov contract.  CNXR is a subcontractor in both cases.

• Weak balance sheet getting weaker.  Negative cash flow.

• Stock price appears manipulated given low trading volume and consistent late-day pump.

• VCs primed to sell:  They have already sold 1m shares into the IPO even at a reduced price.

• Valuation: we believe CNXR should trade closer to $6 per share (-50% from current price) based on 1.7x company’s projected 2015 revenue and 15x adjusted EBITDA.

Company background

CNXR is a web-based consumer shopping and enrollment platform for health insurance distribution.  Its customers are health insurance marketplace operators such as health plans, brokers and exchange operators.  CNXR was founded in 1999 as SimplyHealth, an e-commerce platform for individuals and small business to purchase health insurance.  In 2002, the company changed its name to Connecture to focus on licensing its technology (insurance plan comparison and quotes) to insurance carriers, brokers and other commercial organizations.  From 2010 to 2013, CNXR acquired several companies in broker sales automation and Medicare shopping and enrollment systems.  On December 12, 2014, CNXR raised $45m in an IPO by selling 6.6m shares at $8 per share.

Business model

CNXR has four business segments:

1. Enterprise/Commercial: the product automates sales and enrollment processing for health insurance carriers and brokers in order to do business with consumers online. Allows web-based quoting, shopping, enrollment, administrative review and renewals.  Offered as software hosted by CNXR, revenues are based on an implementation fee, plus subscription software fees.  Implementation typically takes between 6 and 12 months.

2. Enterprise/State: the product is focused on the state exchange markets, offering quoting, shopping, enrollment and management of state health plans.  Offered as licensed installed software, revenues are based on an implementation fee, perpetual software license fee and annual software maintenance.  Implementation typically takes between 6 and 12 months.  CNXR is a subcontractor to the District of Columbia and the State of Minnesota.

3. Medicare: the product includes Medicare plan comparison/shopping tools for medicare.gov and health plans.  This business was acquired through DRX in 2013.  Offered as software hosted by CNXR, revenues are based on an implementation fee plus license fees based on volume of annual enrollment.  Implementation takes from a few weeks to two months.

For the medicare.gov business, CNXR is a subcontractor through the prime vendor, CGI.   The contract is based on an annual license fee.

4. Private exchanges: this white-label product targets benefit consultants, brokers, exchange operators and aggregators with a group defined-contribution benefit exchange solution.  Offered as software hosted by CNXR, revenues are based on implementation fees, annual license fees and transactions fees based on volume of annual enrollment.  Implementation takes from a few weeks to two months.

Table 1 shows the revenue and gross margins of the four business segments.  CNXR expects private exchanges to be its fastest growing segment.  Enterprise/State is expected to decline in 2015 due to the loss of Maryland.

Table 1: Connecture revenue and gross margins by segment

IT contractor masquerading as healthcare software company

CNRX pitches itself as a high-growth healthcare software company (Software-as-a-Service, or SaaS) and therefore claims to deserve high software valuation multiples.  We believe that in reality CNXR is more similar to an IT contractor than a software company.  First, CNXR is a subcontractor (not even a prime contractor) to many deals, such as the state exchanges and medicare.gov.  Secondly, CNXR targets its long-term gross margins to be in the mid-50s (vs. mid-40s today), much lower than the 70-80% gross margins at software companies.  Historically a significant portion of CNXR’s revenue is related to professional services on customer implementation.  We believe CNXR’s IPO was timed to feed off investor appetite for perceived Obamacare beneficiaries.

Poor IPO reception

Due to tepid reception during its IPO roadshow, CNXR lowered its offering price from $12-14 per share to $8 per share.  The stock had a small pop of 10% on the first day of trading.  A month later, lead underwriter JPMorgan initiated coverage at NEUTRAL, even though the stock was only trading at $9.20, well below the initial IPO price range of $12-14.  Although the other underwriters had initiated CNXR at BUY, we found it quite telling that the lead manager was not supporting its own deal.   JPMorgan’s price target at initiation was only $10 per share.

