Description

After 2 years of patiently watching and waiting, I think it is time to short MB.

About MindBody

Mindbody is a leading provider of cloud-based business management software for the health and wellness services industry. The company was founded in 2001 to help yogis manage their studios. It has expanded into spas, salons, fine arts and any other businesses that need scheduling and payments processing capabilities. Mindbody currently has over 60k customers and is the largest provider (by far) in the health and wellness industry. The Company went public on June 19th, 2015 at $14 per share.

The Bull Story

Mindbody has a dominant industry position and large addressable market. The sell-side pegs MB’s total addressable market at $8-15+billion and with 2017e sales of $180mm, Mindbody is just getting started. The Company’s roadshow materials estimated that MB was just 28% penetrated in its core yoga/pilates vertical and that all other verticals were less than 5%, with most at just 1% penetration. In addition, Mindbody’s growing ecosystem has healthy network effects and their core SaaS solution is sticky since customers are unsophisticated and switching vendors is a pain point. As a result, MB is an attractive thematic investment in 1) SaaS and 2) growing demand for health and wellness services. While EBITDA margins are currently negative, long-term margins are estimated to be 30%. This is up from the 20% estimated during the IPO roadshow as management increased long-term guidance after 1Q15 results. Eight sell-side analysts rate the stock a buy and only two analysts rate the stock a hold.

The Bear Thesis

The short thesis on MB is simple. Mindbody has saturated its core health and wellness market and the company is a low quality SaaS business with poor customer lifetime value economics. As a result of the customer economics, the profits that bulls expect are unlikely to materialize.

This short thesis is not new. Friendly Bear attacked Mindbody on SeekingAlpha in October ‘16 and just two weeks later another author, Ariana Research, highlighted that the bull thesis is built on wrong and misleading lifetime value assumptions. I will summarize the key short arguments of both write-ups, below.

Friendly Bear on SeekingAlpha

• MB is a questionable JOBS Act IPO  where management is intentionally hiding key metrics like churn that are necessary for proper LTV analysis

• MB is 60% penetrated in their core fitness market which is by its nature is a high churn, high touch and is an “awful” industry to service

• MB has 15 years of losses and should be profitable today if the customer economics are as claimed

• At a $700+mm EV the valuation is extremely stretched (stock was ~$19/share)

• MB has increased pricing as far as they can and subscriber growth is hitting a wall

• MB is a leader in their saturated yoga/pilates vertical, but is not a leader in other verticals like spa/salon making future growth more costly and challenging

• MB is not a highly productive and scalable SaaS business – their revenue per employee ranks at the bottom vs other local oriented business – and the company is seeing diminishing returns on its spending

• “either the company gives up on the revenue growth dream and sees its multiple correct, or it fails to ever reach profitability and has to keep coming back to the markets for more cash”

Ariana Research on SeekingAlpha

• MB does not have a >5x LTV/CAC ratio since the assumptions needed to get there – annual churn of 15-17% and CAC of $2k –  are optimistic and are inconsistent with other data the Company provides (of note, current company presentation has increased this to a 6:1 LTV to CAC ratio)

• Customer acquisition cost continues to skyrocket as MB stretches for growth outside of their core verticals

• MB’s run-rate valuation is extremely expensive (stock was ~$19/share)

Penetrated Core TAM

While teasing out the real LTV of your average MB customers is impossible without critical information from the Company, proving the saturation in the core yoga/pilates/barre vertical is an easy task. Pick your favorite city and use google maps to identify every yoga/pilates/barre studio in the area. Then see how many of those companies are on Mindbody Connect and hence MB customers.

Based on my own channel work, I estimate MB has captured 80-90% of their core exercise class studios. I think MB is effectively fully penetrated when removing customers that are too small or too large to need MB. This compares with MB management’s estimate of ~30% penetrated in their core vertical, competitors on expert network calls saying MB is in the middle-innings of penetrating their core, and Friendly Bear estimating ~60% penetration. Not surprisingly, MB’s customer growth has had to come from new verticals such as spa and salon where MB faces an uphill battle against strong incumbents. The Sales & Marketing expense vs. net customer additions reflects this challenge:

I could nitpick about other issues with Mindbody. The software is built on an archaic platform that is cumbersome and buggy. Many studio owners dislike the Mindbody Connect application because it makes it easier for their customers to switch to competitors. And owners especially hate the Groupon deals that cannibalize existing business. However, the reality is yoga studio owners are generally unsophisticated technologically and minor scheduling application issues are not enough of a pain point to leave.

