MEDIDATA SOLUTIONS INC MDSO S
January 05, 2015 - 8:31pm EST by
pianist
2015 2016
Price: 47.25 EPS 0.94 1.14
Shares Out. (in M): 55 P/E 50 41
Market Cap (in $M): 2,517 P/FCF 0 0
Net Debt (in $M): -206 EBIT 0 0
TEV ($): 2,311 TEV/EBIT 0 0
Borrow Cost: General Collateral

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  • SaaS
  • Sell-side Research Errors
  • Insider selling
  • Market Saturation
  • Software

Description

EXECUTIVE SUMMARY: I recommend a short position in Medidata Solutions (MDSO) at $47+/share with $30 price target, for a potential return of 37% in 12 months.

 

BUSINESS DESCRIPTION: Founded in 1999, MDSO provides cloud software to help biopharma companies and contract research organizations (CRO’s) manage and automate the clinical trial process. MDSO derives ~83% of revenues from software subscriptions and ~17% from professional services such as consulting, implementation, and support. MDSO’s core product, Rave, is used for electronic data capture (EDC) and represents ~70% of subscription revenues. EDC is used to electronically collect, validate, and report data for clinical trials, which are tasks that were historically performed with pen and paper. The other ~30% of subscription revenues come from a dozen non-Rave modules to design and manage trials, randomize patients, perform analytics, and do medical coding.

 

CONSENSUS BULLISH VIEW: All 11 sell-side analysts covering MDSO are “Buy” rated with $53 average price target, and largely echo management’s view of MDSO. Consensus bulls believe that MDSO holds the following:

(1)   $10 billion total addressable market (TAM) that is under 10% penetrated, even after 27% revenue CAGR from 2007 to 2014E;

(2)   High-teens annual revenue growth for Rave and ability to grow average revenue per customer 3x-4x through non-Rave modules;

(3)   Long-term goals for 20-25% revenue growth, mid-to-high 70% gross margin, and mid-to-high 30% adjusted EBITDA margin.

 

MY CONTRARIAN SHORT CALL: I was long MDSO in 2012-2013, but now think the bull thesis has run its course yet valuation remains lofty. Through over a dozen interviews with competitors, current and former MDSO customers, and in reviewing MDSO’s financials and corporate governance, I believe the EDC market is saturating and non-Rave competition is intensifying. Specifically:

(1)   MDSO’s true TAM is much smaller than what management claims, as MDSO’s core EDC market is approaching mature growth. Meanwhile, MDSO is barely GAAP breakeven, earnings quality is declining, and customer acquisition costs are rising.

(2)   Additional big Rave contracts seem improbable as most leading biopharma companies and CRO’s – MDSO’s main target customers – already have EDC, are price-sensitive, have been consolidating, and are growing clinical trials at a decelerating pace.

(3)   “Wallet share expansion” via non-Rave will be limited, as evidenced by flat revenues per customer in recent quarters. Greater price competition and higher datacenter costs should also drive subscription GM compression (consensus expects expansion).

(4)   MDSO will fall short of its 20-25% long-term revenue growth target, and Rave revenue growth will likely be below mid-teens.

 

WHY A SHORT-SELLING OPPORTUNITY EXISTS:

·        To find short selling candidates, I screen for situations where the shareholder base is already turning over and a growth story has shown evidence of being broken. I use a personal 50-point checklist to ensure I stay disciplined on entry point and risk/reward.

·        While the sell-side remains predominantly bullish on MDSO, enthusiasm is starting to wane as MDSO has now missed consensus expectations in four of the last five quarters, including the most recent 3Q14 reported on 10/28/14, yet shares have been resilient.

·        Since opening at $37.01/share following the 3Q14 miss, MDSO has soared 29% and now trades at 7.4x EV/sales and 34x EV/EBITDA on LTM metrics, and 6.6x EV/sales and 30x EV/EBITDA on NTM consensus estimates that are likely too high.

·        Nine insiders have sold blocks of 10K+ shares in last five months as stock price has declined, akin to abandoning a sinking ship.

·        MDSO is a relatively uncrowded short, as short interest is 11.9% of float and cost of borrow is top rate.

 

VALUATION & MY ESTIMATES vs. CONSENSUS:

·        For revenues, I am at $395mm (vs. consensus $408mm) for 2015 and $455mm (vs. consensus $490mm) for 2016.

·        For EBITDA, I am at $89mm (vs. consensus $93mm) for 2015 and $110mm (vs. consensus $121mm) for 2016.

·        If my short thesis is correct – namely, MDSO’s long-term annual revenue growth falls below 20-25% and EBITDA margin does not materially improve – MDSO could re-rate to 17x EV/ 2015 EBITDA or 3.7x EV/sales on my estimates, for $30 price target.

·        Presently, MDSO trades well above the median of smid-cap SaaS peers, which consensus defines to include stocks such as ATHN, BNFT, EOPN, GWRE, N, OPWR, and VEEV. Many of these companies have been and are expected to grow revenues faster than MDSO, though consensus has awarded MDSO a premium multiple because of its healthcare exposure.

·        If I am wrong, my perceived upside risk is $54/share (~7x EV/2015 sales, 30x EV/2015 EBITDA on consensus).

·        At current share price, I see nearly 3:1 downside/upside ratio and believe the downside case is more likely to occur.

 

CATALYSTS:

·        The main bottoms-up catalysts would be missed revenue and EPS expectations or lowered guidance (next earnings call is 4Q14 in early February) driven by EDC market maturation, greater non-Rave competition, and higher R&D investment. Shares could also decline due to a sector pullback in SaaS and cloud stocks, which trade well above their three- and five-year averages.

 

UPSIDE RISKS: Revenue growth acceleration above management’s 20-25% annual target, improved earnings leverage, or buyout.


---- (My pitch is summarized above. Please read on for background details, evidence supporting my short call, and key risks. Also, there have been previous excellent write-ups on MDSO by heffer504 and MRGE by SlackTide, which I recommend reading for additional color.) ----

 

COMPANY BACKGROUND:

·        Historically, patient data for clinical trials had been captured using pen and paper. Paper medical records were associated with many limitations such as high costs of staffing, unavailability or incompleteness of records at point-of-care, legibility and data transfer issues, and information inconsistency or redundancy, ultimately leading to lengthier and more costly clinical trials.

·        When the Health Information Technology for Economic and Clinical Health (HITECH) Act of 2009 was signed into law as part of President Obama’s economic stimulus actions, the transition to collect clinical data in electronic format began in earnest.

·        MDSO was a key beneficiary of the healthcare industry’s transition to electronic data capture (EDC). MDSO has grown revenues from $63mm in 2007 to $337mm in 2014E (27% CAGR).

·        Today, MDSO’s Rave and Oracle/Phase Forward’s InForm combine for about 70% of the EDC market, with each vendor holding roughly equal market share. Oracle acquired Phase Forward in April 2010, but for several years the integration did not progress well and MDSO took some share from Oracle. However, in more recent quarters per my channel conversations, Oracle appears to be regaining some traction due to better product and personnel integration, as well as improved customer service.