Low earnings quality

CNXR reported two straight “beat-and-raise” quarters out of the box, but we found revenue growth to be deceptive and of extremely low quality.  First, CNXR’s complex revenue model – a combination of amortization of implementation fees, annual license and fees, subscription fees, and transaction fees – obfuscates the true revenue growth of the business.  For at least the past three quarters, CNXR has been amortizing large amount of implementation fees of past contracts, but not replenishing its deferred revenue balance with new deals.  In Q314, deferred was down $13m.  In Q414, deferred was down $7m.  In Q115, deferred was down $8m (see Table 2 below).

Second, CNXR admitted that the only reason it was able to guide Q215 higher than the Street was that it included “the impact of accelerated recognition of previously deferred implementation revenues due to two customer contracts that are expected to end during the quarter.”

In 2014, revenue was also boosted by $5m of accelerated revenue recognition related to the termination of Maryland state exchange contract in Q314.  Without amortization of implementation fees and accelerated revenue recognition, CNXR would have reported lower revenue growth and profitability.

Loss of key customers

CNXR lost Maryland as a customer for its state exchange program when the prime contractor, Noridian Healthcare Solutions, had its exchange contract terminated.  The Maryland state exchange contract accounted for 12% of CNXR’s 2014 revenue.  CNXR currently acts as a subcontractor to CGI, which is the prime contractor on the medicare.gov relationship.  This government contract is up for renewal, and CNRX has admitted it depends on CGI for the contract renewal.  Additionally, in the most recent earnings call, CNXR reported the loss of two regional health plan customers within its Enterprise/Commercial segment.

Weak balance sheet and negative cash flow

CNXR used to its IPO proceeds to pay down a portion of its debt and cash dividends to its VC investors, but its net debt position got worse in Q115 as its cash flow continued to be negative.  If CNXR does not replenish its deferred revenue balance over the next few quarters, we suspect an equity raise may be in the cards.  Of the $49m in gross debt, $29m carries a high interest rate of 12%.  On a trailing twelve months basis, CNXR’s adjusted EBITDA of $3.7m does not even cover its interest expense of $6.3m.  We were shocked that no sell-side analysts asked about the company’s balance sheet and cash flow during the last earnings call.

Table 2: Selected items from financial statements

Suspicious stock price movements

We have noticed suspicious trading patterns on CNXR in recent months.   On many days the stock would open weak and continued to be in the red for most of the day.  Then in the final 30 minutes of trading, a surge of buy orders would push the stock solidly into the green, regardless of the broader market condition.   We suspect a low float and light daily trading volume make CNXR an easy target for manipulation.  We don’t think this behavior will continue once the lock-up expires.

Lock-up expiration

We believe CXNR’s venture capital investors are primed to sell when the lock-up expires on June 10, 2015.   All of them sold some of their holdings during the IPO, even when the price was reduced from $12-14 per share to $8 per share, suggesting that they could not wait to pare their holdings.  In aggregate, the VCs sold 1m shares into the IPO and continue to own over 13.8m shares (60% of total shares outstanding).  We would note that several VCs have invested in CNXR as far back as 2005.  The life on this investment should be expiring (or have expired).

Valuation

CNXR currently trades at 3x its projected 2015 revenue and 30x adjusted EBITDA.  It does not have a true comp.  Its most direct competitors are either in-house solutions at insurance carriers or system integrators like Accenture and IBM.  Sell-side analysts often compare CNXR’s model to those of Benefitfocus (BNFT) and eHealth (EHTH).   BNFT currently trades at 5.6x 2015 revenue while EHTH trades at 1x.  BNFT was actually trading at nearly half the current multiples before Mercer announced a 10% investment in the company.  BNFT offers a broader set of products and services than CNXR and is the technology platform for Mercer’s private exchange.  EHTH targets consumers directly. Finally, we would note that CNXR acquired DRX (its Medicare platform) at 1x forward revenue.  Given the issue we highlighted above about CNXR, we believe it should trade at a significant discount to BNFT.  We think $6 per share is a more appropriate valuation (1.7x 2015 revenue and 15x adjusted EBITDA).

Risks to our short thesis

• Private exchange business takes off

• Mix shift to higher margin recurring revenue is real

• Deferred revenue goes up as backlogs are invoiced

Catalyst

• Lock-up expiration: June 10, 2015

• Insider selling

• Weak balance sheet gets weaker

• Potential equity raise

• Potential loss of medicare.gov contract and additional customers