But studio owners are sensitive to pricing and a 50% price increase over the last 2 years is now a pain point. My work, and recent reported results, suggest MB has pushed too hard and too fast.

Why MB is a timely short

In my view, MB has been an unshortable beat and raise story. Shorts can scream all they want about $200M in accumulated losses, customer acquisition cost metrics that suggest a negative value per new customer and a long term model that will not work. But Mindbody shareholders don’t care about the negative arguments as long as MB is beating sales estimates and progressing on the path to profitability. Stalking MB has been an exercise in short-selling discipline since, in my opinion, the stock is only going to fall apart when either 1) top line growth falls short of expectations or 2) the path to profitability proves a mirage.

I think we are at the inflection point. In 1Q17, Mindbody barely hit sales estimates and lowered profit guidance for the first time. The quarter was notable because MB raised prices 25+% at the start of 2017, the third and largest increase over the last three years. Many studio owners have told me they are now actively trying to switch off the platform due to the incessant price increases.   

Mindbody’s ability to smash estimates looks like a downward dog:

Management argued the declining customers and generally weak results in 1Q17 were actually a positive! They argued MB is churning off low- priced customers and LTV is actually improving. However, CAC continues to skyrocket and churn continues to increase. The 1Q17 investor presentation showed rapidly decelerating growth of high value subscribers. MB's higher pricing makes new customer additions even more challenging. Churn is also accelerating as the high pricing is driving customers to alternative solutions.

MB management remains relentless in their “grow at any price” model because this move has always worked, even going back to when the company was VC-funded. You can read about how MB is a great place to work and it is apparent that this isn't a profit-focused company.

Slowing revenue growth, or the inability to hit profit expectations will force management to rein in S&M spending and the high churn, high CAC, low LTV model will be exposed. The recently lowered EBITDA guidance should be setting off the fire alarm considering the 25% price increase should provide a massive boost to EBITDA. I think we are finally at the inflection point where MB's questionable business model will be revealed.

Friendly Bear predicted that, “either the company gives up on the revenue growth dream and sees its multiple correct, or it fails to ever reach profitability and has to keep coming back to the markets for more cash.” That was prescient.  After lowering 2017 adjusted net income guidance after 1Q17 results, the stock rebounded and marched back to near all time highs. Management deftly raised $125mm by selling 4.4M shares at $27.95 on 5/24/17. Why would management raise capital when they have $90mm of cash, no debt, and are guiding for cash flow breakeven in 4Q17? The CEO has been a steady and consistent seller. He sold over $5.5mm in the last year and was selling his shares last summer as low as $12 per share.

What about the payments side?

It is also worth noting that a healthy portion of MB’s sales growth has come from the payments side of the business, i.e. processing payments where Mindbody collects a percentage of the revenues flowing through the platform. While customer growth and increased throughput at existing customers has driven some of the increase, the biggest driver of growth has been the increasing take rate of processing these payments.

Mindbody has increased its take rate from 0.61% in 1Q14 to 0.88% in 1Q17, a 44% increase in 3 years! This has largely been a function of using scale to lower vendor costs and capture a larger portion of the economics. Can this continue? Possibly, but conversations with industry experts suggest MB has already met or exceeded their long term targets. Squeezing out any additional economics will be increasingly difficult.

Is the increased take rate tailwind over? Mindbody’s take rate increased almost every quarter over the past 3 years but fell flat sequentially in 1Q17. Could this be another tell? Regardless, when Mindbody’s take rate stops growing, the payments business, which represents 40% of total company sales, will only grow as fast as new customer additions and customer SSS growth. This would represent a significant decline from the historical 40% growth and be a shock to analysts who expect 30+% growth to continue. If and when take rate growth stops, total company growth will massively decelerate. I suspect this could be a 2017 event.

SaaS model highlights weak LTV metrics

MB’s investor presentation highlights an LTV to CAC ratio of 6:1. From this presentation I understand why bulls think MB is a high quality SaaS business and their S&M expense is justified. However, I think the way management presents the numbers is a distortion and is flat out wrong. In a footnote, Mindbody says they calculate their LTV using this academic definition:

LTV: (Average Recurring Revenue per High Value Subscriber – Ongoing Cost of Revenue) / (1 – Monthly Recurring Revenue Retention Rate) in the period

The problem is MB’s recurring revenue retention is over 100% because price increases distort the actual customer retention rate. MB wants to focus on recurring revenue retention to avoid disclosing the actual customer churn metrics, which are actually very high. When trying to use MB’s method for calculating LTV, the denominator becomes a meaningless negative number.