·        MDSO also offers a dozen other software tools (“non-Rave”) to cross-sell customers in other clinical trial adjacencies. These modules are aimed to transform MDSO from historically an EDC point solution provider to a platform company. Management asserts that MDSO could increase revenue per customer by 3-4x if its entire suite of modules were adopted.

·        MDSO’s subscription backlog offers about 80% visibility into an upcoming year’s revenues. Subscription revenues are recognized ratably over the contract’s life, which generally ranges 1-5 years. Customers usually purchase a multi-study subscription, where they license MDSO’s solutions for a predetermined number of studies and revenues are recognized ratably over the term. Customers can also enter a single-study arrangement where subscription fees are billed and collected quarterly.

·        Revenue mix: Subscription vs. professional services mix was 78%/22% in 2011, 79%/21% in 2012, 82%/18% in 2013, and 84%/16% in 2014E. Rave/non-Rave mix was 92%/8% in 2011, 84%/16% in 2012, 75%/25% in 2013, and 70%/30% in 2014E.

·        Customers: MDSO had 462 customers through 3Q14. Based on historical disclosures, mix has been ~46% pharma, 25% biotech, 13% CRO’s, 9% device and diagnostics, and 7% academic research centers. ~73% of revenues (and growing) are derived in U.S.

 

HISTORICAL STOCK PERFORMANCE:

·        Between 1Q11 and 3Q13, MDSO reported 11 consecutive quarters where they beat consensus expectations or guidance, causing the stock to rip from $10 to $60. That streak was halted in 4Q13, when 2014 EPS guidance was below expectations (stock down -8.2% after the print), and again in 1Q14 when they badly missed consensus revenue and EPS expectations allegedly due to longer sales cycles for larger deals (stock down -25%).

·        MDSO shares surged +15% on 2Q14 earnings day, though revenues beat consensus by merely $0.4mm, benefiting from an unusual +22% y/y growth in non-recurring professional services. Subscription revenues grew +22% y/y, the lowest growth in the last eight quarters. Nevertheless, after the big 1Q14 miss, bulls seemed assuaged that a “worst case” scenario did not materialize short-sellers covered.

·        Since then, MDSO underwhelmed again on their 3Q14 print and revised guidance, with shares opening down -14% before rallying back in the ensuing days.

·        Management noted that a key reason for the revenue shortfall in 3Q14 and 2014 guidance reduction was that “a number of significant competitive deals in our sales pipeline…have slipped into future periods.” Software companies, especially those that once claimed to have great revenue stream visibility, tend to blame misses on deal slippage while they are in denial about their core market approaching saturation.

 

EVIDENCE SUPPORTING MY SHORT CALL:

(1)   In speaking with a dozen clinical data managers and business analysts at prominent biopharma companies and CRO’s that have used MDSO products, feedback suggests that the electronic data capture market (EDC) is maturing – While 2008-2013 represented a significant industry transition from paper to digital capture which enabled MDSO to grow aggressively, virtually all large and many medium biopharma companies and CRO’s now have some kind of EDC. Moreover, from 2010-2013, MDSO capitalized on Oracle’s struggles in integrating Phase Forward and poached a number of Oracle customers.

Management stated as recently as the Needham Conference in August 2014 that they view Rave as a “high teens to low 20’s grower.” Given the maturation of the EDC market, industry consolidation, customer price sensitivity, deceleration in clinical trial growth, I believe the EDC market will likely grow in mid-teens at best. One sell-side analyst who recently launched coverage with a Buy rating took a more muted stance in an off-line conversation, as compared with the initiation report. The analyst also could not get management’s growth numbers for Rave to foot, and believes Rave revenues will grow at just 10-15% annually.


EDC has now been on the market for several years, and the most profitable customers and “lowest hanging fruit” appear to have been picked. My conversations with industry specialists indicate that large and medium biopharma companies and CRO’s account for over 80% of the market opportunity, and should grow as a percentage of the total pie as smaller firms get acquired or squeezed out of the industry. New customers only accounted for just 6% of the growth in subscription revenues in MDSO’s 3Q14.

Moreover, MDSO will likely struggle to expand down-market; Blueshift Research notes that “challenges facing MDSO among small to midsize pharma companies include its nontransparent, high pricing, older software design, customer service issues, a lack of focus on the SMB market, and new competitors offering innovation and lower pricing.” My customer checks also suggest that in some cases, MDSO’s EDC is priced twice as much as that offered by smaller private competitors. All of this suggests that MDSO’s true addressable market is likely much smaller than management claims, which I will elaborate upon in section #5.

(2)   Consolidation within the biopharma industry is shifting bargaining power to customers and away from MDSO – As the industry consolidates, there will be less overlap in R&D efforts among various biopharma companies who will gain more negotiating power. Additionally, the number of clinical trials (in addition to duration, size, and complexity) is an important determinant in the pricing of a Rave contract. Data from www.clinicaltrials.gov shows that y/y clinical trial growth has actually decelerated from 35% in 2008 to under 14% in 2014, and further slowdown seems likely.

This slowing trend also appears to be reflected in MDSO’s total billings (revenues plus change in deferred revenues in a given quarter), whose y/y growth has decelerated from +43% in 4Q13 to +27% in 1Q14, +24% in 2Q14, and +17% in 3Q14.

(3)   Average annualized revenues per customer have stagnated to $780,000 over the last six quarters, despite broader adoption of non-Rave tools. The apparent weakening pricing power seems at odds with management’s “wallet share expansion” story – Over the past three quarters, MDSO’s revenues have grown steadily at ~21% y/y, yet concurrently its y/y customer growth rate has accelerated from 13.4% in 4Q13 to 17.3% in 1Q14, 20.4% in 2Q14, and 21.9% in 3Q14. Also, the average number of MDSO products used by each customer has grown from 1.7 in 1Q12 to 2.4 in 3Q14 (per chart below).

Although the number of customers using two or more MDSO products represents 56% of MDSO’s total customer base, up +44% y/y in 3Q14, various factors appear to be inhibiting the expansion in revenues per customer. Factors may include greater pushback on pricing, ineffectiveness of cross-selling as non-Rave products carry comparatively less value vs. EDC, the need for MDSO to bundle more solutions per order just to keep their clients, or a decrease in growth rate of clinical trials using MDSO products.

Management notes that the fact that the average customer uses just 2.4 MDSO products suggests there is significant room for wallet share expansion if all 12 non-Rave products are adopted. In contrast, I see this number is more indicative of a much lower value-add that non-Rave modules carry compared to Rave, especially when revenues per customer are not growing. Moreover, further adoption of non-Rave modules depends largely on the transition from on-premise to the cloud. While there is a lot of buzz around all things cloud-related nowadays, my customer checks indicate that this transition has actually progressed slowly due to concerns around data security and patient privacy.

