AMWL - American Well Corp.: Reiterate Hold As I Await Converge To Be Fully Implemented

2023-06-06 05:09:14 ET

Summary

• I maintain a hold rating on AMWL due to concerns about churn impacting the stock in 2Q23, despite optimism about the company's long-term prospects.
• Good progress can be seen in the implementation progress of Converge platform, with revenue growth expected to resume in 2H23.
• I expect increased gross and operating margins after the Converge migration, which could act as a catalyst for share price increase.

Summary

Previously, I stated that I was positive on American Well Corp ( AMWL ) progress, which should be supported by behavioral health as a significant growth driver, and also when CVS begins to ramp up. However, due to the lack of information, I recommended a hold rating . As I wait for the finalization of the Converge implementation, my rating on AMWL remains at hold.

Despite my optimism regarding the company's long-term prospects, I have given it a hold rating due to concerns about the impact that churn will have in 2Q23. I'm worried that the stock will drop again if there are any bad headline numbers. Keep in mind that even with that 25% increase from the low of $2, the stock is still down significantly from the $4+ at the beginning of the year. The "selling pressure ahead" is still substantial, in my opinion. Positively (and in line with my long-term perspective), however, management has emphasized the rapid progress made in migrating to the Converge platform, with revenue expected to resume its upward trend in 2H23. Put together, it seems clear to me that the best time to invest would be in 2H23 when Converge settles, and management can start guiding aggressively when the benefits of Converge surfaces.

Converge implementation in focus

For readers that are new to the name, AMWL is a year into implementation and execution with focus on the Converge platform. The good news is that implementation is on track to completion over the next 12 months. Since the number of new customers migrating to the legacy platform is expected to be negligible after FY24, the full effects of Converge will become apparent at that time. While all is good, I like to this migration just like many software companies that migrated their customers to cloud (from on-premises). The fact of the matter is that with each migration, especially a large one like AMWL, there will be churn. There are 2 types of customers that will churn, in my view:

1. User that are not heavy users and typically only use limited functions like video conferencing. AMWL does not provide a lot of value to these group of users, and they are likely to switch out when it gets “troublesome”.
2. Users that have been unhappy with AMWL solutions, service, etc., but stayed on because it is easier to continue using than evaluate and migrate. These groups of users will likely churn when they are forced to evaluate other choices (in this case is AMWL migration to Converge).

For these two groups, they will be hard to retain and upsell further products anyway, so I view them as low-quality customers that will eventually churn. Fortunately, management reported that they had seen only a little churn in the middle market and none at all among their most valuable strategic clients.

Margin

I would be on the lookout for increased gross and operating margins after the migration. With respect to gross margin, it should benefit from the sunsetting of the legacy platform (which saves ~$5-10 million a year), and I expect gross margins to benefit as mix shifts away from Visit revenue (~50% of total revenue). Since Visit typically have gross margins in the mid-20% range and subscription businesses typically have margins in the 60+% to 70% range, the latter impact would have a greater cumulative effect over time (subscription will eventually take up most of the mix).

As for EBIT margin, I expect the R&D line to decline as the Converge transition is completed. This is an important point to note and model as there is a sizable amount of R&D spend tied to the development of Converge that is going to flow out of the system. If we look at management’s guide, they reiterated that R&D in 4Q23 will be more than 20% below the prior year level – which is a tell-tale that AMWL will see greater operating leverage from then on. All in all, I believe margin is going to inflect at some point, and that will be a catalyst to the share price increasing.

Valuation

The most difficult part of modeling AMWL today, in my opinion, is determining what multiple it will be worth once growth accelerates with a more visible path to profits. Start from the revenue forecast, as I mentioned earlier, FY23 is going to be pretty much a muted year, but growth will start inflecting in FY24 as AMWL sees no more incremental churn.

Following the migration, management will be able to devote all of their efforts to driving growth. The tricky part is modelling profits which are still in negative territory today. It will take some time for margins to inflect to positive territory, which I believe the market is heavily discounting. Nonetheless, given the better growth outlook and margin profile (FY21 revenue grew only 3.1% with a -58% adj. EBITDA margin), I believe the stock would be valued at least at the same multiple as it was in late FY21. However, I reiterate that the best time to buy is likely to be in 2H23 or even FY24, as the migration will be nearly complete by then.

Conclusion

My current rating on AMWL remains at hold. Although I am optimistic about the company's long-term prospects, I have concerns about the potential impact of churn in the second quarter of 2023. The stock has already experienced significant downward movement, and I worry that any negative headline numbers could cause further decline. However, management has highlighted the progress made in migrating to the Converge platform, with expectations of revenue growth resuming in the 2H23. As such, I believe the best time to invest in AMWL would be in 2H23 or even in FY24 when the Converge migration is nearly complete and management can provide aggressive guidance based on the benefits of Converge. Additionally, I anticipate increased gross and operating margins after the migration, which could act as a catalyst for share price increase.

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