DH - Definitive Healthcare: Weakness In Performance Is A Function Of Macro Not Fundamentals

2023-05-31 04:10:33 ET

Summary

• DH faces challenges due to macro pressures impacting new business and growth prospects, but remains a strong business in healthcare data intelligence with a robust technological moat.
• Despite an elongated sales cycle and increased churn, DH has demonstrated its ability to win back customers.
• Considering DH's under-penetrated market, long-term tailwinds, and resilient business model, I reiterate a buy rating for the stock.

Investment thesis

The one thing I took away from the performance of Definitive Healthcare ( DH ) since I covered it was that it is really tough to go against the macro environment. First, I'd like to address the recent lackluster performance of the stock, which I attribute to the weakening demand environment that has been a drag on both new business and growth prospects.

In 1Q23 , The number of net new customers has dropped sequentially, and the expansion of business clients has slowed significantly. Despite an 18% increase to $59 million in total revenues, growth in deferred revenues and RPO slowed, further validating the existence of macro pressures are truly large demand headwinds.

I am still sticking to my guts that DH is a really good business that I continue to see as the industry leader in healthcare data intelligence, with a sizable technological moat and a sound financial profile. DH serves as a central hub from which users can glean an overarching perspective on the healthcare industry as a whole, or zero in on a specific subset of it, as well as discover relevant decision-makers to approach for sales.

In my opinion, DH is in a good position to benefit from a re-acceleration of top-line growth following a reduction in macro-level pressures. The Atlas data set , when coupled with generative AI capabilities, should be a major contributor to this growth going forward. As such, based on DH's large, underpenetrated market opportunity, numerous, long-term tailwinds, and well-rounded business model, I am restating my buy rating. That said, as we enter the uncharted waters of 2H23, investors need to be aware that share price and business performance volatility will likely increase.

Elongated sales cycle

This has been a common theme amongst many industries, where underlying customers are pushing deal implementations/closings further out as the uncertain macro environment has forced them to shore up cash in the balance sheet. Even DH hasn't been immune to the trend toward longer sales cycles. Ending 1Q23 with approximately 3,011 customers on the Definitive platform, DH saw continued pressure in the health provider and biotech markets, resulting in a 2.3% year-over-year increase but a 1.2% quarterly decrease.

There was also a decline in the number of customers with $100k ARR, which, at 529, represented an 18.3% increase year over year but a 1.9% quarterly drop. As end-market budgets continue to be squeezed, DH is continuing to see increased churn in 1Q23. Historically, sales cycles have taken anywhere from three to six months, with larger deals taking even longer; however, DH is now seeing an average extension of two to three months, which is negatively influenced by some deals being heavily scrutinized.

I expect this trend to continue throughout FY23. However, I do think that difficult times reveal the industry's true heavy hitters. To me, the fact that DH was able to win back a customer who had churned in 2022 demonstrates the efficacy of their lead generation and pipeline activities, as well as the value of their products and services. It clearly demonstrates that DH's solutions are superior and that customers are willing to return to DH even in times of uncertainty.

Guidance

I believe management reiteration of FY23 guidance is a clear statement that they are not expecting things to turn for the better in FY23. Given the ongoing deal delays, both new and existing pipelines, I find that to be reasonable. That said, one could argue that the guidance has reset expectations, and moving forward time is in favor of DH.

Management believes that there is an opportunity for revenue growth to reaccelerate in 2H23 if the macro environment improves from 2H22 and 1Q23 levels, which is not assumed by the FY23 topline guide. I believe a lot of investors and consensus are likely to just match their estimates with the current set of guidance. As such, when macro turns for the better, and DH performs better than-expected, a lot of this consensus will likely revise estimates, thereby driving the stock up.

Valuation

I figured my previous approach to modeling the company might not be the best way given the DCF was based on a 10-year outlook. As such, I have rebuilt the model using a forward revenue approach to better reflect the sensitivity to growth. My assumption is that growth will trough in FY23 (13%) followed by an acceleration in FY24 (16%).

I don’t think this assumption is very drastic given the business grew 18% LTM, and with my expectations of things starting to turn around next year, DH should also see easy growth comps. As DH accelerates its growth, we should see multiples moving upwards, at least back to where it was trading at the start of this year ~8x forward revenue. In my opinion, if DH can accelerate growth back to >20%, I would not be surprised to see multiples inflect further upwards.

Conclusion

Despite recent challenges in the demand environment affecting DH, I maintain a positive outlook on the company. The stock's lackluster performance can be attributed to macro pressures that have impacted new business and growth prospects. However, I believe DH remains a strong business, serving as a leader in healthcare data intelligence with a robust technological moat and solid financial profile.

The company's central position in the healthcare industry and its comprehensive data offerings position it well for future growth. Despite an elongated sales cycle and increased churn, DH has demonstrated its ability to win back customers. While management's FY23 guidance suggests a cautious outlook, the potential for revenue growth to reaccelerate in the second half of the year presents an opportunity for positive surprises. Considering the company's underpenetrated market, long-term tailwinds, and resilient business model, I reiterate my buy rating on DH stock.

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