(4)   My conversations with customers suggest that Rave may not be that differentiated from competitors in terms of quality yet may be much more expensive – I spoke with a clinical research coordinator at a leading pharmaceutical firm, who currently uses Rave and offered these insights: “It is solid for what it does but it’s expensive. I don’t think MDSO’s interface is any better or worse than others I have used. In fact, generating clinical trial reports can be cumbersome and full of unnecessary extra steps. I’ve seen other CRO platforms which seem much more intuitive. You can navigate those via trial and error, but with Rave there’s a long learning curve. Also, their customer service is not as attentive as they used to be.”

Another clinical data manager that has worked at three of the top 10 biopharma companies told me, “Almost no consideration is given as to whether employees know a platform and have to learn another system from scratch. Given the constant scrutiny of the bottom-line, biopharma companies and CRO’s typically go with whatever is the cheapest solution, and employees just get sent to new training whenever a new solution is adopted. We aren’t talking about nickels and dimes either: for example, a MDSO bid for a Phase II trial lasting a few months might be north of $300,000 with Rave obviously being a big chunk of that value. So when competitor bids come in under $100,000, the cost savings are too big to pass up.”

 

Finally, a clinical research director at a mid-sized pharmaceutical company, which previously used MDSO but now uses BioClinica and Merge among others, noted the following: “There’s still growth in EDC, but the whole life-sciences industry is trying to manage costs better and MDSO seems to have priced themselves out of the market for many outside of big pharma. I could see MDSO trying to get into more trials with the big guys, but big pharma probably holds the cards when it comes to negotiations. As for us, we’re constantly getting pitched by smaller companies with EDC solutions that are just as good, so we’re pretty agnostic about brand. I’m just tasked with finding the best pricing, and many private vendors are offering good products that are sometimes half the price of MDSO’s.”

 

(5)   Total addressable market (TAM) for non-Rave modules is more competitive and much smaller than management purports – Management has estimated its total addressable market to be between $8-10 billion, but I see the true opportunity as being much smaller. First, let us segment the market between EDC and non-EDC. If we assume that MDSO’s Rave revenues grow at what I consider to be a generous 20% annually through 2016 off a base of ~$170mm in 2013, and MDSO and Oracle/Phase Forward each hold 35-40% of the EDC market according to industry sources, then the implied EDC market is between $840mm and $1 billion.

Another method to estimate the EDC market is to segment the biopharma and CRO customer base into large, medium, and small companies. I will define the “large” cohort as the 35 firms whose market caps are greater than $20bn (at the time of today’s publication), and whose clinical trials are the largest and most costly. A large-scale clinical trial can cost over $100mm, and EDC reportedly can account for up to 20% of the total cost of a clinical trial. As a sanity check, MDSO’s largest contract in history, which was announced on its 2Q12 results, was for $100mm+ over five years (~$20mm/year). This was for a platform deal, but where EDC was likely the most valuable component.

Assuming all 35 of these “large” customers engaged in similar contracts yielding $20mm/year (despite my checks suggesting pricing is coming down), the large annual opportunity would be $700mm. The next 65 biopharma companies, which I consider to be “medium,” range from $2-20bn in market cap, and whose annual clinical trial spend is more than an order of magnitude smaller on average. If we assume $2mm/year in revenues, the “medium” annual opportunity would be $130mm. The “small” cohort would be the next 400 firms between $150mm to $2bn market cap, and if we assume each generates about $0.5mm/year, the annual opportunity would be $200mm. I assume minimal penetration for any smaller companies or Phase I or Phase IV trial work, since the price of MDSO’s offerings is likely prohibitively expensive. The sum total across these three segments is $1.03 billion, which triangulates with my earlier estimate based on optimistic EDC growth.

Thus, if I am correct that the EDC market is ~$1 billion and compare that with management’s assertion that its total addressable market is $8-10 billion, this would imply that the TAM addressable by non-Rave solutions should be $7-9 billion. However, I am skeptical, as Rave continues to be the lion’s share of economics for any particular deal. Moreover, my industry checks suggest that the full suite of MDSO products will never be adopted by a given customer, because it is too expensive and/or the customer does not need it.

Furthermore, the non-Rave market appears far more competitive than the EDC market, where MDSO and Oracle mostly dominate. At the Healthcare Information and Management Systems (HIMSS) Conference in Orlando in February 2014, a rising number of companies showcased products for various e-clinical applications such as clinical trial management, budgeting, coding, and business analytics. These products are used to translate clinical data from an EDC into operational or financial decision-making data. Such competitors include Oracle, Parexel (PRXL), BioClinica (BIOC), Merge Healthcare (MRGE), Decision Resources, Nextrials, and OmniComm. My industry checks also suggest that uptake of non-Rave modules has been scattered, as there does not appear to be a “gold standard” offering and thus the sales process may not actually be repeatable.

One clinical data manager at a leading CRO told me that he thought solutions offered by competitors to at least equivalent to MDSO’s non-Rave modules. “The EDC space is maturing, and now the entire buzz is about analytics. MDSO says they can do data analytics and benchmarking, but their engines aren’t that good and they are struggling to prove that their analytics provide increased revenues for clients. We also don’t find MDSO’s pricing to be competitive, either.”

(6)   MDSO is barely GAAP breakeven, and earnings quality and CAC ratio have both been declining – GAAP net profit margins have deteriorated from 20.2% in 2011 to 8.3% in 2012 and 6.0% in 2013, and will be barely breakeven in 2014. This suggests that after including stock option expense, MDSO’s recent revenue growth has actually been unprofitable. Even on a non-GAAP basis, adjusted EBITDA margins will decline ~150 bps y/y in 2014 from 24.3% in 2013, as growth in R&D and sales and marketing expense has been outpacing revenue growth. Management also spoke of their plans at the analyst day in December to invest more heavily in the near-term, yet consensus currently forecasts ~150 bps of EBITDA margin expansion in 2015.

Furthermore, to assess the quality of payback on sales and marketing for a SaaS company, we can look at the customer acquisition cost (CAC) ratio. To calculate the CAC ratio, which approximates the payback period on a sales and marketing investment, I annualize the quarterly change in subscription gross profits and divide that by the previous quarter’s sales and marketing expense. I use all GAAP numbers, which includes stock options. Since each MDSO customer contract is negotiated based on various characteristics of a customer’s clinical trials and the number of solutions required, we must make some simplifying assumptions. I assume that 70% of sales and marketing expense is dedicated to new business acquisition (in-line with industry standard), and that configuration and deployment will take roughly a quarter (hence the use of trailing sales and marketing spend in the denominator). From this, we can see that the CAC ratio is on track to decline from 1.6x in 2013 to 1.0x in 2014.

The key takeaway is that MDSO has not only been ramping overall expenses faster than revenues, but is also seeing incrementally smaller returns on their customer acquisition investments. Therefore, although MDSO is a solid business with respectable revenue growth and products that have a clear place in the market, I believe bulls’ expectations for MDSO’s longer-term profitability are ambitious and current valuation leaves little margin for error.

