|Shares Out. (in M):||48||P/E||0||0|
|Market Cap (in $M):||1,794||P/FCF||0||0|
|Net Debt (in $M):||-79||EBIT||0||0|
|Borrow Cost:||General Collateral|
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GAAP financial statements represent a uniform set of disclosures for every publicly listed company. Software as a service (SAAS) companies heavily invest through their income statement in sales and marketing (S&M), which dilutes the value of GAAP disclosures and has the potential to hide significant value creation for shareholders. As a result, public investors fixate on topline revenue growth and rely on management guidance and estimates for assessing underlying unit economics. Investors typically value SAAS companies with an EV/Sales multiple due a lack of earnings and the selective disclosures made by public companies. For this reason, we believe Mindbody presents an interesting opportunity as a short.
Mindbody is a low-quality SAAS company trading at 6x sales with declining unit economics, intense competition and an apparently saturated legacy market. We believe subscriber growth will be muted in the future leaving pricing as the primary throttle to drive future revenue growth. Price increases will only further pressure greater subscriber churn, thereby impairing future cash flows in hope of maintaining a revenue growth story and a higher market multiple.
To compensate for decelerating subscriber growth, the Company, in 2018, acquired Booker Software for $150 million cash. The integration is off to a poor start as management has found Booker in worse shape than previously thought. Despite the rocky start to Mindbody’s first major acquisition, management continues to view acquisitions as a driver of future growth.
Our short thesis will materialize in one of two ways: Mindbody will either give up on or fail in pursuing its revenue growth story or continue its unprofitable pursuit of subscriber growth and ultimately fail to earn an acceptable return on capital. In either scenario, the current $2 billion enterprise value would be significantly impaired. We believe Mindbody has more than a 50% downside.
What is Mindbody?
Mindbody sells software subscriptions to the fitness, wellness and beauty industries. Mindbody connects local studios and salons to consumers through Mindbody’s app to drive incremental revenue for its subscribers. Mindbody generates revenue by selling software subscriptions to subscribers (~$204 per user per month), providing payment services (~$118 per user per month), and selling hardware (insignificant dollars).
Mindbody was founded in 2001 and adopted a SAAS business model in 2005. Mindbody has yet to report an annual profit.
Mindbody’s revenue is driven by three variables: revenue per subscriber (i.e., price), total subscribers (i.e., volume), and subscriber mix. The only driver of sustainable revenue growth for Mindbody is total subscriber growth. This vital driver is faltering which leads to serious questions about Mindbody’s ability to drive revenue.
At the end of 2016, management bifurcated subscribers into “high-value” subscribers and “solo” subscribers. This change came in tandem with the Company making a strategic shift to focus on growing high-value subscribers and forcing out its solo subscribers (12% of subscribers at the time of their announcement).
Solo subscribers make up a significant portion of the total addressable market; however, Mindbody found serving these customers is unprofitable. The main driver affecting profitability was the lack of payment volumes, which are necessary to make Mindbody’s business model viable. This realization significantly reduced Mindbody’s addressable market from 4.2 million to 300 thousand potential subscribers, significantly impairing their growth story.
This bifurcation was reasonably digested by the market and largely explained the deceleration and ultimate decline in total subscribers. Unfortunately for Mindbody, in 2017, high-value subscriber growth decelerated from double digits to low single digits by 2018.
Q1 2018 showed only 2.2% organic growth in high-value subscribers. Following Q1 2018, Mindbody introduced a new term: “Mindbody Higher Priced Tiers”. Higher Priced Tiers is a subsegment of high-value subscribers and this subsegment grew in Q2 by 16% year over year. This growth highlights a mix shift in Mindbody’s existing user base. While it is a positive development, it is a one-time lever for the Company and not a source of sustainable revenue growth.
Management then further qualified high-value subscribers between target market and other markets in a slide from their investor day. (We used this slide to create the table below.) The results include 10,000 customers acquired in the Booker transaction and 500 from FitMetrix in Q1 2018. If these acquired subscribers are excluded, then organic growth of high-value subscribers in Mindbody’s target market was, at best, 4.7% year over year or 1,600 high-value subscribers.
We believe management has gone through multiple iterations in segmenting and redefining their user base to continue a growth narrative in their subscriber base to maintain their market valuation. Interestingly, the market has allowed their posturing to work to date.
One of the drivers behind Mindbody’s slowing subscriber growth is the substantial price increases implemented for their subscription product. We believe Mindbody’s lack of pricing power, evidenced by increased prices resulting in negative effects on subscriber growth, is a sign of a bad business model with a commodity product. Management in their most recent investor day made it clear they are going to continue to increase prices.