Because Mindbody does not provide enough information to do a proper LTV or CAC analysis, I need to make an assumption about one of the variables in order to analyze the business. By holding churn constant I can see how MB’s critical SaaS metrics are changing. We will start by looking at how the business looks at a 4% quarterly churn rate or 16% annual rate. I encourage others to build a spreadsheet to run their own scenario analysis. It’s very simple.

Purple = estimate (churn), Blue = actuals,  Black = formulas

In row 16 you can see that MB’s LTV/CAC ratio is in the low 3’s and has generally not improved at all over this four-year time period. This is nearly half of the 6x LTV/CAC ratio that MB advertises. This is despite a 60% cumulative price increase which should drive LTV much higher. The problem is CAC is growing as fast or faster. Why does this matter?  Academic literature on the SaaS industry highlights how an LTV/CAC ratio of 3 equates to a low quality, borderline unsustainable SaaS business while LTV/CAC of 6-7x is viewed as high quality.

As you can see with row 11, MB’s average CAC payback has remained relatively flat over the last four years at around 2 years (20-24 months). A CAC payback above 12 months is generally frowned upon while “many of the best SaaS businesses are able to recover their CAC in 5-7 months.”( http://www.forentrepreneurs.com/saas-metrics-2/) MB’s CAC recovery is ~24 months! This is not indicative of a high quality business, and when factoring in ongoing company costs such as R&D and G&A, MB has an adjusted LTV / CAC ratio that is often below 1!

Critics of this analysis will argue it all hinges on churn. I agree. However, if I cut churn in half (2% quarterly, 8% annual) and likely well below MB’s actual churn, it increases LTV/CAC since customer lifetime now doubles, but the concern is the CAC payback is 3 years today. Another negative is that LTV/CAC would be getting progressively worse over time despite the massive price increases. See row 11 and 16:

On the flip side, if I increase churn to 6% quarterly and 24% annually you can see that while my CAC  payback improves to about 1.5 years, my LTV/CAC analysis is under 3x and also has not improved over time. Again, see 11 and 16 below:

No matter how you slice it, MB has unhealthy SaaS economics. Moreover, these economics have not improved despite a 60% increase in pricing! Eventually the weak unit economics will catch up to the reported results in the form of decelerating sales growth and continued operating losses.

High expectations and lofty valuation provide margin of safety to the short

Despite the large price increase at the beginning of 2017, MB did not raise 2017 sales guidance. More importantly, the guidance looks difficult to achieve. Year over year sales growth has decelerated almost every quarter and was 32% in 1Q17, while full-year guidance suggests growth will not decelerate. MB will likely have to increase ARPU 5% each quarter to hit numbers since net customer growth is likely be anemic. From the 1Q17 call: “net change in our subscriber count could fluctuate over the next couple of quarters before regaining strong positive momentum.” Perhaps MB is churning off low value customers and replacing with higher value customers, but I struggle to see how many high value customers are left to acquire.

2017 Sales estimate trends:

Despite guidance that looks unachievable, MB is trading near all-time highs and near a peak NTM EV/sales multiple of 6x. I remind you EV/Sales is the only way to value MB since EBITDA is basically zero.

At $28 a share, MB has an enterprise valuation of $1,070mm. With 60k customers, that’s a valuation of $18k per customer. Does a exercise studio have a present day value of $18k to MB? No chance. Look at MB’s adjusted LTV value in conservative churn situations. Even if we assume MB can hit the aggressive sell-side sales targets in 2017 and 2018 and if we use MB’s aggressive 30% adjusted EBITDA margin guidance on 2018e revenue of $225mm I get to $67mm of adjusted EBITDA. MB is trading at 16x that number! MB is priced for perfection while key underlying SaaS metrics are headed the wrong direction.

$16 Target, 40+% downside

A peak multiple on peak expectations is a dangerous combination. If 2017 revenues are $175mm vs $181mm, growth would be 500bps lower than expected and MB could re-rate back to its average multiple of 4x, or lower. With another miss, a 3x multiple on $175mm of revenues would equate to a $16 stock price. $525mm EV + $220mm of cash (following recent offering) / 46mm shares.

Conclusion

After 2 years of infuriating short sellers, MB is at a critical juncture where price increases are set to expose the lousy LTV economics of Mindbody’s business model. I think the problem is already starting to show up in the numbers. Nameste!

Risks

1. Bulls ignore any profit metrics and continue to focus on top line growth

2. Mindbody makes a strategic acquisition with its war chest of cash

3. Customers are more inelastic to pricing than dilligence suggests

4. LTV of customer improves. Churn stabilizes, customers accept price increases, and CAC stabilizes

Catalyst

Quarterly earnings reports