(7)   Management seems incentivized to aggressively pursue revenue growth and short-term stock price gains, rather than long-term shareholder value creation – The aforementioned erosion in earnings quality should not be surprising after reading the DEF14A proxy filing, as management – like most people – tend to behave the way they are incentivized to behave. Page 30 of the filing shows that management bonuses are determined largely by corporate financial performance objectives, of which 75% is based on revenue/EBITDAO targets and 25% on non-Rave revenue growth. Therefore, while GAAP net income will be nearly zero in 2014 compared to 6.0% in 2013 as stock-based compensation has increased as a percentage of revenues, management will still get paid their big bonuses.

In addition, page 32 notes that management earns annual performance-based restricted stock units, which will vest in full on 12/31/15 upon the conclusion of a three-year performance period dating back to 1/1/13. Two-thirds of award vesting is based on performance goals tied to revenue guidance and “minimum profitability.” The other one-third is based on total stock returns (TSR) vs. the NASDAQ Composite. Page 33 also states that in February 2013, the compensation committee approved “the creation of a special bonus award pool of $7.0 million” payable to senior managers due to stock price performance in the prior year. There are several issues with using TSR as a performance target: it is typically outside the control of executives and can be completely disconnected from underlying business fundamentals, and as such may not be a reliable long-term value driver.

Therefore, management’s incentive structure appears to prioritize shorter-term stock price promotion and “revenue growth at any cost” mentality, both of which seem at odds with traditional measures of long-term shareholder value creation such as GAAP profitability or free cash flow growth.

(8)   MDSO is now limiting disclosures despite once having prided itself on transparency – The Company ceased to provide quarterly guidance starting 4Q13, and also stopped breaking out Rave from non-Rave revenues beginning 1Q14. Management said they are curtailing these disclosures to be “more in line with how we run the business and how the business is best understood and measured.” However, in my experience, the pullback of disclosures is typically not a good sign for shareholders.

(9)   Insiders have been unloading shares as stock price has declined – Ordinarily, I am not too concerned with insiders selling stock on the way up, as I see this as ordinary profit-taking. What is more concerning is when insiders accelerate selling on their way down, which I view as being akin to abandoning ship. Year to date, since MDSO had peaked over $60/share, insiders have unloaded $30mm in stock. Moreover, since MDSO soared 15% the day after it barely beat 2Q14 consensus estimates, insiders accelerated their selling in the $40-45/share range. In the last five months, nine different insiders have sold at least 10,000 shares each at an average ~$45/share, including the President, CEO, CFO, General Counsel, and Chief Commercial Officer, along with the four EVP’s of Strategy, Customer Operations, HR, and Professional Services.

(10)MDSO has significant customer concentration – Per 2013 10-K, top five customers represented 30% of revenues, which probably included Astellas, AstraZeneca, Johnson & Johnson, Roche, and/or Takeda, each of which accounted for over 10% of MDSO revenues in years past. Nevertheless, on the previously mentioned theme of “limited disclosures,” MDSO stopped providing the names of key customers as of its 2013 10-K.

 

MY ESTIMATES vs. CONSENSUS: I forecast a -10% delta in my EBITDA vs. consensus in 2016 and beyond. Main differences:

·        For revenues, I am at $395mm (vs. consensus $408mm) for 2015 and $455mm (vs. consensus $490mm) for 2016.

·        For EBITDA, I am at $89mm (vs. consensus $93mm) for 2015 and $110mm (vs. consensus $121mm) for 2016.

·        Consensus sees 19.8% revenue CAGR from 2014 to 2017, while I am at 15.6%.

·        Consensus sees corporate gross margin expanding 150 bps annually in the next three years, while I expect it to remain essentially flat. Specifically, although subscriptions will grow as portion of revenue mix, I expect their gross margin to come down due to greater competition and customer bargaining power. I also expect data-center and cloud-hosting spending to rise.

·        Consensus sees R&D and sales and marketing as a percentage of revenue each declining 50 bps annually through 2017, while I expect only nominal operating leverage. Even for companies such as Salesforce.com (CRM) that have a truly global brand and footprint, most cloud/SaaS companies tend not to see opex efficiency improve structurally with scale once their core markets have matured, as they must fend off greater competition and pursue avenues of revenue growth that are typically more elusive.

·        In fact, given that MDSO holds adjusted EBITDA margins at the top end of its peer group, I would argue that a “regression to the mean” is far more probable than expansion, especially after already declining from 24.3% in 2013 to 22.0% in 2014E.

 

UPSIDE RISKS: My thesis would be wrong if MDSO achieved the high-end of its 20-25% annual revenue growth target, sees meaningful EBITDA margin expansion, or is acquired. If these outcomes were to happen, I believe MDSO could re-rate to ~7x EV/consensus 2015 sales, which would imply a $54/share price target. The following are various upside risks:

·        Revenue growth could accelerate if the TAM is larger than I have estimated, Rave is adopted for a larger proportion of clinical trials, and add-on modules gain meaningful traction and drive higher average revenues per customer.

·        MDSO does have a strong brand and could succeed in developing an integrated cloud platform. In principle, streamlining data and single sign-on across an entire platform could drive customer stickiness, thereby increasing pricing power. However, most clinical trial employees I spoke with, regardless of the size of their firm, noted that MDSO’s price point was a key concern and there are few efficiency benefits in using MDSO’s non-EDC products versus those of other vendors. In fact, large biopharma or CRO’s typically have experienced IT staff to ensure seamless integration among tools from a variety of vendors. Ultimately, given the rising number of competitors that are functionally- and price-competitive with MDSO’s non-Rave solutions, I do not think customers will become as reliant on a single vendor or “one-stop shop” as bulls may believe.

·        As with most SaaS or cloud companies, there is a possibility of a takeout. There is a reasonable argument that MDSO is a scarce asset insofar as being a leading player competing mainly with Oracle. As such, MDSO could have strategic value to a larger enterprise software company. However, I believe the M&A scenario is mostly priced into MDSO’s current valuation multiple, which is at the high end of precedent M&A transactions with similar revenue growth profiles that had been acquired for 5-8x EV/LTM sales (e.g. Responsys, MarketLeader, Taleo, DemandTec, RightNow, Greenway Medical).

·        For reference, the only time in the last seven months that MDSO hit $50/share was when Morgan Stanley initiated coverage with an Overweight rating and $56 price target on 9/4/14, back when the long-term growth story seemed more certain in my view.

·        One final consideration is that position size should be carefully monitored. From a trading perspective, MDSO and its peers tend to be volatile. From a fundamental perspective, the timing of big deals can make or break a quarter.

 

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

The main bottoms-up catalysts would be missed revenue and EPS expectations or lowered guidance (next earnings call is 4Q14 in early February) driven by EDC market maturation, greater non-Rave competition, and higher R&D investment. Shares could also decline due to a sector pullback in SaaS and cloud stocks, which trade well above their three- and five-year averages.