Mindbody’s software subscription business, on its own, does not generate enough revenue for the Company to cover its costs. Their payments business, and its ~100% contribution margin, is what allows the Company to have any hope of profitability. There are three drivers for payments revenue: take rate, payment volume per subscriber, and total subscribers. We see payments growth materially slowing from its previous levels of >30% growth rate.
Take rate has expanded nicely for Mindbody since its inception rising from 45 bps in FY 2012 to 90 bps before the Booker acquisition. The growth in take rate is attributable to better vendor terms because of increased scale from payment volumes. After the Booker acquisition, Mindbody’s take rate fell to 82 bps. We expect the take rate to return to 90 bps over the next year but believe this driver of growth is near its peak.
Square (SQ) is a payment processor for small and medium sized businesses and offers comparable services to Mindbody’s payments business. Square’s take rate is 1.08% as of Q2 2018 and has been within a narrow range of 4 bps over the past 4 years. Square is operating at scale and processed $65.3 billion in payment volume in FY 2017 compared to Mindbody’s $7.9 billion for the same period. This significant difference indicates that incremental scale in payment volumes for Mindbody will likely not deliver the same take rate expansion as Mindbody has experienced in the past. (kuddos to Bluewater for the SQ comparison)
Payments volume can be segmented into total subscribers and payment volume per subscriber. As laid out above, total subscriber growth has materially slowed which adversely affects payments volumes as well. The last driver Mindbody has for payments growth is volume per subscriber. While the mix shift through 2017 and 2018 to high-value subscribers has lifted this metric, it will eventually be driven by same-store sales of Mindbody’s subscribers and payment adoption rates. Payment volume per average subscriber through 2016, before the mix shift distorts the figure, grew by only 0.8% per year from 2012 to 2016.
We believe revenue growth will be increasingly difficult to come by without a return to significant subscriber additions. The question then becomes, “Can Mindbody acquire customers profitably?”
Key performance indicators necessary to evaluate unit economics for a SAAS company include customer acquisition cost (CAC), average revenue per user (ARPU), contribution margin (CM), and customer churn. These metrics are used to calculate the life-time value (LTV) of a customer. Comparing LTV to CAC is a measure of capital efficiency and expected returns on capital.
Most companies, Mindbody included, report churn in the form of a net revenue expansion rate which takes prior year revenue generated by customers in the prior year and compares it to the current period revenue generated by the remaining customers from the prior year period (i.e., net of customer churn). We view this calculation methodology as misleading since an increase in price, which promotes increased churn, can drive this metric above 100% and hides the negative impact of customer churn.
Mindbody has disclosed an LTV/CAC ratio and included the following formula along with its disclosure in their investor presentations:
CAC: (Sales & Marketing Expense + Subscriber Onboard Cost) / # of New Subscribers in the period
LTV: (Average Recurring Revenue per Subscriber – Ongoing Cost of Revenue) / (1 – Monthly Recurring Revenue Retention Rate) in the period
This metric cannot be recalculated by investors as Monthly Recurring Revenue Retention Rate is not disclosed in the investor presentation. Dollar-Based Net Expansion Rate is disclosed in quarterly earnings, but it is greater than 100% thus generating a negative number and resulting in a meaningless output from the provided formula.
Interestingly, Mindbody’s disclosure of LTV/CAC has changed over time.
Q2 2016 – First disclosure of LTV/CAC at >5x and the LTV/CAC formula
Q4 2016 – LTV/CAC ratio increased to >6x
Q1 2017 – Changed formula to focus solely on High-Value Subscribers
Q2 2017 – Changed formula from a period calculation to a TTM calculation because “it mitigates the impact of one-time or infrequent costs that may be unrelated to the cost of acquiring subscribers”
Q4 2017 – LTV/CAC disclosure is removed from investor presentations.
The last disclosed formula in the Q3 2017 investor deck is below
CAC: (Sales & Marketing Expense + Subscriber Onboard Cost) / # of New High-Value Subscribers for the trailing 12 months
LTV: (Average Recurring Revenue per High-Value Subscriber – Ongoing Cost of Revenue) / (1 – Monthly Recurring Revenue Retention Rate) for the trailing 12 months
Tallguy’s Estimated Unit Economics
Below, we attempt to calculate CAC and LTV/CAC ratio to focus solely on high-value subscribers.