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    Description

    EXECUTIVE SUMMARY: I recommend a short position in Medidata Solutions (MDSO) at $47+/share with $30 price target, for a potential return of 37% in 12 months.

     

    BUSINESS DESCRIPTION: Founded in 1999, MDSO provides cloud software to help biopharma companies and contract research organizations (CRO’s) manage and automate the clinical trial process. MDSO derives ~83% of revenues from software subscriptions and ~17% from professional services such as consulting, implementation, and support. MDSO’s core product, Rave, is used for electronic data capture (EDC) and represents ~70% of subscription revenues. EDC is used to electronically collect, validate, and report data for clinical trials, which are tasks that were historically performed with pen and paper. The other ~30% of subscription revenues come from a dozen non-Rave modules to design and manage trials, randomize patients, perform analytics, and do medical coding.

     

    CONSENSUS BULLISH VIEW: All 11 sell-side analysts covering MDSO are “Buy” rated with $53 average price target, and largely echo management’s view of MDSO. Consensus bulls believe that MDSO holds the following:

    (1)   $10 billion total addressable market (TAM) that is under 10% penetrated, even after 27% revenue CAGR from 2007 to 2014E;

    (2)   High-teens annual revenue growth for Rave and ability to grow average revenue per customer 3x-4x through non-Rave modules;

    (3)   Long-term goals for 20-25% revenue growth, mid-to-high 70% gross margin, and mid-to-high 30% adjusted EBITDA margin.

     

    MY CONTRARIAN SHORT CALL: I was long MDSO in 2012-2013, but now think the bull thesis has run its course yet valuation remains lofty. Through over a dozen interviews with competitors, current and former MDSO customers, and in reviewing MDSO’s financials and corporate governance, I believe the EDC market is saturating and non-Rave competition is intensifying. Specifically:

    (1)   MDSO’s true TAM is much smaller than what management claims, as MDSO’s core EDC market is approaching mature growth. Meanwhile, MDSO is barely GAAP breakeven, earnings quality is declining, and customer acquisition costs are rising.

    (2)   Additional big Rave contracts seem improbable as most leading biopharma companies and CRO’s – MDSO’s main target customers – already have EDC, are price-sensitive, have been consolidating, and are growing clinical trials at a decelerating pace.

    (3)   “Wallet share expansion” via non-Rave will be limited, as evidenced by flat revenues per customer in recent quarters. Greater price competition and higher datacenter costs should also drive subscription GM compression (consensus expects expansion).

    (4)   MDSO will fall short of its 20-25% long-term revenue growth target, and Rave revenue growth will likely be below mid-teens.

     

    WHY A SHORT-SELLING OPPORTUNITY EXISTS:

    ·        To find short selling candidates, I screen for situations where the shareholder base is already turning over and a growth story has shown evidence of being broken. I use a personal 50-point checklist to ensure I stay disciplined on entry point and risk/reward.

    ·        While the sell-side remains predominantly bullish on MDSO, enthusiasm is starting to wane as MDSO has now missed consensus expectations in four of the last five quarters, including the most recent 3Q14 reported on 10/28/14, yet shares have been resilient.

    ·        Since opening at $37.01/share following the 3Q14 miss, MDSO has soared 29% and now trades at 7.4x EV/sales and 34x EV/EBITDA on LTM metrics, and 6.6x EV/sales and 30x EV/EBITDA on NTM consensus estimates that are likely too high.

    ·        Nine insiders have sold blocks of 10K+ shares in last five months as stock price has declined, akin to abandoning a sinking ship.

    ·        MDSO is a relatively uncrowded short, as short interest is 11.9% of float and cost of borrow is top rate.

     

    VALUATION & MY ESTIMATES vs. CONSENSUS:

    ·        For revenues, I am at $395mm (vs. consensus $408mm) for 2015 and $455mm (vs. consensus $490mm) for 2016.

    ·        For EBITDA, I am at $89mm (vs. consensus $93mm) for 2015 and $110mm (vs. consensus $121mm) for 2016.

    ·        If my short thesis is correct – namely, MDSO’s long-term annual revenue growth falls below 20-25% and EBITDA margin does not materially improve – MDSO could re-rate to 17x EV/ 2015 EBITDA or 3.7x EV/sales on my estimates, for $30 price target.

    ·        Presently, MDSO trades well above the median of smid-cap SaaS peers, which consensus defines to include stocks such as ATHN, BNFT, EOPN, GWRE, N, OPWR, and VEEV. Many of these companies have been and are expected to grow revenues faster than MDSO, though consensus has awarded MDSO a premium multiple because of its healthcare exposure.

    ·        If I am wrong, my perceived upside risk is $54/share (~7x EV/2015 sales, 30x EV/2015 EBITDA on consensus).

    ·        At current share price, I see nearly 3:1 downside/upside ratio and believe the downside case is more likely to occur.

     

    CATALYSTS:

    ·        The main bottoms-up catalysts would be missed revenue and EPS expectations or lowered guidance (next earnings call is 4Q14 in early February) driven by EDC market maturation, greater non-Rave competition, and higher R&D investment. Shares could also decline due to a sector pullback in SaaS and cloud stocks, which trade well above their three- and five-year averages.

     

    UPSIDE RISKS: Revenue growth acceleration above management’s 20-25% annual target, improved earnings leverage, or buyout.


    ---- (My pitch is summarized above. Please read on for background details, evidence supporting my short call, and key risks. Also, there have been previous excellent write-ups on MDSO by heffer504 and MRGE by SlackTide, which I recommend reading for additional color.) ----

     

    COMPANY BACKGROUND:

    ·        Historically, patient data for clinical trials had been captured using pen and paper. Paper medical records were associated with many limitations such as high costs of staffing, unavailability or incompleteness of records at point-of-care, legibility and data transfer issues, and information inconsistency or redundancy, ultimately leading to lengthier and more costly clinical trials.

    ·        When the Health Information Technology for Economic and Clinical Health (HITECH) Act of 2009 was signed into law as part of President Obama’s economic stimulus actions, the transition to collect clinical data in electronic format began in earnest.

    ·        MDSO was a key beneficiary of the healthcare industry’s transition to electronic data capture (EDC). MDSO has grown revenues from $63mm in 2007 to $337mm in 2014E (27% CAGR).

    ·        Today, MDSO’s Rave and Oracle/Phase Forward’s InForm combine for about 70% of the EDC market, with each vendor holding roughly equal market share. Oracle acquired Phase Forward in April 2010, but for several years the integration did not progress well and MDSO took some share from Oracle. However, in more recent quarters per my channel conversations, Oracle appears to be regaining some traction due to better product and personnel integration, as well as improved customer service.

    ·        MDSO also offers a dozen other software tools (“non-Rave”) to cross-sell customers in other clinical trial adjacencies. These modules are aimed to transform MDSO from historically an EDC point solution provider to a platform company. Management asserts that MDSO could increase revenue per customer by 3-4x if its entire suite of modules were adopted.

    ·        MDSO’s subscription backlog offers about 80% visibility into an upcoming year’s revenues. Subscription revenues are recognized ratably over the contract’s life, which generally ranges 1-5 years. Customers usually purchase a multi-study subscription, where they license MDSO’s solutions for a predetermined number of studies and revenues are recognized ratably over the term. Customers can also enter a single-study arrangement where subscription fees are billed and collected quarterly.

    ·        Revenue mix: Subscription vs. professional services mix was 78%/22% in 2011, 79%/21% in 2012, 82%/18% in 2013, and 84%/16% in 2014E. Rave/non-Rave mix was 92%/8% in 2011, 84%/16% in 2012, 75%/25% in 2013, and 70%/30% in 2014E.

    ·        Customers: MDSO had 462 customers through 3Q14. Based on historical disclosures, mix has been ~46% pharma, 25% biotech, 13% CRO’s, 9% device and diagnostics, and 7% academic research centers. ~73% of revenues (and growing) are derived in U.S.

     

    HISTORICAL STOCK PERFORMANCE:

    ·        Between 1Q11 and 3Q13, MDSO reported 11 consecutive quarters where they beat consensus expectations or guidance, causing the stock to rip from $10 to $60. That streak was halted in 4Q13, when 2014 EPS guidance was below expectations (stock down -8.2% after the print), and again in 1Q14 when they badly missed consensus revenue and EPS expectations allegedly due to longer sales cycles for larger deals (stock down -25%).

    ·        MDSO shares surged +15% on 2Q14 earnings day, though revenues beat consensus by merely $0.4mm, benefiting from an unusual +22% y/y growth in non-recurring professional services. Subscription revenues grew +22% y/y, the lowest growth in the last eight quarters. Nevertheless, after the big 1Q14 miss, bulls seemed assuaged that a “worst case” scenario did not materialize short-sellers covered.

    ·        Since then, MDSO underwhelmed again on their 3Q14 print and revised guidance, with shares opening down -14% before rallying back in the ensuing days.

    ·        Management noted that a key reason for the revenue shortfall in 3Q14 and 2014 guidance reduction was that “a number of significant competitive deals in our sales pipeline…have slipped into future periods.” Software companies, especially those that once claimed to have great revenue stream visibility, tend to blame misses on deal slippage while they are in denial about their core market approaching saturation.

     

    EVIDENCE SUPPORTING MY SHORT CALL:

    (1)   In speaking with a dozen clinical data managers and business analysts at prominent biopharma companies and CRO’s that have used MDSO products, feedback suggests that the electronic data capture market (EDC) is maturing – While 2008-2013 represented a significant industry transition from paper to digital capture which enabled MDSO to grow aggressively, virtually all large and many medium biopharma companies and CRO’s now have some kind of EDC. Moreover, from 2010-2013, MDSO capitalized on Oracle’s struggles in integrating Phase Forward and poached a number of Oracle customers.

    Management stated as recently as the Needham Conference in August 2014 that they view Rave as a “high teens to low 20’s grower.” Given the maturation of the EDC market, industry consolidation, customer price sensitivity, deceleration in clinical trial growth, I believe the EDC market will likely grow in mid-teens at best. One sell-side analyst who recently launched coverage with a Buy rating took a more muted stance in an off-line conversation, as compared with the initiation report. The analyst also could not get management’s growth numbers for Rave to foot, and believes Rave revenues will grow at just 10-15% annually.


    EDC has now been on the market for several years, and the most profitable customers and “lowest hanging fruit” appear to have been picked. My conversations with industry specialists indicate that large and medium biopharma companies and CRO’s account for over 80% of the market opportunity, and should grow as a percentage of the total pie as smaller firms get acquired or squeezed out of the industry. New customers only accounted for just 6% of the growth in subscription revenues in MDSO’s 3Q14.

    Moreover, MDSO will likely struggle to expand down-market; Blueshift Research notes that “challenges facing MDSO among small to midsize pharma companies include its nontransparent, high pricing, older software design, customer service issues, a lack of focus on the SMB market, and new competitors offering innovation and lower pricing.” My customer checks also suggest that in some cases, MDSO’s EDC is priced twice as much as that offered by smaller private competitors. All of this suggests that MDSO’s true addressable market is likely much smaller than management claims, which I will elaborate upon in section #5.

    (2)   Consolidation within the biopharma industry is shifting bargaining power to customers and away from MDSO – As the industry consolidates, there will be less overlap in R&D efforts among various biopharma companies who will gain more negotiating power. Additionally, the number of clinical trials (in addition to duration, size, and complexity) is an important determinant in the pricing of a Rave contract. Data from www.clinicaltrials.gov shows that y/y clinical trial growth has actually decelerated from 35% in 2008 to under 14% in 2014, and further slowdown seems likely.

    This slowing trend also appears to be reflected in MDSO’s total billings (revenues plus change in deferred revenues in a given quarter), whose y/y growth has decelerated from +43% in 4Q13 to +27% in 1Q14, +24% in 2Q14, and +17% in 3Q14.

    (3)   Average annualized revenues per customer have stagnated to $780,000 over the last six quarters, despite broader adoption of non-Rave tools. The apparent weakening pricing power seems at odds with management’s “wallet share expansion” story – Over the past three quarters, MDSO’s revenues have grown steadily at ~21% y/y, yet concurrently its y/y customer growth rate has accelerated from 13.4% in 4Q13 to 17.3% in 1Q14, 20.4% in 2Q14, and 21.9% in 3Q14. Also, the average number of MDSO products used by each customer has grown from 1.7 in 1Q12 to 2.4 in 3Q14 (per chart below).

    Although the number of customers using two or more MDSO products represents 56% of MDSO’s total customer base, up +44% y/y in 3Q14, various factors appear to be inhibiting the expansion in revenues per customer. Factors may include greater pushback on pricing, ineffectiveness of cross-selling as non-Rave products carry comparatively less value vs. EDC, the need for MDSO to bundle more solutions per order just to keep their clients, or a decrease in growth rate of clinical trials using MDSO products.

    Management notes that the fact that the average customer uses just 2.4 MDSO products suggests there is significant room for wallet share expansion if all 12 non-Rave products are adopted. In contrast, I see this number is more indicative of a much lower value-add that non-Rave modules carry compared to Rave, especially when revenues per customer are not growing. Moreover, further adoption of non-Rave modules depends largely on the transition from on-premise to the cloud. While there is a lot of buzz around all things cloud-related nowadays, my customer checks indicate that this transition has actually progressed slowly due to concerns around data security and patient privacy.