While management does not directly disclose churn, they have talked about it at various conferences indicating that “target market” customer churn is well below 1% a month, and if a subscriber is on the platform for more than two years, the “location churn rate” drops to 5-7%. Both disclosures are well qualified to disclose a specific subscriber segment. At best, we believe annualized high-value subscriber churn is 8% and potentially well into the teens implying an average user life of 6 to 12 years. It is worth noting Mindbody amortizes their deferred commissions over a 4-year period which they determined by “taking into consideration its customer life and its technology useful life.” This disclosure could mean churn is as high as 25%; however, we believe the useful life of the technology weighs down the estimated life.
As revealed by Mindbody’s strategy shift, all capital invested to acquire solo subscribers was wasted. As such, we allocate all sales and marketing expenses to high-value subscribers. The second adjustment is to allocate all revenue to high-value subscribers inflating the revenue contribution per high-value subscriber before the strategy shift.
Unit economics materially weakened in 2017 with CAC inflating from ~$1.5k in FY 2012 to ~$8.4k in FY 2017 and payback periods extending from ~1 year to ~3 years. Similarly, LTV/CAC falls significantly during the same period.
Importantly, the payback period and the LTV/CAC ratio are not fully loaded for the costs of operating the business. Both metrics overlook research and development as well as general and administrative costs. Lastly, the impact of a rising CAC is magnified if one discounts the cash flows - making the above trend even worse.
So, even if subscriber growth were to reaccelerate, it would only be beneficial if Mindbody reverses its 5-year trend of increasingly ineffective sales and marketing spend. Looking at this trend, it would be reasonable to assume that Mindbody has fully saturated their market.
Saturated Legacy Market
At their September 2018 investor day, Mindbody laid out their addressable market and the desired mix between industries. Applying a little additional math, the Company effectively disclosed it has nearly reached its future penetration goal in the Fitness industry (where Mindbody’s legacy product has the best fit). This points investors to a single market to drive future subscriber growth: Beauty. It also explains management’s rationale for the acquisition of Booker.
Booker was a private company spun out of SpaFinder in 2010. Booker originally designed and marketed their software to appeal to multiple diverse industries. Booker sold their product into various verticals ranging from plumbing companies to massage therapy, tree-trimming and pool cleaners. The diversity of the product was cited by one of their lead investors, Medina, in Booker’s $35 million Series C round in 2015 as an advantage. At some point, the strategy shifted to focus solely on salon and spa as Mindbody management disclosed the vast majority of Booker subscribers were salon and spa at time of acquisition.
Funded by private equity, Booker raised at least $77 million from 2011 to 2015 with the 2015 funding round valuing Booker at ~$200 million according to estimates by Forbes. Through 3/31/2018 Booker had recorded an accumulated deficit of $90 million as well as declining reported revenue in FY 2017 compared to FY 2016.
Mindbody purchased Booker in March of 2018 and closed on the acquisition at the beginning of April. Consideration was ~$150 million in cash or 25% below Booker’s last funding round. Booker’s purchase price is ~7.5% of Mindbody’s current enterprise value.
After closing the acquisition, Mindbody management disclosed more information about Booker in their Q2 conference call. Booker had several hundred customer verticals that were “not suitable” for Mindbody’s consumer platform. These customers are expected to churn quickly. We did not consider these several hundred customers in adjusting for organic growth but estimate there are ~500 subscribers.
In a Fortune article in March 2015, Booker’s CEO disclosed the platform had ~9,000 subscribers. Mindbody disclosed 10,000 spa and salon subscribers at the time of purchase, indicating that Booker only gained ~1,500 net subscribers in the three years following the 2015 interview or 5% annualized growth.
On the Q2 conference call, Mindbody cited bad sales and marketing practices at Booker. Booker increased their subscriber numbers by discounting their price (note the lowest and most popular tier [~70% of subs] was ~$85 per month) inflating subscriber numbers and hurting unit economics as well as the perception of the product by customers. This additional detail only makes the 5% annualized growth even worse as Booker was apparently attempting to grow at all costs.
Mindbody believes Booker was underpricing their subscriptions and raised the price of Booker’s subscription to parity with Mindbody’s product offering beginning July 1st. If the discounted subscription drove subscriber additions, then it is reasonable to expect a 52% average price hike would lead to an increase in subscriber churn.
Tallguy’s Estimated Unit Economics
There is no publicly disclosed information on the unit economics at Booker; however, we lay out our estimates and analysis below.