    (4)   My conversations with customers suggest that Rave may not be that differentiated from competitors in terms of quality yet may be much more expensive – I spoke with a clinical research coordinator at a leading pharmaceutical firm, who currently uses Rave and offered these insights: “It is solid for what it does but it’s expensive. I don’t think MDSO’s interface is any better or worse than others I have used. In fact, generating clinical trial reports can be cumbersome and full of unnecessary extra steps. I’ve seen other CRO platforms which seem much more intuitive. You can navigate those via trial and error, but with Rave there’s a long learning curve. Also, their customer service is not as attentive as they used to be.”

    Another clinical data manager that has worked at three of the top 10 biopharma companies told me, “Almost no consideration is given as to whether employees know a platform and have to learn another system from scratch. Given the constant scrutiny of the bottom-line, biopharma companies and CRO’s typically go with whatever is the cheapest solution, and employees just get sent to new training whenever a new solution is adopted. We aren’t talking about nickels and dimes either: for example, a MDSO bid for a Phase II trial lasting a few months might be north of $300,000 with Rave obviously being a big chunk of that value. So when competitor bids come in under $100,000, the cost savings are too big to pass up.”

     

    Finally, a clinical research director at a mid-sized pharmaceutical company, which previously used MDSO but now uses BioClinica and Merge among others, noted the following: “There’s still growth in EDC, but the whole life-sciences industry is trying to manage costs better and MDSO seems to have priced themselves out of the market for many outside of big pharma. I could see MDSO trying to get into more trials with the big guys, but big pharma probably holds the cards when it comes to negotiations. As for us, we’re constantly getting pitched by smaller companies with EDC solutions that are just as good, so we’re pretty agnostic about brand. I’m just tasked with finding the best pricing, and many private vendors are offering good products that are sometimes half the price of MDSO’s.”

     

    (5)   Total addressable market (TAM) for non-Rave modules is more competitive and much smaller than management purports – Management has estimated its total addressable market to be between $8-10 billion, but I see the true opportunity as being much smaller. First, let us segment the market between EDC and non-EDC. If we assume that MDSO’s Rave revenues grow at what I consider to be a generous 20% annually through 2016 off a base of ~$170mm in 2013, and MDSO and Oracle/Phase Forward each hold 35-40% of the EDC market according to industry sources, then the implied EDC market is between $840mm and $1 billion.

    Another method to estimate the EDC market is to segment the biopharma and CRO customer base into large, medium, and small companies. I will define the “large” cohort as the 35 firms whose market caps are greater than $20bn (at the time of today’s publication), and whose clinical trials are the largest and most costly. A large-scale clinical trial can cost over $100mm, and EDC reportedly can account for up to 20% of the total cost of a clinical trial. As a sanity check, MDSO’s largest contract in history, which was announced on its 2Q12 results, was for $100mm+ over five years (~$20mm/year). This was for a platform deal, but where EDC was likely the most valuable component.

    Assuming all 35 of these “large” customers engaged in similar contracts yielding $20mm/year (despite my checks suggesting pricing is coming down), the large annual opportunity would be $700mm. The next 65 biopharma companies, which I consider to be “medium,” range from $2-20bn in market cap, and whose annual clinical trial spend is more than an order of magnitude smaller on average. If we assume $2mm/year in revenues, the “medium” annual opportunity would be $130mm. The “small” cohort would be the next 400 firms between $150mm to $2bn market cap, and if we assume each generates about $0.5mm/year, the annual opportunity would be $200mm. I assume minimal penetration for any smaller companies or Phase I or Phase IV trial work, since the price of MDSO’s offerings is likely prohibitively expensive. The sum total across these three segments is $1.03 billion, which triangulates with my earlier estimate based on optimistic EDC growth.

    Thus, if I am correct that the EDC market is ~$1 billion and compare that with management’s assertion that its total addressable market is $8-10 billion, this would imply that the TAM addressable by non-Rave solutions should be $7-9 billion. However, I am skeptical, as Rave continues to be the lion’s share of economics for any particular deal. Moreover, my industry checks suggest that the full suite of MDSO products will never be adopted by a given customer, because it is too expensive and/or the customer does not need it.

    Furthermore, the non-Rave market appears far more competitive than the EDC market, where MDSO and Oracle mostly dominate. At the Healthcare Information and Management Systems (HIMSS) Conference in Orlando in February 2014, a rising number of companies showcased products for various e-clinical applications such as clinical trial management, budgeting, coding, and business analytics. These products are used to translate clinical data from an EDC into operational or financial decision-making data. Such competitors include Oracle, Parexel (PRXL), BioClinica (BIOC), Merge Healthcare (MRGE), Decision Resources, Nextrials, and OmniComm. My industry checks also suggest that uptake of non-Rave modules has been scattered, as there does not appear to be a “gold standard” offering and thus the sales process may not actually be repeatable.

    One clinical data manager at a leading CRO told me that he thought solutions offered by competitors to at least equivalent to MDSO’s non-Rave modules. “The EDC space is maturing, and now the entire buzz is about analytics. MDSO says they can do data analytics and benchmarking, but their engines aren’t that good and they are struggling to prove that their analytics provide increased revenues for clients. We also don’t find MDSO’s pricing to be competitive, either.”

    (6)   MDSO is barely GAAP breakeven, and earnings quality and CAC ratio have both been declining – GAAP net profit margins have deteriorated from 20.2% in 2011 to 8.3% in 2012 and 6.0% in 2013, and will be barely breakeven in 2014. This suggests that after including stock option expense, MDSO’s recent revenue growth has actually been unprofitable. Even on a non-GAAP basis, adjusted EBITDA margins will decline ~150 bps y/y in 2014 from 24.3% in 2013, as growth in R&D and sales and marketing expense has been outpacing revenue growth. Management also spoke of their plans at the analyst day in December to invest more heavily in the near-term, yet consensus currently forecasts ~150 bps of EBITDA margin expansion in 2015.

    Furthermore, to assess the quality of payback on sales and marketing for a SaaS company, we can look at the customer acquisition cost (CAC) ratio. To calculate the CAC ratio, which approximates the payback period on a sales and marketing investment, I annualize the quarterly change in subscription gross profits and divide that by the previous quarter’s sales and marketing expense. I use all GAAP numbers, which includes stock options. Since each MDSO customer contract is negotiated based on various characteristics of a customer’s clinical trials and the number of solutions required, we must make some simplifying assumptions. I assume that 70% of sales and marketing expense is dedicated to new business acquisition (in-line with industry standard), and that configuration and deployment will take roughly a quarter (hence the use of trailing sales and marketing spend in the denominator). From this, we can see that the CAC ratio is on track to decline from 1.6x in 2013 to 1.0x in 2014.

    The key takeaway is that MDSO has not only been ramping overall expenses faster than revenues, but is also seeing incrementally smaller returns on their customer acquisition investments. Therefore, although MDSO is a solid business with respectable revenue growth and products that have a clear place in the market, I believe bulls’ expectations for MDSO’s longer-term profitability are ambitious and current valuation leaves little margin for error.

    (7)   Management seems incentivized to aggressively pursue revenue growth and short-term stock price gains, rather than long-term shareholder value creation – The aforementioned erosion in earnings quality should not be surprising after reading the DEF14A proxy filing, as management – like most people – tend to behave the way they are incentivized to behave. Page 30 of the filing shows that management bonuses are determined largely by corporate financial performance objectives, of which 75% is based on revenue/EBITDAO targets and 25% on non-Rave revenue growth. Therefore, while GAAP net income will be nearly zero in 2014 compared to 6.0% in 2013 as stock-based compensation has increased as a percentage of revenues, management will still get paid their big bonuses.

    In addition, page 32 notes that management earns annual performance-based restricted stock units, which will vest in full on 12/31/15 upon the conclusion of a three-year performance period dating back to 1/1/13. Two-thirds of award vesting is based on performance goals tied to revenue guidance and “minimum profitability.” The other one-third is based on total stock returns (TSR) vs. the NASDAQ Composite. Page 33 also states that in February 2013, the compensation committee approved “the creation of a special bonus award pool of $7.0 million” payable to senior managers due to stock price performance in the prior year. There are several issues with using TSR as a performance target: it is typically outside the control of executives and can be completely disconnected from underlying business fundamentals, and as such may not be a reliable long-term value driver.

    Therefore, management’s incentive structure appears to prioritize shorter-term stock price promotion and “revenue growth at any cost” mentality, both of which seem at odds with traditional measures of long-term shareholder value creation such as GAAP profitability or free cash flow growth.

    (8)   MDSO is now limiting disclosures despite once having prided itself on transparency – The Company ceased to provide quarterly guidance starting 4Q13, and also stopped breaking out Rave from non-Rave revenues beginning 1Q14. Management said they are curtailing these disclosures to be “more in line with how we run the business and how the business is best understood and measured.” However, in my experience, the pullback of disclosures is typically not a good sign for shareholders.

    (9)   Insiders have been unloading shares as stock price has declined – Ordinarily, I am not too concerned with insiders selling stock on the way up, as I see this as ordinary profit-taking. What is more concerning is when insiders accelerate selling on their way down, which I view as being akin to abandoning ship. Year to date, since MDSO had peaked over $60/share, insiders have unloaded $30mm in stock. Moreover, since MDSO soared 15% the day after it barely beat 2Q14 consensus estimates, insiders accelerated their selling in the $40-45/share range. In the last five months, nine different insiders have sold at least 10,000 shares each at an average ~$45/share, including the President, CEO, CFO, General Counsel, and Chief Commercial Officer, along with the four EVP’s of Strategy, Customer Operations, HR, and Professional Services.

    (10)MDSO has significant customer concentration – Per 2013 10-K, top five customers represented 30% of revenues, which probably included Astellas, AstraZeneca, Johnson & Johnson, Roche, and/or Takeda, each of which accounted for over 10% of MDSO revenues in years past. Nevertheless, on the previously mentioned theme of “limited disclosures,” MDSO stopped providing the names of key customers as of its 2013 10-K.

     

    MY ESTIMATES vs. CONSENSUS: I forecast a -10% delta in my EBITDA vs. consensus in 2016 and beyond. Main differences:

    ·        For revenues, I am at $395mm (vs. consensus $408mm) for 2015 and $455mm (vs. consensus $490mm) for 2016.

    ·        For EBITDA, I am at $89mm (vs. consensus $93mm) for 2015 and $110mm (vs. consensus $121mm) for 2016.

    ·        Consensus sees 19.8% revenue CAGR from 2014 to 2017, while I am at 15.6%.

    ·        Consensus sees corporate gross margin expanding 150 bps annually in the next three years, while I expect it to remain essentially flat. Specifically, although subscriptions will grow as portion of revenue mix, I expect their gross margin to come down due to greater competition and customer bargaining power. I also expect data-center and cloud-hosting spending to rise.

    ·        Consensus sees R&D and sales and marketing as a percentage of revenue each declining 50 bps annually through 2017, while I expect only nominal operating leverage. Even for companies such as Salesforce.com (CRM) that have a truly global brand and footprint, most cloud/SaaS companies tend not to see opex efficiency improve structurally with scale once their core markets have matured, as they must fend off greater competition and pursue avenues of revenue growth that are typically more elusive.

    ·        In fact, given that MDSO holds adjusted EBITDA margins at the top end of its peer group, I would argue that a “regression to the mean” is far more probable than expansion, especially after already declining from 24.3% in 2013 to 22.0% in 2014E.

     

    UPSIDE RISKS: My thesis would be wrong if MDSO achieved the high-end of its 20-25% annual revenue growth target, sees meaningful EBITDA margin expansion, or is acquired. If these outcomes were to happen, I believe MDSO could re-rate to ~7x EV/consensus 2015 sales, which would imply a $54/share price target. The following are various upside risks:

    ·        Revenue growth could accelerate if the TAM is larger than I have estimated, Rave is adopted for a larger proportion of clinical trials, and add-on modules gain meaningful traction and drive higher average revenues per customer.

    ·        MDSO does have a strong brand and could succeed in developing an integrated cloud platform. In principle, streamlining data and single sign-on across an entire platform could drive customer stickiness, thereby increasing pricing power. However, most clinical trial employees I spoke with, regardless of the size of their firm, noted that MDSO’s price point was a key concern and there are few efficiency benefits in using MDSO’s non-EDC products versus those of other vendors. In fact, large biopharma or CRO’s typically have experienced IT staff to ensure seamless integration among tools from a variety of vendors. Ultimately, given the rising number of competitors that are functionally- and price-competitive with MDSO’s non-Rave solutions, I do not think customers will become as reliant on a single vendor or “one-stop shop” as bulls may believe.

    ·        As with most SaaS or cloud companies, there is a possibility of a takeout. There is a reasonable argument that MDSO is a scarce asset insofar as being a leading player competing mainly with Oracle. As such, MDSO could have strategic value to a larger enterprise software company. However, I believe the M&A scenario is mostly priced into MDSO’s current valuation multiple, which is at the high end of precedent M&A transactions with similar revenue growth profiles that had been acquired for 5-8x EV/LTM sales (e.g. Responsys, MarketLeader, Taleo, DemandTec, RightNow, Greenway Medical).

    ·        For reference, the only time in the last seven months that MDSO hit $50/share was when Morgan Stanley initiated coverage with an Overweight rating and $56 price target on 9/4/14, back when the long-term growth story seemed more certain in my view.

    ·        One final consideration is that position size should be carefully monitored. From a trading perspective, MDSO and its peers tend to be volatile. From a fundamental perspective, the timing of big deals can make or break a quarter.

     

     

    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise do not hold a material investment in the issuer's securities.

    Catalyst

    The main bottoms-up catalysts would be missed revenue and EPS expectations or lowered guidance (next earnings call is 4Q14 in early February) driven by EDC market maturation, greater non-Rave competition, and higher R&D investment. Shares could also decline due to a sector pullback in SaaS and cloud stocks, which trade well above their three- and five-year averages.

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