As a part of GAAP accounting, customer relationships are capitalized and amortized in an acquisition as an intangible asset. Mindbody capitalized $48.4 million of the purchase price to customer relationships or $4,840 per subscriber (i.e., CAC) and provided a range of three to eight years as a useful life for customer relationships. We took the midpoint of customer life and the high end of customer life to establish an estimated range of annualized churn between 12.5% to 18%. This range of churn is consistent with our estimates of Mindbody’s churn.
We check our assumptions to determine other possible outcomes for churn and CAC in the table below as well as provide a range of possible LTV/CAC ratios and payback periods. We assume the ~$50 increase in subscription pricing does not increase churn and, optimistically, Mindbody captures some synergies in cost of revenue resulting in a higher contribution margin. While the proforma Booker economics are superior to Mindbody’s, they are not stellar and remain unproven at a higher price point.
Mindbody can drive some further upside in Booker by increasing the amount of payment volumes per subscriber. Less than half of Booker’s gross merchandise value (GMV) runs through its payment systems. Transitioning this GMV to Mindbody’s payment rails would lend a large upside, but it is similar to take rate expansion in that it is a one-time boost to revenue growth. Sustained revenue growth will have to result from increasing subscriber additions which must be done profitably.
The Salon and Spa space is incredibly crowded, and the code required for booking software is inexpensive to create. To differentiate itself, Mindbody has positioned itself as a premium product with a premium price tag.
One of the largest competitors in the market is Shedul.com which offers its software for free. Shedul has raised over $11 million in venture funding to support its operations and growth. It appears that Shedul does not currently generate any revenue, but its discounting strategy has been an effective form of customer acquisition. The Company has an estimated 83,000 subscribers which equates to $132 of customer acquisition cost if one counts all the capital raised to date as sales and marketing.
Shedul founders noted their success in going after Mindbody, Booker, and StyleSeat subscribers in an interview in 2017. While it is unclear if Shedul will generate any value from these subscribers; it is clear Shedul’s strategy is indicative of the intense competition software providers face in the Salon and Spa industry.
While we highlighted Shedul, we could do the same with more than 50 other companies operating in the same space. Some maintain a similar strategy to Mindbody by offering a premium product with a premium price while others compete with more affordable options. With the amount of capital invested in this space and the lack of substantial barriers to entry, it is difficult to see how Mindbody can continue to increase pricing without seeing a significant increase in churn.
For anyone interested in looking more into Mindbody’s competition, check out Capterra. Capterra, a subsidiary of Gartner, ranks software options against their peers and offers verified user reviews. Capterra ranks Booker 6th and Mindbody 17th in most popular Salon Management Software.
Inclusive in the purchase of Booker was an email marketing application called Fredrick. While management cites Fredrick multiple times throughout their conference calls, they disclosed that it contributed immaterial amounts of revenue for Booker. At Mindbody’s investor day management boasted of impressive revenue growth rates for Fredrick since it was acquired, but the growth is likely driven by accounting games as partner revenue is booked as net revenue while owned properties revenue is booked gross.
Mindbody raised ~$265 million in cash from the issuance of a convertible note offering in Q2 2018; the proceeds were used to establish a war chest should Mindbody see an opportunity to buy a competitor or partner. While management stated they have no interest in M&A while integrating Booker, they want to be ready, should someone decide to sell, so they can have a seat at the table.
We took out all sales and marketing spend and run off the existing subscriber base over a 50 year period with 50% operating margins (Huge Stretch), 6% annual churn (Huge Stretch) and Revenue per user growing ~9% for the first eight years to a terminal growth of 3%. The result was ~$1 billion of value when discounted at a 10% rate.
Feel free to poke holes here but we are comfortable with our approach...
We believe Mindbody’s legacy market is saturated and will no longer meaningfully contribute to growth. Mindbody realized this in 2017 when they did an equity raise in Q2 2017 and sought to purchase growth through Booker. Management will now face the challenge of integrating Booker to drive subscriber growth while improving unit economics in a highly competitive environment. In our view, Mindbody’s $2.0 billion valuation is being supported by the growth opportunities of a $150 million acquisition.
We believe management will stick with their revenue growth story for as long as possible with pricing continuing to drive revenue growth over the next year while integrating Booker. This increase in pricing should cause increased subscriber churn, and we will, therefore, monitor CAC and high-value subscriber additions to confirm if our thesis is correct. If so, then poor unit economics will eventually win out and profitability will not materialize to justify the Company’s current valuation.
The single largest risk is a material improvement in unit economics driven by (1) lower CAC and (2) decreased churn.
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